Why Groupon Can Actually Hurt Business

So I punched out some quick math today regarding Groupon and saw some pretty enlightening stuff. You may have noticed that Groupon has things such as $40 for $20 as promotional offers for restaurants and services. However, from the restaurant industry standpoint the increased volume doesn't necessarily equal a profitable endeavor.

Take a restaurant for example that has a profit margin of 10%, average for the industry. A sale of $40 would yield a profit of about $4 ($40 x 10%), meaning $36 of that $40 sale is going to pay for cost of food, rent, and all other costs associated with the restaurant's operations. If we suddenly drop that sale price to $20, each sale is now actually costing the restaurant $16 ($36-$20) instead of making them $4 in profit,  so we now have a cost per coupon of $16. Wow, very expensive!

Now we need to factor in the change in volume, for example, how much does it cost to feed 160 versus 80, because it isn't simply 80 x $36 or 160 x $36. There are economies of scale at work here. How much does it actually cost? I don't know, that would be on a case by case basis. However, I can imagine that the incremental change in volume needed in order to actually turn a profit on such an offer starting at a $16/coupon disadvantage would need to be tremendous.

Instead of looking at Groupon as a money making endeavor, it's probably best viewed as a marketing expense. At a cost of $16/coupon used, the restaurant exposes itself to new clientele that otherwise may not have come in the first place, in the hope that they can convert the discounted sale into a full priced sale sometime in the future. The present value of that future sale? Again on a case by case basis, but assuming the 10% profit margin, the sale would need to be higher than $160 (present value) on a group of the same size just to break even on the marketing investment.

But then again if Groupon is just a marketing expense now, why not use a service such as OpenTable that has a network marketing aspect, costs significantly less per cover, and actually contributes to the bottom line?

The Stock Market is a Lot Like Baseball

The stock market has always amazed me. It's such an integral part of our economy, our jobs and our financial futures yet the average person has very little knowledge as to how it functions. You would think that such an important aspect of our daily lives would have been taught to us in school, yet we walk away with only basic economic concepts.

The underlying fact is that because so many people know little about it, investing can be a daunting and in the case of Madoff, be a harmful experience. So much relies upon what we have already accumulated, yet we still aren't where we want to be. Understanding the stock market and how it functions can help us make investment decisions with a little more confidence.

The stock market can be compared to the World Series. There are two teams, announcers, an audience and a whole bunch of other components that really tie the two together concepts together in similarities.

In the stock market there are buyers and sellers, these can be likened to the two teams playing. There are two teams playing against each other and only one will win. The fundamental truth here is that in order to buy a stock, someone has to sell it to you. That means that the person selling it to you thinks no more economic value will be extracted from it while you think there is still potential. One of you is wrong.

Another component in the stock market is mutual funds. Mutual funds are the employees who work in the back office for the championship team. They'll get a ring if their team wins, but their bonus is never as big as the players themselves.

The audience can be likened to index funds, they're just there to watch be at the game and win over time just for being there. However, they don't really see any immediate benefit besides exposure to the game.

The announcers are like Wall Street, calling the play by play and reporting on recent happenings. They sway between excitement to lethargy depending on what is happening in the moment. However, as knowledgeable as they may seem, they cannot be relied upon to accurately predict the long term outcome. The only thing they do is broadcast and sometimes point out arbitrary facts.

Now that all the basic components of the stock market have been described, we need to talk about the game itself. Now while a typical World Series game lasts nine innings, the stock market world series is game that doesn't end. So how is a winner determined? The winner is determined depending upon the individual time horizon of the players on each team.

So if you are buying Procter & Gamble for a long term investment and it drops in the short term, you haven't lost the game yet until your time horizon has been reached. This allows there to be multiple winners and losers all simultaneously, making the game a little more fair to the participants involved.

Also, unlike the World Series where only one game is played at a time, there are many games being played all at once in the stock market depending upon what stock you are talking about. Each stock has its own game being played. So there is the Johnson & Johnson game being played along side the Procter & Gamble game and so on and so forth. As an investor, you will find yourself playing in different games on all different teams depending upon the position you've taken in your portfolio. Some you may feel are going to be winners making you a buyer, while some you may feel is going nowhere or down, making you a seller (or even a short).

This sort of competitive play goes on in all the different markets associated with the stock markets (derivatives, CDS's, futures, etc.) and it is up to you as an investor to decide what games you want to be in and what your role is going to be. Are you a player, a back office manager, or an audience member? It depends upon your strengths and comfort level in the games you are a part of.

(This article originally posted on April 19th, 2010 on Technorati. Read the original article here.)

Refining The Capital Asset Pricing Model for Practical Investment Use

The capital asset pricing model is a great display of academic prowess in financial theory. However, it does have its limitations. Mainly, the criticism it receives is that it makes a number of assumptions that do not necessarily hold true in market conditions. The biggest one I feel is is the beta coefficient, or β.

To break it down the capital asset pricing model (CAPM) is a way of determining the cost of equity for a company. This is often also referred to as the investor's expected rate of return for investing in a security. The formula is as follows:

where:

E (Ri) = expected rate of return of investment i
Rf = the risk free rate of return (usually the 10-year bond return)
βi = beta coefficient of investment i (the individual price volatility of the investment relative to the market as a whole).
E(Rm) = expected return of the market as a whole


The biggest concern is with β. The capital asset pricing model as it stands alone assumes that the riskiness of an investment is based upon the past price volatility of the investment. This is HUGE assumption, because future prices cannot be accurately extrapolated from the past prices. Market prices of a security are determined not only by supply and demand from investors, but also the profitability and growth prospects of a security. The beta coefficient is assuming that market prices are efficient and that all information is known to all investors.

However, we know that not all information is known to all investors, and not all information is important to all investors. Also time horizons for investors differ (another huge assumption of the model), therefore even if all information was known, some information may disregarded by short term investors if it does not serve their time horizon. The information that a trader will be looking at may affect his view of the price, while a long term value investor may see information that reflects his view of the price.

In present circumstances, the current market prices are the averages of investor perceptions. Therefore, if most investors are arguably short term oriented, the price of that stock will more favorably reflect short term prospects. For example, if Ford stock has low upwards movement prospects in the short term because Ford is taking non-cash charges (thus reducing current earnings) , the majority of investors may be uninterested in that stock, and the price of the stock will reflect there lack of demand for it.

This is why it is important to have a somewhat longer investment horizon. You want to account for short term prospects and long term prospects. Yeah, Ford may be taking short-term non-cash charges and reducing their earnings, but is a non-cash charge really a reflection of a change in business value, especially if the company is still making adequate capital expenditures to improve the business for the long term?

The market is not perfectly efficient, which gives the individual investor an edge if they are willing to resist the temptation of short term sentiments.

So how do we adapt CAPM for reliably determining the cost of equity? Simplistically, an investor can expect the market to return 11% on average over time. Therefore, it is reasonable to say that an investor should expect no more than an 11% return on average from their portfolio (this is supported by the latest indexing fad).

Even though the expected return may fall short of what an investor's actual return may be, it is fair to say that a prudent and rational investor should expect no more than what the market will return (unless of course the risk free rate were to exceed that, in which case the last thing anybody would be concerned about is their return on investment when the whole market is collapsing!).

With the cost of equity set to be at a value of 11%, the discount rate for a security can thus be figured out by the company's weighted cost of capital, utilizing the borrowing rates of a company after taxes and our constant cost of equity. Thus we have a maximum discount rate for a public company to be no more than 11%* (if the company is 100% equity financed).

This figure to me seems fair, considering Warren Buffet discounts utilizing only the risk free rate.





*This discount rate only can be comfortably applied to non-controlling shares of publicly traded companies of a reasonable size (excluding micro caps) without getting into liquidity discounts, size discounts, and control premiums.