The Perfect Apple

And How It Can Be Destroyed

By V. Laxmanan, Sc. D.

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Hello World!
I am retelling here a story that has been told in another article with a long, wordy and nerdy, title. Now, I am just going to call it the story of the Perfect Apple! And, how it can be destroyed! Yes, it can happen and that is what I fear might happen soon. Apples conjure up warm images within our hearts. Ah, that raw bite and taste of a delicious and sweet apple! An apple a day keeps the doctor away, we all learned in elementary school. Then we heard about the apple that fell on top of Newtons head which led him to think about gravity. That apple tree still stands but no Newton seems to be sitting under it anymore. Then, we heard about the apple tree that George Washington cut. Or, was it a cherry tree? No one knows for sure and many think it (the story) was a lie, about Washington saying he cannot tell a lie! What a lie really about never lying! But, this is a true story about another Apple. About that Apple we have all come to love and admire, over the last decade or so. I could not believe what I found while I was analyzing the financial data of various companies (my recent foray into this started as a result of the Facebook IPO fiasco). The profits-revenues data for Apple Inc. shows a PERFECT positive correlation with r2 = 0.99985. This is as PERFECT as it can ever get. Physicists, chemists, biologists, engineers, and doctors, would all love to see such a PERFECT correlation in their experimental results. My analysis shows y = 0.278x 4.28 for Apple, Inc. where x is revenues and y is profits, both in billions, for the years 2008-2011. But, this PERFECT Apple faces the real danger of being destroyed! Yes, it can happen soon, because Wall Street analysts do not seem to be aware of this simple linear law. They use ratios like the profit margin y/x, or the earning per share (EPS). Wild speculations and unreasonable expectations about future profits and profit margins can indeed destroy Apple. Now, do read the full story. The Apple story is told at the very end, after many other examples are discussed. I await the friendly decision of my readers! (Read on and find out who said this first!)
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Table of Contents
Topic No.
1 2 3 4 5 6 7 8 9 10 11 12

Topic
Summary Introduction Hewlett Packard, HP Verizon Communications International Business Machines, IBM Microsoft Yahoo! Delta Air Lines Apple Appendix 1: Analysis of Ten-year data for Apple Einsteins Heartiest Laugh Appendix 2: Mendels law and One-third law Business

Page No.
4 6 10 13 16 19 26 30 35 40 49 50

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Some Examples of Corporate Financial Behavior

A Brief Analysis of some 2012 Fortune 500 companies based on simple mathematical laws describing the financial world

Summary
The main purpose of this document, which will be frequently updated, is to provide an ongoing analysis of the profits-revenues data for various companies, operating in different sectors of the economy, in different countries, under different tax laws, under different social, political, and economic climates, to show that, nonetheless, simple mathematical laws describe the behavior of companies worldwide. This is due the same statistical averaging process that takes place at the microscopic level, in the world of physics, but which leads to simple, testable, mathematical laws at the macroscopic level.

As we will see here, three types of linear behavior, called Type I, Type II, and Type III, behavior are implied by the simple linear law y = hx + c relating revenues x and profits y. A company exhibits Type I or Type II behavior if profits increase with increasing revenues. It exhibits Type III behavior if profits decrease with increasing revenues (or contrarily, if profits increase with decreasing revenues, yes, some companies seem to do it). A more complex behavior is the nonlinear power law and the power-exponential law. The appearance of Type III behavior also
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usually seems to be accompanied by the appearance of a maximum point on the profits-revenues graph (and thus nonlinearity). Type III behavior, and the appearance of the maximum point, in particular, call for URGENT action to restore long term viability and profitability of a company. Ford Motor Company and Verizon Communications are examples (revealed to date, and, perhaps, Yahoo!) of companies which appear prominently in the Fortune 500 list that reveal the maximum point (dubbed Mount Profit). Another small company, currently ranked number 2 in the Fortune Small Business 100, also reveals the Type III behavior. Yahoo also exhibits an interesting variant of the Type III behavior (profits increasing with decreasing revenues) and seems to be operating past its maximum point. The methods of financial data analysis advocated here have served the physical and engineering sciences very well over the centuries. The times may be ripe to extend them to business, economics, and management sciences. Finally, as we will see, the financial data for each company studied here, all of which appear in the Fortune 500 list for 2012, tells a little story. If we can understand this story, we can also understand how to turn the company into a profitable one and get its Profits Engine all revved up. Revenues Costs

Thermodynamics

Profits

From an understanding of Heat Engines to an understanding of Profits Engines

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Introduction
As noted in several recently published articles by the present author, all available on this website, we can think of money in economics as being just like energy in physics. Hence, the power-exponential law, see equation 1 below, with x being revenues and y being profits, may be thought of as a generalization of Plancks blackbody radiation law that can be extended from physics to economics with a simple reinterpretation of the meaning of the various mathematical symbols. y = mxn [ e-ax/(1 + be-ax) ] + c (1)

This law with (c = 0 and b = - 1) was first derived by Max Planck in a paper presented to the German Physical Society in December 1900 paper (and published in January 1901). Planck, who had despised statistics and probabilistic arguments all his professional life (that were increasingly becoming fashionable, especially those claiming a violation of the second law of thermodynamics at a microscopic level, first advanced by James Clerk Maxwell with his famous creature called the Maxwells demon), finally, and in an act of desperation as he puts it, decides to uses some rather simple and straightforward statistical arguments (from the theory of permutations and combinations) to derive the above law. This law can be readily extended beyond physics to economics and the financial world using the same statistical arguments, if we invoke the analogy of energy in physics = money in economics. This is readily understood if one studies the example given by Boltzmann, in a paper published in 1877, where he shows how to distribute a fixed amount of energy between seven different molecules. This is also the starting point for Max Planck when he developed quantum physics in 1900. The many different ways (W) of distributing a fixed amount of energy (among many molecules of a gas, for example) gives rise to what is known as entropy S. The formula relating S and W is S = k ln W where the proportionality constant k is now called the Boltzmann constant. Instead of energy distribution, we can use the exact same example given by Boltzmann to understand distribution of money (or revenues) between N different people (in a social context), or N different products of a company, and so on (in the financial, or economic context). http://www.scribd.com/doc/95728457/What-is-Entropy
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Plancks blackbody radiation law, i.e., equation 1 above, was derived using the general formula for entropy S and the energy distribution (P units among N entities) given in this 1877 paper by Boltzmann. This is, perhaps, the simplest explanation that can be advanced for extending Plancks law from physics to economics and beyond. Consider now the following, even more simple, argument. In his famous 1905 paper (which actually fetched him the Nobel Prize), Einstein uses a simplified version of Plancks law to explain certain puzzling aspects of the photoelectric effect that were not fully understood more than 100 years ago. Einstein shows that light can be thought of as being made up of imperceptibly small particles (now called photons), each having a fixed energy hf where f is the frequency of light and h is a constant called the Planck constant. Hence, when light falls on the surface of a metal, the photon, with energy hf, transfers some of its energy to the metal and ejects electrons from within it surface. The maximum kinetic energy K of the electron is given by the simple linear equation K = (hf W) where W is now the energy that must be given up to eject the electron. This is simply a statement of the law of conservation of energy. The photoelectric law is a simple linear y = hx + c which can be thought of as a special case of equation 1 above. The graph of K versus f is a straight line with a slope h and an intercept c = - W. The photoelectric law is very similar to the law Profits = Revenues Costs that describes the behavior of the financial world. Not all of the revenues appears as profits. Some of it must be given up, like some of the energy of the photon, and only a part of the total energy hf appears as the energy of the electron, K. Likewise, only a small part of the revenues appears as the profits. Just like K depends on the nature of the metal, specifically the work function W, the profits produced depends on the nature of the company, specifically its cost structure. Indeed, the linear law, y = hx + c, relating profits y and revenues x may be shown to be a consequence of the classical break even analysis for profitability of a company and has been discussed in earlier articles. Imagine a company producing and selling N units of a product. The total costs C is the sum of the fixed costs a and the variable costs bN which depends on the number of units produced and sold. Thus, C = a + bN. If p is the unit price, the total revenues R = pN. Hence, it follows that the profits P = R C = pN a bN =
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(p b)N a. Eliminating N = R/p, we get, P = [(p b)/p]R a which implies a simple linear relation between profits P and revenues R. Several examples of companies that follow the three types of linear laws (depending on the relative values of h and c, positive or negative) and nonlinear laws (depending on the values of the power law index n, which may less than or greater than unity, n < 1 or n > 1), which can be deduced from equation 1 above, have already been discussed in earlier articles. The most dramatic confirmation is, however, the maximum point on the graph of profits versus revenues, implied by equation 1. This maximum point is actually observed in the graph of profits versus revenues for Ford Motor Company for the years 1990-2011. Further details may be found in the two documents listed below. 1. http://www.scribd.com/doc/94325593/The-Future-of-Facebook-I The Future of Facebook, Published May 21, 2012. 2. http://www.scribd.com/doc/94647467/Three-Types-of-Companies-FromQuantum-Physics-to-Economics Three Types of Companies: From Quantum Physics to Economics, Published May 24, 2012. 3. http://www.scribd.com/doc/95140101/Ford-Motor-Company-Data-RevealsMount-Profit Maximum point on profits-revenue curve revealed by Ford Motor Company, Published May 29, 2012. 4. http://www.scribd.com/doc/95329905/Planck-s-Blackbody-Radiation-LawRederived-for-more-General-Case Published May 30, 2012. The main purpose of this document, which will be frequently updated, is to show that the simple linear relation holds when we consider the behavior of several companies from the real world, from many different sectors of the economy. In what follows, we will provide first a table of the profits and revenues, obtained from publicly available financial data (with a logo of the company to highlight the discussion) along with the x-y plot(s) of profits versus revenues to highlight the simple mathematical laws that apply, regardless of the seemingly many different complexities that govern corporate behavior. The same complexities apply in the physical world as well. As discussed by physicists, when the kinetic theory of gases was first conceived (by Rudolf Clausius, in the mid 1800s, and then greatly extended by James Clerk Maxwell and Ludwig Boltzmann in the 19th century),
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there are zillions of microscopically small particles within a gas, moving chaotically in all directions, colliding with each other and with the walls of the container (and obeying Newtons laws of motion, sometimes even relativistic arguments have been advanced for very high velocity molecules). At any given instant, the particles are moving at many different velocities. Nonetheless, there is a statistical averaging that describes the velocity (and hence the kinetic energy, or more generally just energy, distribution). The Maxwell-Boltzmann velocity distribution, which gives the number of particles with a given velocity v, is also a special case of the mathematical law given above as equation 1. The maximum point on the velocity distribution curve gives the most probable state. The average energy is usually less than this most probable energy. Likewise, using the analogy between energy and money proposed here, we can begin to make progress to understand the chaos or the entropy that seems to govern the financial world and the economy as a whole. The arguments are really quite simple and have been discussed in some detail in the references cited above. We will now consider some of the leading companies in the annual Fortune 500 list to illustrate the three basic types of companies by considering the annual profits-revenues behavior. The following link gives the Fortune 500 list for 2012. http://money.cnn.com/magazines/fortune/fortune500/2012/full_list/ A quick listing of companies (to date) showing the different types of behavior predicted theoretically using the mathematical law given by equation 1 above. Linear law Type I: HP, Verizon, IBM, Microsoft, Yahoo! Delta, Apple Linear law: Type II: Microsoft Linear law: Type III: Verizon, Yahoo! Maximum point on Profits-Revenue curve: Ford, Verizon

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Rank 10 in Fortune 500 List published in 2012

Investor Relations > Financial Information

Fundamentals - Annual Income Statement

http://h30261.www3.hp.com/phoenix.zhtml?c=71087&p=irol-fundIncomeA Year Revenues, x $, millions 39,330 42,371 45,226 48,870 56,588 73,061 79,905 86,696 91,658 104,286 114,552 118,364 126,033 127,245 Profits, y $, millions 2,678 3,104 624 3,561 -903 2,539 3,497 2,398 6,198 7,264 7,660 8,329 8,761 7,074 Profit margin, y/x

1998 1999 2001 2000 2002 2003 2004 2005 2006 2007 2009 2008 2010 2011

0.068 0.073 0.014 0.073 -0.016 0.035 0.044 0.028 0.068 0.070 0.067 0.070 0.070 0.056

The x-y graph for HP, see Figure 1, reveals a simple linear trend, with profits increasing as revenues increase. Of course, there is a lot of scatter in the graph but the upward trend is unmistakable. Notice also the best-fit line (deduced using classical linear regression analysis), obviously does NOT pass through the origin of the (x, y) plot here but makes a finite positive intercept on the revenues (x) axis. In other words, revenues must exceed a certain minimum value before the company can report a profit. This is called Type I behavior, see Ref. [2] above. Many companies exhibit this Type I behavior (for example ExxonMobil, which heads the Fortune 500 list, discussed in Ref. [2].) However, as companies grow and mature, this Type I behavior gives way to Type II and eventually Type III behavior. The maximum point on the graph of profits versus revenues revealed for
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Ford Motor Company represents this transition from Type I to Type II to Type III behavior.
12,000 10,000

Profits, y [$, millions]

8,000
6,000 4,000 2,000 0

x0
-2,000 0 25,000 50,000 75,000 100,000 125,000 150,000

Revenues, x [$, millions] Figure 1: The Profits-Revenues graph for Hewlett Packard (1998-2011) revealing Type I behavior, y = hx + c =h(x x0) with x0 = - c/h, with x0 > 0 and c < 0. The equation of the best-fit line y =0.079x 2075.35. The constant h = 0.079 is the marginal rate of increase of profits (MRP) and is similar to the marginal tax rate in tax law. A fixed increase in the taxable income always leads to the same fixed increase in the taxes owed. Likewise, it appears that a fixed increase in revenues always yields the same fixed increase in profits. The constant value of h 0.08 is also supported if we consider individual (x, y) pairs such as the 2007 and 2008 data which yields h = 0.076, or the 2006 and 2010 data, which yields, h = 0.07. The earlier data, for 1998 and 2000, yields h = 0.093 and suggests, perhaps, an increase in costs as revenues have increased over the last decade. Hopefully, companies, like HP in this example, will be able to draw and benefit from such lessons that can be gained from such as analysis of the profits-revenues data.
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Leo Apothekar, President and CEO HP Annual Report 2010

For the year we delivered:

Net revenue of $126 billion, up 10% year-over-year. GAAP Operating Profits of $11.5 billion, up 13% yearover-year.

Notice that revenues have grown steadily and more than doubles since 1998, the first year for which data has been compiled here. The revenues were nearly $40 billion in 1998 and had more than doubled to $86.7 billion in 2005 (eight year period) and have continued to grow since then. The revenues were nearly 50% higher in 2011 compared to 2005. Profits have nearly tripled between 2005 and 2011. But, in the earlier period, from 1998 to 2005, profits did not register the same behavior although the general trend of increasing revenues with increasing profits is revealed by the x-y graph. The simple analysis here actually reveals the importance of the nonzero intercept c, which is related to the fixed costs of operation. Hence, the familiar profit margin y/x used to analyze corporate performance is essentially a misleading one. If the law relating profits and revenues is y = hx + c, the profit margin y/x = h + (c/x) can either increase or decrease in unpredictable ways depending on the nonzero c, or the fixed costs. The slope h, or the marginal rate of increase of profits (MRP) is a much better indicator of corporate profitability and performance. For HP, only about 8% of the increase in revenues, on the average, appears as profits, i.e., h is quite low. Like the work function W in Einsteins photoelectric equation, each photon of energy hf is only able to produce an electron with the kinetic energy K since an amount W must be given up. Likewise, for HP, for every $1 billion increase in the revenues, about $920 million must be given up and only $80 million appears as profits. Only a reduction in the work function (which is related to its cost structure) for HP will yield a long term increase in profitability and increase in the slope h (or MRP); see example of IBM, Fig. 4.
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Verizon Communications Inc. Fortune 500 List, Rank 15 in 2012

http://www.gurufocus.com/financials.php?symbol=VZ http://money.cnn.com/magazines/fortune/fortune500/2012/snapshots/2773.html The second-largest U.S. telecommunications group saw profits buoyed by surging smartphone sales, but its success last year

Year 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002

Revenues, x $, millions 110,875 106,565 107,808 97,354 93,469 88,144 75,112 71,283 67,752 67,625

Profits, y $, millions 2,404 2,549 3,651 6,428 5,510 5,480 7,397 7,261 3,509 4,575

Profit margin, y/x 0.022 0.024 0.034 0.066 0.059 0.062 0.098 0.102 0.052 0.068

Comments Type III Behavior from 2008 to 2011

Type I Behavior 2002-2004

The most striking and noticeable trend, and unfortunately not a very pleasant one, is the consistent decrease in the profits, between 2008 to 2011, with a significant increase in the revenues. Revenues, x, increased from $97.35 billion in 2008 to $110.9 billion in 2011 but profits, y, decreased from $6.43 billion in 2008 to $2.4 billion in 2011. This has been called the Type III behavior (see Ref. [2]) and has also been observed in some other cases of profitable companies, most notably Universal Insurance Holdings, Inc. (Rank 2 in the recent Fortune Small Business FSB 100 List) and also Ford Motor Company. This has been discussed in Refs. [2] and [3] above and is also observed here with Verizon, Figure 2.
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A TRUER CONNECTION
Lowell McAdam Chairman and Chief Executive Officer Verizon Communications We see expanding opportunities to build truer connections with our customers and communities by using our unique platforms to meet crucial needs across America and the world. Verizon will create new and more effective products, solutions and processes that will make us an even more valuable partner to our customers, communities and shareowners.

10.0
9.0 8.0

Profits, y [$, billions]

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 80 85 90 95 100 105 110 115 120

Revenues, x [$, billions] Figure 2: Type III behavior revealed by the profits-revenues data for Verizon Communication, Inc. for 2008-2011. The arrow indicates the direction of time. The straight line connecting the (x, y) pairs for the years 2008 and 2011 has the
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equation y = -0.296x + 35.23 where revenues x and profits y are in billions. Slope h = (y2 y1)/(x2 x1) = (2.4 3.7)/(110.9 107.8) = - 0.296. Once slope h is determined, the intercept c = 35.23 is obtained from y1 = hx1 + c = y2 = hx2 + c. Type III behavior usually suggests that the company has gone past the maximum point on its profits-revenues curve and is now operating to the right of the curve, in the region where profits decrease with increasing revenues. This was also suspected with Ford Motor Company when recent data revealed a Type III behavior. The existence of the maximum point on the profits-revenues graph was then later confirmed by considering data for earlier years, from 1990-2011. We see the same trend here with Verizon Communications. Verizon must take immediate steps to address its costs structure responsible for this Type III behavior and the appearance of the maximum point, see Figure 3.
10 9 8

Profits, y [$, billions]

7 6 5 4 3 2 1 0 0 20 40 60 80 100 120 140 160

Revenues, x [$, billions] Figure 3: The profits-revenues graph for Verizon Communications, Inc., for the ten year period 2002-2011, reveals what appears to be a sharp maximum point. The Type III behavior, i.e., decreasing profits with increasing revenues is also revealed if we consider the (x, y) pairs for the years 2010, 2007, 2006, 2005. The company
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changes from Type I behavior, i.e., increasing profits with increasing revenues (2002-2004), to Type III behavior within an extremely narrow range of revenues. The appearance of a maximum point on the profits-revenues graph, and/or the Type III behavior, even with a company reporting profits, is not necessarily healthy and suggests the need to address the underlying costs structures that lead to this behavior. As with Ford Motor Company, Verizon Communications has also been struggling over the last few years to maintain profitability in the face of increasingly tough competition. The simple approach to financial data analysis outlined here helps identify the fundamental issues that must be addressed by a company to enhance its profitability. Verizon will soon start reporting losses, with increasing revenues, if the present trends continue and deeper issues associated with revenue enhancement methods are not addressed.

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FORTUNE 500 List: Rank 19 in 2012

International Business Machines

ftp://public.dhe.ibm.com/annualreport/2005/2005_ibm_annual.pdf http://www.ibm.com/annualreport/ http://www.ibm.com/investor/financials/ http://money.cnn.com/magazines/fortune/fortune500/2012/snapshots/225.html Virginia M. Rometty, President and CEO

The only IBM CEO not yet invited to become a member of the Augusta National Golf Club, in Augusta, Georgia. (The club has a male only membership policy. IBM has been a corporate sponsor for all major Augusta golf events. Hence, in the past, all IBM CEOs, were automatically invited to join the club. )

I am pleased to report that IBM had another strong year in 2011. Your company continued to outperform our industry and the market at large. We capped IBMs first century by achieving record revenue, profit, free cash flow and earnings per share. At the same time, we continued to deliver superior returns to you, and we are well positioned for future growth in a globally integrating economy. Revenue and income: Our revenue in 2011 was $107 billion, up 7 percent. We grew operating pre-tax income by 9 percent, to $21.6 billion, our highest ever. Margins: IBMs operating pre-tax income margin rose for the ninth consecutive yearto 20.2 percent, up 10 points since 2000. We achieved this by continuing to shift our business mix to more profitable segments and by driving productivity. More than 90 percent of our segment profit in 2011 was from software, services and financing. Earnings per share: We have continued to achieve strong EPS growth. Last year was another record, with diluted operating earnings per share of $13.44, up 15 percent. This marked nine straight years of double-digit EPS growth.
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30 25

Profits, y [$, billions]

20 15 10 5 0 -5 -10 0 20 40 60 80 100 120 140 160

x0

Revenues, x [$, billions] Figure 4: The profits-revenues graph for IBM for the years 2001-2011. A nice Type I behavior, with the best-fit equation, y = 0.474x 32.46 = 0.474 (x x0) where x and y are in billions, is evident here. The solid dot represents the cut-off revenues (related to the fixed costs, x0 = $72.5 billion) below which IBM will report a loss. Once revenues exceed this cut-off value, profits increase rapidly, as revealed by the high value of slope h = 0.474. This means that 47.4% of the additional revenues (above the cut-off) are converted into profits. Can IBM further improve its profitability? Yes, by increasing the slope h even further and by decreasing the cut-off revenue x0 = $72.5 billion to a much lower value.

Notice the emphasis on Profits, Revenues, and EPS in the Letter from the President and the CEO, in the Annual Reports. Hence also our focus here on developing a full and complete understanding of the fundamental mathematical law(s) relating profits and revenues for any company.

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FORTUNE 500 List for 2012

Rank 37. Microsoft

http://money.cnn.com/magazines/fortune/fortune500/2012/snapshots/3063.html http://money.cnn.com/quote/financials/financials.html?symb=MSFT http://investing.money.msn.com/investments/stock-incomestatement/?symbol=MSFT http://www.microsoft.com/investor/reports/ar99/highlights.htm http://www.microsoft.com/investor/reports/ar02/financials/item8_income.htm Revenues, x $, billions 69.94 62.5 60.4 58.44 57.6 51.12 44.28 39.79 36.84 32.19 28.37 25.296 22.956 19.747 15.262 11.936 9.05 6.075 Profits, y $, billions 23.15 18.8 17.7 14.6 14.6 14.07 12.6 12.25 8.17 7.53 7.829 7.346 9.421 7.785 4.49 3.454 2.195 1.453 Profit Margin, y/x 0.331 0.301 0.253 0.250 0.293 0.275 0.285 0.308 0.222 0.234 0.276 0.290 0.410 0.394 0.294 0.289 0.243 0.239 Shares diluted, billions 8.5 8.8 8.9 8.9 9.3 9.74

Year 2011 2010 2008 2009 2009 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

EPS $2.69 $2.10 $1.62 $1.62 $1.87 $1.44

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As seen from the tabulated profits-revenues data, both profits and revenues have increased steadily for Microsoft with the profit margin varying between a low of 22.2% in 2004 to a high of 33.1% in 2011. However, as we will see shortly, the graphical representation of the same data provides additional insights that are NOT readily revealed with the tabular form of the data, or the ratio analysis, specifically the determination of the profit margin and the EPS. Notice also the increasing values of the EPS for the period 2007-2011. Although earning (i.e., profits) increased during this period, contributing to the increase in the EPS, the number of outstanding shares also decreased significantly during the same period. This also contributed to the increasing EPS. This is often overlooked. A graphical representation of the earnings versus shares is therefore required to fully understand the increasing EPS values. In most cases, however, the number of shares does NOT vary significantly. Hence, one is essentially relying on the absolute increase in profits (earnings), not just the profit margins, to increase EPS.
30.00

25.00

Earnings (Profits), y $, billions

20.00

15.00

10.00

5.00

0.00 8.00

8.50

9.00

9.50

10.00

10.50

Number of shares, x [billions]

Figure 5a: Just as the profit margin is the ratio of profits to revenues, the EPS is also a simple ratio. Hence, EPS increases with
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increase in earnings (i.e., profits). It will also increase if the number of outstanding shares decreases. This trend is revealed by the dashed straight line with the negative slope. The EPS is the slope of the ray(see Figure 5b) joining any point on such a straight line back to the origin (0, 0). The origin (0,0) is, of course, outside this graph which is draw to a greatly expanded scale. As we move down the dashed line (to increasing shares), the EPS will decrease because of a decrease in earnings and also because of the increase in shares. Conversely, moving up the line, as in the case of Microsoft between 2007 and 2011, with decreasing shares and increasing earnings, increases the EPS.
35.00
30.00 25.00 20.00 15.00 10.00 5.00 0.00 0 1 2 3 4 5 6 7 8 9 10 11 12 13

Earnings, E [$, billions]

Slope of the ray (dashed line) joining the point (S, E) to (0, 0) equals EPS = E/S = 23.15/8.5 = $2.72

Number of shares, S [$, billions]

Figure 5b: The slope of the ray joining the point with coordinates (S, E) on this diagram equals the EPS. Since a higher EPS is desirable from a financial performance standpoint, increases in the EPS rely primarily on the increase in the earnings (i.e., the absolute level of profits) since the number of shares does not usually change very significantly. In the case of Microsoft, the number of shares decreased along with
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the increase in earnings thus increasing the EPS even more. The three (S, E) points for 2009, 2010, and 2011, actually lie on a straight line with a negative slope as seen here. Hence, the rate of increase of earnings with decreasing shares is essentially constant. 40.00 35.00

Profits, x [$, billions]

30.00 25.00 20.00 15.00 10.00 5.00 0.00 -5.00 -10.00

y = 0.51x 2.28 = 0.51 (x 4.48)

y = 0.693x 25.3 = 0.693 (x 36.52)

10

20

30

40

50

60

70

80

90

100

Revenues, x [$, billions]

Figure 6: The profits-revenue graph for Microsoft for the period 1995-2011. Revenues have increased more than ten-fold during this period and profits have increased both nearly a factor of 12. Nonetheless, although both revenues and profits increased, there was a period of adjustment, from 2000 to 2007, when revenues increased with only modest increase in the profits, before the rapid rate of increase in profits began once again starting 2008. The upward sloping dashed straight line reveals the trend from 1995-2000 and the solid line the more recent trend. It is clear now that the familiar profit margin, the ratio y/x, provides a rather poor description of these very significant historical trends.

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Perhaps, even more significant are the conclusions that can be deduced from the simple mathematical equations for the two linear trends. These equations say it with numbers and were deduced by considering only two (x, y) pairs those for 1999 and 2000 for the earlier period - and those for 2009 and 2011- for the recent period. Both these straight lines capture the trend for the respective periods very nicely. (Hence, there is not much to be gained, for example, by considering a rigorous linear regression for these two periods.) Since the slope h is positive and the intercept c is negative, it follows that Microsoft exhibits Type I behavior during both these periods. However, there was a very large change in the value of the intercept c, which became significantly more negative, due to the post-2000 period of adjustment, which lasted for several years. In other words, the fixed costs have increased significantly for Microsoft although it is now operating on a straight line with a steeper slope. The current operating slope h = 0.693 means, once revenues exceed the cut-off, or breakeven value, profits increase very rapidly. Nearly 70% of the additional increase in revenues appears as profits, compared to only about 50% in the earlier period prior to 2000. This is a very significant and favorable development for Microsoft. One could use the same term work function used by Einstein to explain the photoelectric effect. Microsoft will be able to further increase its profits significantly if efforts are devoted to reduce this work function, or the fixed costs of operation. Now, let us consider what happened during the period of adjustment and the transition from one Type I behavior to the other. The simplest analysis of this situation is possible by simply joining the (x, y) pairs for two points on each of the Type I straight lines. The straight line joining the data for 1999 and 2009 provides such a simple solution, see Figure 7. The mathematical equation of this straight line is y = 0.176x + 4.31. The slope h = 0.176 is significantly reduced in the Type II mode. More importantly, the intercept c has changed from its negative value (which is characteristic of Type I behavior) to a positive value (characteristic of Type II behavior). The other data points for this transition period fall above and below this straight line. Perhaps, a linear regression would yield a better description but there is not much to be gained at this point from such an improvement in the quantitative analysis.
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50.00

40.00

Profits, x [$, billions]

30.00

20.00

10.00

0.00

Type II behavior y = 0.176x + 4.31 line joining 1999-2009

0 10 20 30 40 50 60 70 80 90 100

-10.00

Revenues, x [$, billions]

Figure 7: The transition between the two Type I behaviors discussed earlier was accomplished with an intervening period of Type II behavior when profits increased at a much lower rate with increasing revenues. What is truly amazing, however, is that Microsoft was able to switch back from Type II behavior to Type I behavior after the falling into the Type II mode for an extended period of time. This suggests that significant efforts were made to accomplish revenues enhancements during the transition. This was accompanied also with the penalty of a higher work function (higher fixed costs). But, it is very significant that Microsoft has regained its Type I behavior. Companies can fall from Type I to Type II mode and then into the more adverse Type III mode and then rapidly descend into a crisis mode with profits decreasing even as revenues increase. (We see this now with Verizon which must get into the Type II mode and then regain its Type I behavior, see Figure 8.)

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It is hoped that the discussions provided thus far provide further convincing evidence for the efficacy of the analytical approach suggested here, based on the deduction of simple mathematical laws, aided by x-y graphs, to understand corporate financial behavior.
14,000 12,000

Profits, y [$, millions ]

10,000 8,000

6,000
4,000 2,000 0 0 40,000 80,000 120,000 160,000

Revenues, x [$, millions ]

Figure 8: Profits-revenue graph for Verizon Communications, with the additional data for 1996-2000. The upward sloping straight line with a positive slope (Type I behavior) describes the earlier data from 1996-2000, y = 0.399x 14,029.7 = 0.399 (x 35,150). Then, in 2001, Verizon suddenly reported its lowest profit of $389 million (the data point closest to x-axis). This was followed by a short period of rapid increase in profits with a very small increase in revenues (2002 to 2005), a sharp maximum point, followed a descent into Type III behavior (dashed line with negative slope), with profits decreasing with increasing revenues.

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2012 Fortune 500 list Yahoo! Rank 483

http://money.cnn.com/magazines/fortune/fortune500/2012/snapshots/10867.html http://investing.money.msn.com/investments/financial-statements?symbol=YHOO Ten-year financial summary at above link.

Year
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Revenues, x $ billions
0.95 1.63 3.57 5.26 6.43 6.97 7.21 6.46 6.32 4.98

Profits, y $, billions
0.11 0.24 0.84 1.9 0.75 0.64 0.42 0.598 1.23 1.05

Comments
Revenues from 02 to 08 Profits reached a maximum in 05 and then Revenues from 09 to 11 but profits

The ten-year financial data for Yahoo! is summarized in the above table. As we will see shortly, the profits-revenues data for Yahoo! indicates a rather interesting variant of the Type III behavior in recent years. Between 2000 and 2008, revenues increased continuously, see Figure 9, and reached a peak value of $7.21 billion, and then started decreasing. The profits, however, reached a maximum of $1.9 billion in 2005 and then started decreasing with increasing revenues. Hence, Yahoo! indicates both Type I and Type III behavior in these two periods, see Figure 10. Between 2008 and 2011, however, Yahoo! illustrates a rather unusual Type III behavior. The profit-revenue graph has a negative slope, see Figure 11, but now profits increase with decreasing revenues.

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Revenues and Profits [$, billions]

8.0
7.0

Revenues, x
6.0
5.0 4.0 3.0 2.0

Profits, y
1.0 0.0 2000

2002

2004

2006

2008

2010

2012

Year
Figure 9: Profits and revenues for Yahoo! plotted versus time t in years. Profits increase with increasing revenues, between 2002 and 2005. While revenues continue to increase, profits start decreasing and then begin to increase again. Beyond 2008, revenues again begin to decrease but now profits begin to increase. The last period gives rise to an interesting variant of the Type III behavior.

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3.0 2.5

Profits [$, billions]

2.0 1.5 1.0 0.5 0.0 -0.5

Type I (2002-2005)

Type III (2005-2008)

-1.0
0.0 2.0 4.0 6.0 8.0 10.0

Revenues, x [$, billions]

Figure 10: Profits-revenues graph for Yahoo! between 2002 and 2008. Profits reached a peak value of $1.79 billion in 2005 and then started decreasing with increasing revenues. Thus the graph reveals Type I behavior (positive slope h > 0, and negative intercept c < 0) until 2005 and then changes to Type III behavior (negative slope h < 0 and positive intercept c > 0) between 2005 and 2008. The peak is at the point (5.26, 1.9) for 2005. Arrows indicate the direction of time.

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3.00 2.50

Type III Behavior Decreasing Revenues Increasing Profits (2008-2011)

(5.26, 1.9) for 2005

Profits [$, billions]

2.00 1.50

2010 (6.32, 1.23)

1.00

2011
0.50 0.00

2008

-0.50 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0

Revenues, x [$, billions]

Figure 11: An interesting Type III profits-revenues behavior is revealed between 2008 and 2011. Profits are actually increasing with decreasing revenues as Yahoo! moves up the downward sloping line to increasing profits. The open diamond (for 2010) is an exception and does not fall on this second Type III line plotted here. It is to be hoped that Yahoo! will soon regain its Type I behavior and start its upward trek to higher profits with increasing revenues.

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2012 FORTUNE 500 List Rank 83. Delta Air Lines

http://money.cnn.com/magazines/fortune/fortune500/2012/snapshots/2126.html http:/money.cnn.com/quote/financials/financials.html?symb=DAL Delta Air Lines (DAL) is an interesting example of a Fortune 500 company, ranked 83 in the 2012 list (previous rank was 88), with losses being reported for five of the eight years for which profits and revenues data has been compiled in the table below. It is also of interest to note that the number of shares (S), used to calculate the EPS, has been going up as well. The shares went up by 80% between 2008 and 2011. Hence, earnings (i.e., profits) must increase significantly just to keep the EPS constant. Year Revenues, x Profits, y ($, billions) ($, billions) 15.24 16.48 17.53 19.15 22.7 28.06 31.76 35.18 -5.2 -3.84 -6.21 1.61 -8.92 -1.24 0.59 0.85 Costs, z = (x y) (Revenues Profits) 20.44 20.32 23.74 17.54 31.62 29.3 31.17 34.33 Shares millions EPS

2004 2005 2006 2007 2008 2009 2010 2011

468 827 843 844

-$19.06 -$1.50 $0.70 $1.01

Since Profits = (Revenues Costs), it follows that we can estimate the costs from the available data. This is an overall or effective cost after taking into account all its obligations. This is given in the fourth column. Costs > Revenues when the company reports a loss and Costs < Revenues when it reports a profit.

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4 2

Profits [$, billions]

0 -2 -4 -6 -8 -10 0 10 20 30 40

Revenues, x [$, billions]

Figure 12: Profits-revenues graph for Delta Air Lines for the period 2004-2011. Excluding the two outliers it appears that we can conclude that profits increase with increasing revenues. Notice that revenues have increased consistently each year and have more than doubled between 2004 and 2011. The (x, y) pairs for 2004 and 2007 yields a straight line with the highest positive slope h, whereas the (x, y) pairs for 2004 and 2011 also yields a straight line with somewhat lower positive slope. Consider, therefore, the graph of profits versus revenues in Figure 12. This seems to reveal no readily discernible pattern although it appears that DAL does exhibit Type I behavior based on the most recent data. Profits increased with increasing revenues between 2010 and 2011. The profits-revenues equation would be y = 0.0764x 1.831 if we consider only these two data points. However, as noted already, the data for 2004 to 2009 is less conclusive, with both losses and
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profits with increasing revenues. If we ignore the two outliers shown by the arrows (19.15, 1.61) for 2007 and (22.7, -8.92) for 2008, it appears that a case can be made for profits increasing with increasing revenues.
50 45

Costs, z = (x y) [$, billions]

40 35 30 25 20

z =(x y) = 0.721x + 9.28

15 10 5 0 0 5 10 15 20 25 30 35 40 45 50

Revenues, x [$, billions]

Figure 13: Graph of costs z = (x y), deduced from the financial data, versus revenues. Since both costs and revenues are positive quantities, we expect to see a positive correlation. This is revealed here. From linear regression analysis, the best-fit line can be shown to have the equation z = (x y) = 0.721x + 9.28. This yields the profits-revenue relation y = (1 0.721)x 9.28 = 0.279x 9.28 which is a Type I relation as suspected. To test this hypothesis, let us consider the graph of Costs, z = (x y) versus Revenues, x. Both costs and revenues are positive quantities and we expect a
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positive correlation, see Figure 13. A nice upward trend is observed and the numerical value of the slope m = 0.721 is deduced using classical linear regression analysis. Notice that on the costs-revenues graph we again see the same two outliers but all the other data points follow the best-fit line very closely. Indeed, a reanalysis, after eliminating these two outliers from the regression, yields a slightly modified equation z = (x y) = 0.67x + 10.43 or y = 0.33x 10.43. The correlation coefficient is very high (denoted in statistics literature as r2 = 0.975). Thus, although the situation with Delta Airlines appears dismal, with the company operating close to its breakeven or cut-off revenue, the high positive value of the slope h = 0.33 deduced for profits-revenues equation implies that once past the breakeven or the fixed costs, nearly one-third (33%) of the additional revenues will appear as profits. In other words Delta Airlines must focus on reducing its Work Function as Einstein puts it in his explanation for the photoelectric effect. If a photon of energy E = hf strikes the surface of the metal, only a portion of this energy is seen as the kinetic energy K of the electron that is ejected, because some work W must be done to eject the electron. K = E W = hf W. This is the photoelectric equation, deduced after a lot of discussion of about entropy and energy of light (based on the power-exponential law given as equation 1). Reducing W, which is a characteristic property of the metal, increases K, the energy that appears in the electron. Likewise, each unit of revenue that is produced by a company does not appear as profits to the outside world. A big chunk of the revenue is absorbed in the form of costs. Costs are just like the work function W in the photoelectric law. The difference between a metal, with a fixed W, and a company is that efforts can be directed to reducing its work function, i.e., the costs. Then profits will appear. In the case of Delta Airlines, it is clear that the company is capable of converting 33% (one-third) of the revenues into profits, once it is past the breakeven point. It is to be hoped that Delta, and other companies in a similar situation, will benefit from such analysis and become profitable not just profitable consistently profitable and work like a Profits Engine to benefit the shareholders, the employees, the customers, and society at large.
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Finally, for completeness, we present the profits-revenues graph for Delta Airlines once again in Figure 14, with the Type I profits-revenue equation superimposed on to the data.
6 4

Profits [$, billions]

2 0 -2 -4 -6 -8 -10 0 10 20 30 40 50

y = 0.33x 10.43 = 0.33(x 31.64) x > x0 = 31.64 equals profits

Revenues, x [$, billions]

Figure 14: Profits-revenues graph for Delta Airlines with the Type I profits-revenues equation superimposed on to the recent financial data. Once revenues exceed the breakeven value of x0 = $31.64 billion, Delta has the potential to convert one-third (33%) of the additional revenues into profits for its shareholders, with immense benefits to follow for its customers, employees, and to society at large. The simple analysis presented here shows how the airline can return to profitability and that too in a consistent manner and operate like a well-tuned Profits Engine.

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2012 FORTUNE 500 List: Rank 17. Apple

http://money.cnn.com/quote/financials/financials.html?symb=AAPL http://investing.money.msn.com/investments/financialstatements?symbol=AAPL& Apple ranks 17 in the Fortune 500 list for 2012. This magazine named Apple the most admired US company in 2008 and also as the most admired in the world from 2008-2012. Its former Chairman and CEO, Steve Jobs, has been compared to none other than the automotive giant Henry Ford. The profits-revenues data for Apple, one of the most successful companies in modern corporate history, tells a story that matches and may be readily found at the links given above and has been summarized in the table below. Shares, S (millions) for EPS diluted 936.6 924.7 907.0 902.1 EPS (diluted)

Year

Revenues, x $, billions 108.6 65.1 36.3 32.5

Profits, y Profit margin, $, billions y/x 25.9 14.0 5.7 4.8 0.238 0.215 0.157 0.148

2011 2010 2009 2008

$27.68 $15.15 $6.29 $5.36

One can only wish that every company has such a sterling report card! Take the revenues. These have tripled between 2009 and 2011. But, look at the profits. Did they triple? They should also triple, shouldnt they, if we use the profit margin y/x as a measure of performance? If the denominator x goes up 3 times, the numerator y should also go up 3 times. This is what using ratios such as the profit margin, or the earning per share (EPS), implies. In the case of Apple, the profits have more than tripled, going up from $5.7 billion in 2009 to $25.9 billion in 2011 or by a factor of 4.54, i.e., they have more than quadrupled. This should be convincing proof that the profit margin might be misleading indicator of corporate
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performance. Why did the profits go up 4.54 times when the revenues went up 3 times? As we will see shortly, the graphical representation of the same data, see Figure 15, yields some insights.
40.0 35.0

Profits, y [$, billions]

30.0 25.0 20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 0 20 40 60 80 100 120 140

y = 0.278x 4.28 with r2 = 0.99985

Revenues, x [$, billions]

Figure 15: The profits-revenues graph for Apple, Inc. reveals a nice linear behavior, as for a Type I company (h > 0 and c < 0), with all the four data points lining up almost PERFECTLY on a straight line. The equation for the best-fit line through these four points is y = 0.278x 4.28 = 0.278 (x 15.377). According to statistical theory, the linear regression coefficient r2 = +1.0 for a PERFECT positive correlation. Here we get r2 = 0.99985. This is as perfect as it can get in terms of a predictable relation between revenues and profits. Hence, at least in the short term, we can expect Apple to operate along this line. If revenues go up, profits will go up and should lie, no doubt, on an extension of this straight line. We should be able to confirm this with data for 2012 within the year. (Of course, one could test the same using quarterly data and check the predictions out on a quarterly basis.)

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It is clear that one cannot blithely use simple y/x ratios to assess the year-on-year performance of a single company or even compare different companies (within a sector of the economy, or across different sectors). This also means that we must tread cautiously even with the use of the ratios such as EPS. The number of shares used to determine the EPS are listed by Apple (following the lead taken in this regard by Microsoft, as well). The EPS has increased from $5.36 in 2008 to $27.68 in 2011, or more than 5 times. This is due to two reasons. First, the absolute level of profits (earnings) which appears in the numerator of this ratio has gone up for Apple. The earnings went up by 4.54 times, as already noted. Second, the number of shares, which appears in the denominator of the ratio, has also gone up. However, the rate at which profits are growing is far greater than the rate at which the shares are growing and this explains the rapid increase in the EPS. In other words, it is clear that one must consider rates of change rather than simple ratios. This is what calculus teaches us as already discussed in earlier articles (see Refs.[1] and [2] cited earlier in the introduction). Notice also that the profit margin y/x has been increasing year after year, whereas the rate of increase of profits, with increasing revenues, as given by the slope of the graph, is a constant. If revenues increase by an amount x, the profits will always increase by the same fixed amount y = hx. The slope h is the marginal rate of increase of profits (MRP) as revenues increase. (This is like the marginal tax rate and similar terms used in economics theory.) The reason for the increase in the profit margin y/x is also obvious if we look at the implications of the linear law y = hx + c = 0.278x 4.28. If profits The profit margin y = 0.278x 4.28 y/x = 0.278 (4.28/x)

The nonzero intercept c = - 4.28 explains why we see the profit margin increasing year-after-year. Since the second term is negative, the theoretical maximum profit margin is 0.278, or 27.8%. As revenues x increase, the second term will decrease and the profit margin y/x will go up. The higher the revenues x, the higher will be the ratio y/x and eventually y/x will reach its maximum value (mathematically known as the asymptotic value) of h = 0.278.
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While Apple has certainly benefited thus far from this perception of an ever increasing profit margin, the analysis presented here also serves as a Fundamental operational changes cautionary note. Unless Apple will be required to increase the does something dramatic (to profit margin once this barrier is increase the slope h of the graph, reached. Unfortunately, this aspect see box), it will soon be of the financial behavior of a confronted with the theoretical company has NOT yet been barrier of 27.8% profit margin. understood. Since the profit margin was 23.8% in 2011, and 21.5% in 2010, should it again be expected to go up by another 10% (23.8% + 2.38%) to 26.18% or, better yet, go up by 15% or 20% to something like (23.8% + 4.76%) 28.56%? This is IMPOSSIBLE with the present operating profits-revenues equation. Such unreasonable expectations should NOT be encouraged and could destroy a company like Apple. (Of course, the Wall Street speculations will all be centered on the change of guard with the sad passing away of Steve Jobs, when Apple begins to hit such a brick wall in a couple of years by 2014 at the latest!) And, so it is, as noted earlier in the analysis of Facebook financial data (after its disastrous IPO), see Ref. [1], the superficial analysis of financial data, based on simple ratios such as the profit margin (y/x) or the EPS, should be shunned since such a misguided and simplistic analysis only ends up destroying companies in the long run (with a short term boost in the market place due to the wildly rising profit margins resulting from the negative
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If the linear law applies, the slope h of the profits-revenues graph is also the theoretical maximum value of the profit margin, y/x, which can be achieved.

Notice also that all the profit margins in the table given earlier are less than 27.8%.

intercept, c. (Microsoft also benefited from the same Type I behavior, a negative c, in the 1980s and 1990s.) In summary, the analysis of the financial data for Apple, Inc. presented here while revealing some very positive details also serves as a cautionary note against future wild speculations and expectations about how this companys profits and revenues will, or should, increase, in the near future. These should be tempered by a fuller understanding of the simple linear law relating profits and revenues. For Apple, this means a fixed h = 0.278 or MRP of 27.8% for the future increases in revenues.

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Appendix 1: Analysis of Apples Ten-year Financial Data

http://www.scribd.com/doc/95906902/Simple-Mathematical-Laws-GovernCorporate-Financial-Behavior-A-Brief-Compilation-of-Profits-Revenues-Data After presenting the foregoing analysis of Apples financial performance in the above document, I decided to study the ten-year data for Apple Inc. to see how well the analysis holds. As can be appreciated the foregoing analysis is based on the most recent years, 2008-2011. Now let us consider the 10-year data which has been compiled in the table below. Shares, S (millions) for EPS diluted 936.6 924.7 907.0 902.1 889.3 877.5 EPS (diluted)

Year

Revenues, x $, billions 108.6 65.1 36.3 32.5 24.6 19.3 13.9 8.3 6.2 5.7

Profits, y Profit margin, $, billions y/x 25.9 14.0 5.7 4.8 3.5 1.99 1.33 0.266 0.068 0.065 0.238 0.215 0.157 0.148 0.239 0.215 0.192 0.163 0.142 0.103

2011 2010 2009 2008 2007 2006 2005 2004 2003 2002

$27.68 $15.15 $9.08 $6.78 $3.93 $2.27

The most striking feature here is the consistent year-after-year increase in both revenues and profits with a nearly 20 fold increase (18.86 times to be exact) in revenues and almost 400 fold (398.8 times to be exact) increase in the profits. The huge discrepancy between how much revenues have increased compared to the profits also means that the ratio y/x, i.e., the traditional profit margin is NOT a very good measure of the financial performance. As already discussed within the context of the 2008-2011 data review, using this simple ratio to assess profitability or financial health of a company (or to compare companies) implies that we ALSO ACCEPT the idea that a doubling of revenues
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will double the profits, or that tripling of revenues will triple the profits and so on. Obviously, we do NOT see this, as with Apple Inc. and many other companies discussed in other articles (cited here and others available at this website). The profits-revenues graph in Figure 16 reveals a slight non-linearity and an acceleration of profits growth over the entire ten year (2002-2011) period.
30.0

Profits, y [$, billions]

25.0

20.0

15.0

10.0

5.0

0.0 0.0 20.0 40.0 60.0 80.0 100.0 120.0

Revenues, x [$, billions]

Figure 16: The profits-revenues graph for Apple, Inc. for the period 2002-2011. There appears to be a slight acceleration in the profits growth, with increasing revenues, during the entire ten-year period. This is confirmed by the fact that revenues increased by 18.86 times whereas profits increased by 398.8 times. For the moment, we will neglect this nonlinearity (which is due entirely to the early data when both revenues and profits were quite low).

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40.000 35.000

Profits, y [$, billions]

30.000 25.000 20.000 15.000 10.000 5.000 0.000 -5.000 -10.000 0 20 40 60 80 100 120 140 160

y = 0.264x 3.067 r2 = 0.9974

Revenues, x [$, billions]

Figure 17: As for many other companies, a simple linear law seems to relate the profits and revenues data for Apple, Inc., for the period 2002-2011. There is, no doubt, a slight acceleration in the profits growth and this is due mainly to the very low revenues and profits in the early years (2002 to 2004). The predominant trend, however, is the simple linear trend. The best-fit line through the data points has the equation y =0.265x 3.067 = 0.265 (x 11.58) with the correlation coefficient r2= 0.9974. Reanalyzing, including all the ten data points, does not change the regression equation significantly. With data for all the ten years, the best-fit equation is y = 0.253x 2.249 = 0.253 (x 8.889) and r2 = 0.9932. The regression coefficient is still greater than 0.99. As noted earlier, in the discussion of the most recent data for 2008-2011, all scientists and engineers would love to see such results in their experimental studies of various phenomena. The same trend is confirmed by the quarterly data, see Figure 18 below.

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16

Quarterly Profits, y [$, billions]

14 12 10 8 6 4 2 0 -2 -4 0 10 20 30 40 50 60

y = 0.302x 1.242 = 0.302 (x - 4.2) 2 r = 0.9865

Quarterly Revenues, x [$, billions]

Figure 18: The linear law relating the profits and revenues is also confirmed with the quarterly data for 22 consecutive quarters (from Q12007 to Q12012) for Apple, Inc. More remarkably, the constant h = 0.302 which is very close to the value obtained by considering the most recent annualized data, h = 0.278 for 2008-2011. Also, the linear regression coefficient r2 = 0.9865 is again quite high. It is of interest to note that, back in 1929, the astronomer Edwin Hubble proposed his famous law for the expansion of the universe (now called Hubbles law), based on data which actually showed just an overall upward trend with a lot of scatter. No finance or business major, or economics major, would dare to propose any type of mathematical law based on the data that Hubble had back in 1929. These points have already been discussed in Ref. [2] cited above and are merely being revisited here.

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http://www.scribd.com/doc/94647467/Three-Types-of-Companies-FromQuantum-Physics-to-Economics It is worth recalling that the most recent data for 2008-2011 yields the best-fit equation y = 0.278x 4.28 = 0.278 (x 15.377). The slightly higher value of the slope h = 0.278, compared to h = 0.265 for 2005-2011 confirms the slight acceleration in profits growth that was suspected from the plot in Figure 16.
45.000 40.000

Profits, y [$, billions]

35.000 30.000 25.000 20.000 15.000 10.000 5.000 0.000 0 20 40 60 80 100 120 140 160

y = 0.05 x1.33

Revenues, x [$, billions]

Figure 19: The nonlinear power law model y = mxn + c which is a special case of the power-exponential law (with a = b = 0), which was given as equation 1 in the introduction to this article. Here for simplicity we will also assume that the constant c = 0, in other words profits y will go to zero exactly as revenues x go to zero. (As discussed earlier this is not true because of the fixed costs of operation, which is never zero.) As we see here, a very good fit to the data is obtained with n = 1.33 and m = 0.05. Other values of m and n might yield a good fit as well. These values of the power law constants m and n were deduced by simple curve fitting and have
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no other statistical justification. The value of n = 1.33 was chosen since it close to other well-known values of the power law index, such as n = 1.5 in Keplers third law relating the period of a planetary orbit to the semi-major axis of the orbit. Fixing n using such heuristic arguments, then automatically fixes the value of m. (It can be shown that m = 0.024 and n = 1.5 also yields a very good fit.) The rate of increase of profits y with increasing revenues x is readily determined once we deduce the mathematical law relating x and y. Using elementary rules of calculus (in fact, the first rule we learn in our calculus course is the derivative for xn), it can be shown that dy/dx = m (nxn-1) = n [mxn/x] = n(y/x). This means that when revenues x increase the slope will increase or decrease depending on the value of the index n. With n > 1, the rate of increase of y is greater than the rate of increase of x and hence the slope of the graph increases, as we see visually. However, this discussion is being offered here only for completeness. One must be extremely cautious in using such power laws or exponential laws to make forward predictions (about profits, assuming revenues increase), since one is likely to overestimate (or underestimate if n < 1) and hence become a victim of failed expectations (a rather common problem with the stock market analysis; there is often a tendency to get bullish or bearish with never a middle path). Such a cautionary note was also sounded earlier in the analysis of Facebook financial data and the historical data for Google (see Refs. [1] and [2], reproduced below). http://www.scribd.com/doc/94325593/The-Future-of-Facebook-I see Figure 3 here for Facebook financials http://www.scribd.com/doc/94647467/Three-Types-of-Companies-FromQuantum-Physics-to-Economics see Figure 10 for early year Google financials. In summary, the present analysis of the Apple Inc. financial data for earlier years (2002-2011) confirms the conclusions reached using the data for the most recent years (2008-2011). Caution must be exercised in using the profit margin and continual expectation of increased profit margins (likewise ever increasing EPS) since the fixed costs inherent in any operation are actually being overlooked in any ratio analysis. While such a ratio analysis is simple and straightforward, it sooner or later leads us fundamental contradictions since a brickwall will soon
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be hit and profit margins (or the EPS) will just not keep on increasing because Wall Street expects such an increase. There are fundamental laws lurking beneath the huge masses of financial data now being accumulated on a quarterly and annual basis, in the routine SEC filings, and in lists such as the Fortune 500 or Forbes 500 or Business Week corporate score cards. All of these await more detailed and thoughtful analysis. This is a humble attempt in that direction. I hope I will be forgiven for any excesses and transgression in my exuberant choice of words to describe the current Wall Street frenzies, based on simplistic ratio analysis (ultimately also harmful to Wall Street investors!) Facebook is already facing a bleak future primarily due to all the Wall Street hype preceding the IPO. Next in line may be Apple, with the departure of Steve Jobs being used as the single most reason for the failed expectations. Nay, before we jump to these conclusions, let us look at the story that each company is telling us and look beyond ratios such as profit margins, EPS, and a myriad such ratios, too numerous even to list here. It is all very simple. If y = hx + c, then the ratio y/x = h + (c/x) can increase or decrease as x increases, in unpredictable ways, because of the nonzero c. This is just the situation with a simple linear law. If we must contend with nonlinearities as well, the ratio analysis will get us very fast into a ditch. That is how the US economy collapsed and it all happened very very fast, in just about 25 to 30 years with no efforts being made to understand the fundamental laws that govern the financial, business, and economic world. Yes, there are laws, just like the laws that govern the physical world. Think about what science, or physics, or astronomy, was like before Galileo, Kepler, and Newton. That is where, I humbly submit, we are today in our understanding of business, finance, economics, and the management sciences. Like the fundamental understanding of heat engines that began with James Watt, we must learn how a Profits Engine works so that we can build one in the 21st century, to deliver any rated amount of profits, just like we know how build a heat engine to deliver any rated horsepower.
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Look again at that simple diagram at the bottom of page 5, ending the summary. Almost 100 years would pass before James Watt started selling his improved steam engines (in 1775 that gave birth to the Industrial Revolution) and the laws of thermodynamics would be enunciated in the second half of the 19th century, starting with the theoretical speculations of a young French engineer named Sadi Carnot (in 1824). Two experimentalists and four theoreticians paved the way!

James Watt (1736-1819)

Sadi Carnot (1796-1832)

James Prescott Joule (1818-1889)

Rudolf Clausius (1822-1888)

James C. Maxwell (18311879)

Ludwig Boltzmann (1844-1906)

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Lord Kelvin (1824-1907) Max Planck (1858-1947) Albert Einstein (1879-1955) Lord Kelvin conceived the Absolute Zero temperature (Kelvin scale, 0 Kelvin = 273 C) and gave the famous Two Clouds lecture in 1900. The two clouds would soon blow away due to the theoretical contributions by Planck (in 1900) and Einstein (in 1905).

The theory of electromagnetism, quantum physics, and even the theory of relativity, would be impossible without the contributions of these six over a period of almost 150 years starting with the answer James Watt conceived for the famous question, How many horses can your engine replace? So, Watt tried to answer the self-posed question, How much work can a horse do? Even Newton did not know the meaning of work done by a force. The idea of energy and the law of conservation of energy would be unthinkable without the how many horses answer that Watt found. The longest journey begins with the smallest step that we willfully take.

Sources:
http://www.geocities.com/Athens/Acropolis/6914/termode.htm http://library.thinkquest.org/C006011/english/sites/carnot_bio.php3?v=2 http://www-groups.dcs.st-and.ac.uk/history/Biographies/Clausius.html http://en.wikipedia.org/wiki/Rudolf_Clausius http://en.wikipedia.org/wiki/James_Prescott_Joule http://en.wikipedia.org/wiki/James_Clerk_Maxwell http://en.wikipedia.org/wiki/Ludwig_Boltzmann http://en.wikipedia.org/wiki/William_Thomson,_1st_Baron_Kelvin http://en.wikipedia.org/wiki/Max_Planck http://en.wikipedia.org/wiki/Albert_Einstein
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Einsteins Heartiest Laugh

The Work Function

Albert Einstein E = mc2

Cool dude! Yeah, we all know it. But, this did NOT get him the Nobel Prize.

K = (E W) = (hf W)
Very few know this cool equation. This is what GOT him the Nobel Prize.
Only a part of the energy of a photon E = hf appears as the energy K of the electron. The rest, called W, must be given up. Einstein called W the work function, the work that must be done to produce the electron with energy K. There is a work function lurking in every process in economics and finance it is the fixed cost. The law is always y = hx + c. Very rarely is it y = mx, or y = hx, or y = ax. The ratio y/x = ????

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Appendix 2: Evidence for the One-third Law Mendels Law and the Business World
Analysis of the Most Recent Quarterly Data (1Q2010 to 1Q2012) for Apple The Austrian monk, Gregor Mendel published his famous papers on genetics, in February and March 1865, see the original papers along with the raw data at http://www.mendelweb.org/Mendel.html . In these papers he describes his experiments on pea plants conducted meticulously over a period of eight years. Mendel also makes the following interesting observation, Whether the plan upon which the separate experiments were conducted and carried out was best suited to attain the desired end is left to the friendly decision of the reader.

Number Recessive trait [Green seeds, y]

35

30
25 20

y = Mx = (1/3)x
15 10 5 0 0 20 40 60 80 100 120

Number of Observations of Dominant trait [Yellow seeds, x]

Perhaps, we could all learn a thing or two from Mendel about how to win acceptance of our peers when presenting (unconventional) findings of the type that we are discussing here. Anyway, lets consider an interesting way of looking at the data from these famous experiments. The most important observation of Mendel, and one that is now taught in all elementary biology courses, is that, after a great
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many experiments, the dominant and recessive characteristics appear in the average ratio of 3:1. Mendel arrives at this far reaching conclusion very early, see article [5] of his paper where he concludes the description of the experiments with the first generation hybrids. The straight line with a positive slope M = 1/3 is superimposed on to the data. The striking feature is the large scatter that we see here. Mendel considers the color of the seeds (he calls them albumen) produced by ten plants. The raw observations are given below. The constant M = 1/3 may be called the Mendel constant.

Mendels Experiment with plants where color of seeds was studied

Plant Yellow, Green, Y/G No. x y ratio 1 25 11 2.27 2 32 7 4.57 3 14 5 2.80 4 70 27 2.59 5 24 13 1.85 6 20 6 3.33 7 32 13 2.46 8 44 9 4.89 9 50 14 3.57 10 44 18 2.44 Total 355 123 2.89 Difference Difference x y Comment

45 46

16 14

Plants 1 and 4 Plants 4 and 5

12 18 26

4 7 9

Plants 7 and 8 Plants 2 and 9 Plants 4 and 10

Notice how the ratio of yellow to green seeds varies from a low of 1.85 to a high of 4.89. There is NOT a single experiment in the table here where the exact ratio of 3:1 is observed. In experiment 3, with 5 greens we should have 15 yellows but the actual is 14. In experiment 6, with 6 green seeds, we should have 18 yellow, but the actual is 20. These are the two experiments that come close. But, take a look at the totals in the bottom row. This is tending towards the now accepted ratio of 3:1. Consider also the following. If we examine the graph carefully we notice that there are several (x, y) pairs that seem to fall on straight lines that are parallel to the line with the slope of 1/3. In other words, these imaginary lines have either a positive or a negative intercept and the general law is y = Mx + c.
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Sometimes, it is difficult to understand the significance of the constant c and why it is positive or negative, as we see here (especially with limited observations). Take the experiments with plants 1 and 4. There are 45 additional yellows (70 25) and 16 additional greens (27 11). An exact 1/3 ratio would mean 15 additional greens. In other words, the ratio M = y/x 1/3, the overall ratio. Between plants 2 and 9, we have 18 additional yellows and 7 additional greens, instead of the exact number of 6 needed for the 1/3 ratio. Between plants 4 and 10, we have 26 additional yellows and 9 additional greens. We are only missing one additional yellow to make up the ratio of 3:1. The main point is that when we see an unmistakable trend on a x-y graph, such as we see here with Mendels experiments from genetics, or with Hubble observations on distant galaxies, we must make an attempt to study the data more carefully and deduce simple laws that can then be vigorously tested. Of course, the friendly decision of the reader always helps a lot to enable initial acceptance which leads to more testing and confirmation of the ideas.
18.0

Quarterly Profits, y [$, billions]

16.0

14.0
12.0 10.0 8.0

6.0
4.0 2.0 0.0 -2.0 -4.0 0 10 20 30

y = 0.324x 5.96, r2 = 0.979 1Q 2007 to 1Q 2012

40

50

60

Quarterly Revenues, x [$, billions]

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Figure 20: Evidence for the one-thirds and two-thirds split between profits and costs. The quarterly profits-revenues graph for Apple, Inc. for the period 1Q2007 to 1Q2012. The best-fit line has the equation y = 0.324x 1.928 = 0.324 (x x0) =0.324 (x 5.96). The slope h = 0.324 is very nearly equal to one-third (1/3). Hence, it appears that once the revenues exceed the breakeven value of x0 = $5.96 billion, nearly one-third of the additional revenues will appear as profits. Recall also that exactly the same behavior was also observed earlier in the analysis of the profits-revenues data for Delta Airlines, see Figure 14, although the company reported losses for 5 out 8 years. The unmistakable upward trend, however, suggests the potential for converting one-third of the additional revenues, beyond the breakeven, into profits (or reduced losses in the case of Delta). The one-third and two-thirds split is also standard practice between attorney client relations as well. A similar business agreement was also entered into by James Watt and Matthew Boulton, in 1775, when they started marketing the improved steam engines to coal miners to help pump water out of the flooded coal mines. The company founded by Watt and Boulton would provide the steam engine for FREE, and also service and maintain it for FREE. In exchange, a fee would be charged. This was one-third the difference between the cost of hay to feed the horses and the coal needed to operate the engine. Many horses obviously had to be fed to keep the mines working. Fee for Steam Engine = 1/3 [Cost of hay to feed horses Cost of Coal] Of course, there were many who objected to the decision to employ steam engines in manufactories (later shortened to factories), especially mills since many feared loss of employment. Other consequences too are now being felt and debated. More than a century after Watts invention changed the world, Svante Arrhenius, who got the Nobel Prize in Chemistry (in 1903), proposed the far-reaching idea of a global warming and attributed it to the greenhouse effect caused by greatly accelerated carbon dioxide emissions resulting from the increased burning of coal in a variety of industrial applications.

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http://en.wikipedia.org/wiki/Svante_Arrhenius Arrhenius ideas gained greater acceptance in the 20th century, especially after the astronomer Carl Sagan showed that Venus, a twin of the Earth, had probably suffered a runaway greenhouse effect, leading to torridly high temperatures on the planet (hot enough to melt lead). The atmosphere of Venus, whose rare transit across the sun was observed eagerly yesterday June 6, 2012, is composed almost entirely of carbon dioxide (96.5%) with remainder being nitrogen (3.5%) with trace amounts of other toxic gases. http://www.youtube.com/watch?v=nP2FCM-6rvw http://www.youtube.com/watch?v=sV4Cq-AZoaE&feature=related http://en.wikipedia.org/wiki/Atmosphere_of_Venus
http://www.amnh.org/education/resources/rfl/web/essaybooks/cosmic/p_sagan.html

Perhaps, as we gain greater understanding of the financial behavior of various companies, this one-third law could become the gold standard for how a corporation should operate. If the complex process such as genetics lends itself to simple laws, there must be simple laws that dictate how the financial world operates as well.

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About the author V. Laxmanan, Sc. D.

The author obtained his Bachelors degree (B. E.) in Mechanical Engineering from the University of Poona and his Masters degree (M. E.), also in Mechanical Engineering, from the Indian Institute of Science, Bangalore, followed by a Masters (S. M.) and Doctoral (Sc. D.) degrees in Materials Engineering from the Massachusetts Institute of Technology, Cambridge, MA, USA. He then spent his entire professional career at leading US research institutions (MIT, Allied Chemical Corporate R & D, now part of Honeywell, NASA, Case Western Reserve University (CWRU), and General Motors Research and Development Center in Warren, MI). He holds four patents in materials processing, has co-authored two books and published several scientific papers in leading peer-reviewed international journals. His expertise includes developing simple mathematical models to explain the behavior of complex systems. While at NASA and CWRU, he was responsible for developing material processing experiments to be performed aboard the space shuttle and developed a simple mathematical model to explain the growth Christmas-tree, or snowflake, like structures (called dendrites) widely observed in many types of liquid-to-solid phase transformations (e.g., freezing of all commercial metals and alloys, freezing of water, and, yes, production of snowflakes!). This led to a simple model to explain the growth of dendritic structures in both the ground-based experiments and in the space shuttle experiments. More recently, he has been interested in the analysis of the large volumes of data from financial and economic systems and has developed what may be called the Quantum Business Model (QBM). This extends (to financial and economic systems) the mathematical arguments used by Max Planck to develop quantum physics using the analogy Energy = Money, i.e., energy in physics is like money in economics. Einstein applied Plancks ideas to describe the photoelectric effect (by treating light as being composed of particles called photons, each with the fixed quantum of energy conceived by Planck). The mathematical law deduced by
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Planck, referred to here as the generalized power-exponential law, might actually have many applications far beyond blackbody radiation studies where it was first conceived. Einsteins photoelectric law is a simple linear law, as we see here, and was deduced from Plancks non-linear law for describing blackbody radiation. It appears that financial and economic systems can be modeled using a similar approach. Finance, business, economics and management sciences now essentially seem to operate like astronomy and physics before the advent of Kepler and Newton.

With my sincere thanks to many Internet sources that have been used to compile this document as evident by all the corporate logos and various photographs used here to make the presentation more interesting.]

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