Friday, October 3, 2008

Common Size Comparisons

At a certain point in time, you may believe in the future prosperity of a certain industry. You may wish to compare various companies within that industry in order to handpick a few select companies that meet your criteria. But companies come in various shapes and sizes, so what's the best way to compare their income statements? One helpful method is to create a common size income statement, which states each item as a percentage of revenue.

For the most part Coke (KO) and Pepsi (PEP) are in the same industry. But with their differing sizes, it's difficult to make a meaningful side-by-side comparison of their income statements. Depicted below, however, is a common size statement for each of these companies from 2007, with each item representing a percentage of each company's respective revenue:

We clearly see that Coke can charge a premium for its products as compared to Pepsi, as its cost of goods sold is only 36% as compared to Pepsi's 46%. We also see that for every $1 of revenue Coke makes, 21 cents is pure profit, compared to only 14 cents for Pepsi. At the same time, Coke has higher operating expenses. We can't tell why from this statement, as I chose to bundle expenses into major categories, but one could easily breakdown the income statement into smaller categories to get a better idea of which company is investing a bigger share of its dollars in advertising or R&D for example. If one company is under-investing in a category you deem to be important, it will show up here!

Of course, this is only the income statement. One could also construct a common size balance sheet in order to compare each company's relative assets. And of course this wouldn't be a post on Barel Karsan if we didn't remind you to also read the notes to the financial statements, not just the financial statements themselves, as you can find all sorts of useful info there from things like corporate airplanes to disclosures on outstanding stock options, which can at times be punitively high.

2 comments:

Anonymous said...

Well, let's see: Coke has beverages and just about nothing else. PepsiCo has Pepsi, Tropicana, Naked, Frito Lay, Quaker Oats, etc. PEP is much closer to a packaged food company hence the margin difference. They are NOT "for the most part in the same industry". Look at CCE vs. PBG if you want similarities.
BTW I like the book summaries.

Saj Karsan said...

Hi Anonymous,

You're absolutely right. My intention was not to compare PEP and KO as much as it was to demonstrate how one might compare two similar companies. You are quite correct that Pepsi's diversified products make the KO/PEP comparison difficult.

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