Inflation

Remember, income taxes can never turn a positive business into a negative one.  Even if tax rates are 90%, the business is still profitable.

Inflation is the real killer.  If a business earns 20% ROE (Return on Equity) and inflation is 10%, they have just halved their profit. Add in corporate income tax of 50% and they earn zero.  zilch. nada.

Always be aware of the economic condition in which a company is operating.  It will help you realize what kind of gains are illusory and which ones are genuine.

For example, company A exists in an environment of 20% taxation, with an inflation rate of 5%.  They earn a 10% ROE.  Therefore, their real ROE is (10%*(100%-20%) - 5%) or 3%.  Now if inflation suddenly doubles they are really in the hole -2%.  However, due to the fact that everybody pays more money for goods and services they are still posting a paper profit, and may in fact, be bringing more dollars in the door.  But remember, it's not how much you make, it's how much you keep.

A simpler way to look at it is this:  if a company has to pay more for its inputs (supplies) then it must naturally have to charge more for its outputs (products) in order to maintain the same operating margin.  If it does not then it will lose economic strength regardless of whether more money is coming in the door.  The important question is, is it coming in at the same rate or ratio?

Most companies do not operate in an environment that allows them to ramp up costs at will and thus, in inflationary times, end up losing some ground.

5 ways for a company to increase Return on Equity

1. Increase asset turnover (sales/assets)
2. Widen Operating Margins (profits/expenses)
3. Pay lower taxes
4. Increase leverage (more debt)
5. Use cheaper leverage (refinance)