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Percentages not points vs Rising Gross and Net Margins

First let me say that I thoroughly enjoyed the Rule Breakers, Rule Makers book and intend to use the model. Second, a disclaimer stating that whilst I regularly read the website, I am not a regular to this board so the things I mention may already have been covered.

I have been reading this book with a critical mind, analyzing the motives of the authors as much as they exhort us to analyze the motives of brokers and the "wise". So far I believe that whilst what motivates brokers and what motivates investors are at odds with each other, what is best for this web site and the Fool culture is the same as what is best for investors in general. However I will maintain a continuing analysis to ensure this doesn't change.

Now on to two points about this book. First is a minor point. Has anybody picked up the typo on page 242-243? Disney's net margins are 9% and under the model given, that earns 1 point not two. Minor but something which can be changed for the next edition in the pursuit of excellence.

Secondly, the discrepancy between Chapter 7 entitled "Percentages not points" and page 264 "Six metrics of business momentum". Under the criterion for Rising Gross Margins and Rising Net Margins, the model uses 3 points for growth, 2 for falling 0-0-1%, 1 for falling 1-3%, and 0 for falling greater than 3%.

The problem is when you compare percentage points to percentage points, it becomes a point not a percentage. Huh??? Scratching your head in confusion?

Lets do an example. Business AAA has net margins of 15% in 1997 and 12% in 1998. This drop of 3 percentage points gives it a score of 1 point. Compare Business XXX which has net margins of 4% and drops to 1%. This drop of 3 percentage points also gives it a score of 1 point.

But AAA has dropped it net margins by (15-12)/15 = 20% whereas XXX has dropped its net margins by (4-1)/4 = 75%.

Understandably the two parts of the book were written by different people. Also, using points instead of percentages is a simpler method, misleading but simpler (as mentioned in Chapter 7). Additionally, the Financial Location point system does balance out the Financial Direction slightly (because the Location point takes into account the size of the net and gross margins).

However in the spirit of never pointing out a problem if you have no solution to offer, I offer the following.

Strictly following the book, under Chapter 12, "A measure of excellence" page 221 gross margins above 60% 2 points, 40-60% 1 points, below 40% 0 points. Therefore, take the mid point as 50% gross margin.

A 1% gross margin drop to 49% actually equals a 2 percentage point drop in gross margins. A 3% gross margin drop to 47% equals a 6 percentage point drop.

So altering page 264 (Rising Gross Margins) slightly, I suggest if gross margins grow it should earn 3 points. If fallen by less than 2 percentage points then it should earn 2 points. If fallen between 2-6 percentage points it should earn 1 point and falling greater than 6 percentage points it shouldn't earn a point.

Following the same method for Net Margins page 223, we find the mid point to be 8.5% net margins.

A 1% net margin drop to 7.5% actually equals a 12 percentage point drop (rounded to nearest full percentage point). A 3% net margin drop to 4.5% equals a 35 percentage point drop.

Therefore net margins grow = 3 points. Net margins fall by less than 12 percentage points = 2 points. Net margins fall between 12 and 35 percentage points = 1 point. Falling by greater than 35 percentage points = 0 points.

It may be that the net margin percentage point drops are too excessive but that's subjective so lets not get into that. In this, I've used the book as much as possible, only pointing out the discrepancy on Chapter 7 "Percentages not points" with the Rising Gross and Net Margins. I've tried to avoid any personal opinions.

This level of complexity may be at odds with the model being simple to use. I just offer this up as a criticism and solution so that everybody keeps their minds lively and continues to question that which is given to them instead of blind acceptance.

With humility and a lopsided smile,

realzen

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