The Secret Ingredient Behind Profits

Consider Apple, whose current market value is 2.53 trillion, highest in the world, well above Saudi Aramco. This is no flash-in-the-pan. Apple became the first US company to surpass $1 trillion in market value, in 2018. How come? What is Apple’s secret ingredient? How did it get to create $2.53 trillion in wealth? It is not so secret. It is the combination of value creation and cost reduction.

Consider iPhone 6, launched back in 2015. (See Figure). Apple never discloses cost data. But many have taken apart iPhones and tried to estimate the source and cost of components. The Figure shows that the cost of producing an iPhone, sold for $649 retail, is about $200. That leaves a hefty $449 profit margin. That will pay for a lot of innovation and continued sustained value creation. (The numbers are illustrative). But that is only half the story. Why are millions willing to pay $649, in 2015, for a cell phone? And why would they pay, on average, say, $700? Because it creates value for them, serious value. This is the value margin, the gap between what people receive (in monetary terms) and what they give (in paying the price). Or call it ‘social margin’. It is high enough to generate queues when iPhone launches occur, and crucial customer loyalty, we are now at iPhone 14.

Another good example of value margin is found in Moneyball, The Art of Winning an Unfair Game, a 2003 book by Michael Lewis. It is about the Oakland Athletics major league baseball team and its general manager Billy Beane. That team used an analytical, evidence-based approach to assembling a competitive baseball team, despite Oakland’s small budget. [1]

How? By identifying high-value players, using data analysis to spot them, who were largely unappreciated and hence, low cost. It was not complicated. Can the player hit? Can the player create runs? (Value). And then, what is the player’s salary (Cost)? Value up, cost down. The Oakland A’s are not Apple. But they did win the 2002 American League West, a huge surprise, losing only to the Minnesota Twins in the American League Division Series. Many teams now use Moneyball methods.

An investment strategy focused on the two secret ingredients might work as follows. Check out a company’s products. Are they relatively expensive? And despite this, do people love them? Really love them? Enough to pay a pretty penny and still be truly happy? This is value margin, or customer margin. If it is high and sustained, customers become clients. Apple has clients, not just customers, they come back, again and again.

Making a profit is not a mathematical exercise of cutting costs below revenue. Businesses have tried that, slashing costs, laying off workers, slashing R&D budgets, and went out of business. Value creation is about maximizing value of your product, which allows you, with diligent management, to charge a price that has a sufficient margin for sustainable profits and continued innovation. That’s the simple, not-so-secret ingredient for longevity of a company.

[1] Oakland’s budget was the third smallest in 2002 of the 30 teams, and just over a quarter of that of the New York Yankees.

Originally published on Noam Maital's Medium blog.