Google: A Lovable One-Trick-Pony

Another Single-product Company Analyzed Using the New Methodology

Google is a one-trick pony at heart -- in online, search-related advertising. Google says that 96% of its revenues come from advertising. And most of that comes from ads that can be targeted to consumers, based on their search and browsing habits. Don't just believe me; ask former CEO Eric Schmidt. If you've got a one-trick pony, you want the one we have. We picked the right trick, Schmidt said in an interview. --- From a recent article by Michael Brush at MSN Money

1. http://money.msn.com/investing/8-one-trick-pony-companies-toride-brush Michael Brush 2. http://gigaom.com/2010/07/29/is-google-a-one-trick-pony-yessays-ceo-schmidt/ Om Mallik 3. http://www.businessweek.com/technology/content/jan2011/tc2011 0128_084457.htm in Bloomberg Business Week 4. http://articles.businessinsider.com/2010-1015/tech/30023441_1_adsense-text-ads-display-ads see Henry Blodget Now, they have the Nexus 7 tablet, offered at $199 which can rival Apples. Read on about Google.

Page 1 of 31

Table of Contents
No. 1. 2. 3. 4. 5. 6. 6. Topic Introduction Linear Profits-Revenues law for Google Fundamental Significance of the Linear Law Brief Discussion: Line of Excellence and Einsteins Work Function Summary and Conclusions Appendix 1: Big Bang Event at Google Inc. 2000-2004 Bibliography of related articles (available on the Internet) To measure is to know. If you cannot measure it, you cannot improve it. Said Lord Kelvin who conceived the profound idea of an Absolute Zero for temperature and gave us what we call the Kelvin scale. http://zapatopi.net/kelvin/quotes/ This is really about successful companies, like Google and Apple. But, why do companies fail? The answer is simple. They really do not know their fixed cost and their variable cost. What does it mean to know? Just listen to Lord Kelvin. What is fixed cost? This is the cost that is incurred when N = 0 units are sold. What is variable cost? The more the units N sold, the higher the costs. The revenues R = pN generated from sales seem to disappear magically. This is the meaning of the simple equation C = a + bN for the total costs incurred by a business that is making and selling N units of a single product. To know, measure (a, b, p). If not, you really do not know. The Profits P = (R C) will disappear. Page No. 3 5 11 13 22 25 28

Page 2 of 31

 1. Introduction
Who would have thought about Google as a one-trick-pony? By the way, or BTW in internet-speak, this is NOT supposed to be a good thing. What is a one-trick pony? Well, see http://www.wisegeek.com/what-is-a-one-trickpony.htm for an interesting answer. I guess this all goes back to those nostalgic days when there were no cars, or even bicycles, and everyone used to ride a horse and so we all had to learn to ride a horse and so we would all go pony shopping with mom and dad - instead of bike shopping or car shopping. Remember that first bike you got, or that first car? And, in those old days, in that pony market, we would fall in love with some adorable pony that can do just one single trick and mom said it is no good but we still love it and insist on bringing it home! Now, thats a one trick pony. But, we all love them. So, from today on, there shall be nothing disparaging about a one-trick pony. And so it is with companies. Some companies seem to focus on only one thing, or one product, and they seem to do it better than anyone else and thus produce a steady stream of revenues and profits. Like WD-40, the company that sells those lubricant sprays we get in the blue and yellow cans that everyone has in their garage. Or Annies Inc. that sells organic and natural foods that are now found in mainstream grocery stores. Or, Spanx that sells special undergarments to shape tummies, thighs, and bottoms. Investors find these companies easy to understand. Ford must also be a one trick pony, and Toyota, and Whirlpool. Anyway, heres a list of eight one-trick ponies given by Michael Brush at MSN Money (http://money.msn.com/investing/8-one-trick-pony-companies-to-ride-brush ): 1. Etch a Sketch (OART), a toy made by Ohio Art, got national attention when an aide to Presidential candidate Mitt Romney mentioned that resetting their candidates positions would be as easy as shaking Etch-A-Sketch! 2. Annie's (BNNY): Organic and natural food producer. 3. WD-40 (WDFC), founded in 1953, which sells its famous lubricant spray.
Page 3 of 31

4. Crocs (CROX), which sells cheap and goofy rubber shoes. 5. Spanx which sells butt-busting, tummy-taming, thigh-thinning, undergarments (still a privately held company). And, yes, for men too! 6. Select Comfort (SCSS) Sleep products, including mattresses, and everything between the bed and the pillows. 7. Google (GOOG), famous for its search engine, now may be for its new tablet! It is also a one-trick pony since 96% of its revenues come from advertising that can be targeted to consumers, based on their internet search and browsing habits. 8. Alexion (ALXN) which sells a very high priced drug for a rare blood disease (10,000 patients at most). Since I have been studying companies big and small, I decided to take a look at all these eight essentially single-product companies (hence, the funny name) to see if there was indeed something different, or something very special, about them. I have already posted an article about Annies Inc. and its recent financial performance, see http://www.scribd.com/doc/98652561/Annie-s-Inc-A-SingleProduct-Company-Analyzed-Using-a-New-Methodology As we will see shortly, even these single-product companies show a rather diverse profits-revenues behavior. Yet, they all follow exactly the same universal law relating profits and revenues. This has been discussed in the article on Annies Inc., and in other articles (see bibliography at the end of this article). This article is about Google. I have considered the ten-year financial data, which is readily available at MSN Money. The profits-revenues data is summarized in Table 1. The familiar profit margin is the ratio y/x where y is profits and x is revenues, usually converted to a percentage. Note that this traditional measure of a companys performance has varied from a low of 7.2% in 2003 to a high of 29.1% in 2006, with the most recent value being 25.7% for 2011. The reason this erratic variation in the profits margin will also become clear from what follows here. The profits-revenues data has been grouped together, intentionally, in Table 1. The reason for this will become obvious if we consider the graphical representation of the same data in Figure 1. This reveals an interesting pattern which is not obvious
Page 4 of 31

in the tabular form of the same data. We will discuss this in greater detail in the following sections.

Table 1: Profits-Revenues Data for Google (2002-2011)

Year Revenues, x Profits, y Profit Change Margin%, Revenues, 100(y/x) x 22.68 7.19 12.51 23.94 29.06 25.32 27.57 29.02 Change Profits, y Slope h = y/x

2002 2003 2004 2005 2006 2007 2009 2010

0.43951 1.47 3.19 6.14 10.6 16.59 23.65 29.32

0.09966 0.10565 0.39912 1.47 3.08 4.2 6.52 8.51

1.0305

0.006

0.0058

The changes are between the two extreme points in the group. 7.41 2.681 0.362

12.73

4.31

0.339

21.8 4.23 19.40 2008 37.91 9.74 25.69 16.11 5.51 0.342 2011 On the graph, the 2008 data point seems like an outlier, profits are lower. However, the 2011 data point is also slightly lower but less pronounced.

2. Linear Profits-Revenues law for Google

As revenues x increase, profits, y, also increase. The only exception to this almost perfect linear relation is the data for 2008. In 2007, with revenues of $16.59 billion, the profits were $4.2 billion. But, in 2008, when revenues increased to $21.8 billion, profits only increased slightly, to $4.23 billion. (At this point, the reasons for such blips are of no interest to us.) However, if we take a look at the data carefully, we see the same pattern with the profits data for 2011 compared to both 2009 and 2010. Let us pursue this for a moment since it gets us to the important point about the slopes h given in the last column of Table 1. If we

Page 5 of 31

extrapolate from the straight line joining 2009 and 2010, the profits for 2011 are slightly lower. This can be shown rigorously as follows. The line joining 2009 and 2010 data has the equation y = hx + c = 0.351x 1.78. Between 2009 and 2010, the profits increased by y = 1.99 and the revenues increased by x = 5.67. Hence, the rate of increase of profits with revenues, given by the slope h = y/x = 1.99/5.67 = 0.351 which means 35% of the additional revenues appeared as profits. The intercept c = (y1 hx1) = (y2 hx2) can be fixed once the slope h has been determined. We get c = -1.78 since this small straight line segment passes through both the 2009 and 2010 data. Now, extrapolate to x = 37.91 for 2011. We get y = (0.351 37.91) 1.78 = 11.52. The profit y predicted by this extrapolation is lower than the observed value of y = 9.74 for 2011.
12

10

Profits, y [$, billions]

0
0 5 10 15 20 25 30 35 40

Revenues, x [$, billions]

Figure 1: The ten-year profits-revenues data for Google obtained from financial summary given at MSN Money.

Page 6 of 31

Notice, however, that although the profits for 2011 were slightly lower, the data for 2008 and 2011 seem to fall on a line that is roughly parallel to the general trend that we see here. This suspicion is confirmed as follows. Let us find the slope h between 2008 and 2011. This is given in the table. We get h = 0.342. This is amazingly close to the slope h = 0.339 if we consider the data for the three years 2007, 2009 and 2010. These three data points fall roughly on the line joining 2007 and 2010 with a slope h = 0.339. The other slopes determined considering different three year groups are roughly constant. The average value of the three slopes given in Table 1 is h = 0.345. In other words, it appears that Google has been able to consistently convert about 35% of the annual increase in the revenues into profits. Google does seem like a good one-trick pony, confirming the CEOs boast, which was quoted earlier. Now, let us carry out a straightforward linear regression analysis and find the equation of the best-fit line between the data points. This is shown in Figure 2. At first, I considered all the ten points, even the 2002 and 2003 data when profits were very low, and the 2008 data, which obviously is an outlier. The equation determined was y = 0.268x 0.217 = 0.268 (x 0.81). Eliminating the 2002 and 2003 gives the best-fit equation y = 0.271x 0.277 but the 2008 data is still included. Notice that the slope changes very slightly. Eliminating the 2008 data gives a new equation is y = 0.276x 0.172 = 0.276 (x 1.025). The slope h = 0.276 is slightly higher and the intercept c = -0.172 is lower and correspondingly the intercept made on the revenues-axis (the x-axis), when y = 0, increases from x = 0.81 to x = 1.025. This implies a slight difference in fixed costs. (This last point is clarified in the next section.) The main point of this discussion, however, is the perfectly linear relation between profits and revenues. Although profit margins vary widely, when revenues increase by a fixed amount x profits always increase by the same fixed amount y = hx where h = 0.345 on the average if we consider the high slopes, or h = 0.27 is we consider the best-fit. It is also clear why the profit margin is varying erratically from year to year. Since y = hx + c, the profit margin is given by y/x = h + c/x = 0.275 0.172/x. This is made up of two parts, the constant value 0.275 and the negative term -0.172/x. As revenues increase, the second term decreases and so
Page 7 of 31

the profit margin will go up. If the slope h or the intercept c changes (as in the shift we see in 2008 and 2011), there is even more variation. 14 12

Profits, y [$, billions]

10 8 6 4 2

0
-2

10

15

20

25

30

35

40

45

50

Revenues, x [$, billions]

Figure 2: The profits-revenue data for Google, for the ten-year period (2002-2011) is reconsidered here. Eliminating the 2002, 2003 and 2008 data from the regression analysis, the best-fit equation through this data is y = 0.276x 0.172. The linear regression coefficient r2 = 0.988 is very high indicating a nearly perfect positive correlation (Note that r2 = + 1.0 for a PERFECT positive correlation when all points fall exactly on the best-fit line with zero deviation.) A careful examination of Figure 2 shows that the best-fit line pivots away from the higher slopes that were determined from a cursory look at Figure 1. The groups of data considered earlier can be seen to align along a line with a slightly higher slope that cuts the best-fit line. Is there any fundamental justification for this nice linear relation revealed here with Googles ten-year data?
Page 8 of 31

Yes. Indeed, we see exactly the same linear relation when we analyze the data for literally hundreds of companies that I have been doing since 1998-2000 when I first got interested in this problem. Annies Inc. which makes the list of one-trick ponies also reveals the same trend as discussed in more detail in the article cited already. http://www.scribd.com/doc/98652561/Annie-s-Inc-A-Single-ProductCompany-Analyzed-Using-a-New-Methodology The data for Apple Inc. shows an almost PERFECT correlation, see Figure 3, with r2 = 0.99985. The quarterly data for Apple, over the same period, including 1Q2012 data, was also analyzed (21 quarters total) and again reveals a nice linear relation between profits and revenues, see Figure 4.
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

Revenues, x [$, billions]

Figure 3: Profits-revenues data for Apple (2008-2011) shows a nearly PERFECT positive correlation, y = 0.278x 4.282 = 0.278 (x 15.378) with r2 = 0.99985.

Page 9 of 31

Table 2: Profits-Revenues data for Apple (2008-2011)

Profit Margin % 100(y/x) 108.6 25.9 23.85 2011 65.1 14.0 21.51 2010 36.3 5.7 15.70 2009 32.5 4.8 14.77 2008 Notice the systematically increasing profit margins with increasing revenues Year Revenues, x Profits, y

16 14

Profits, y [$, billions]

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

Revenues, x [$, billions]

Figure 4: Quarterly data for Apple (1Q2007 to 1Q2012) also reveals a nice linear relation between revenues and profits, y = 0.3015x 0.1242 = 0.3015(x -4.12) with r2 = 0.9865.

Page 10 of 31

 3. Fundamental Significance of the Linear Law

It has not yet been generally appreciated that all businesses follow the same, very simple, mathematical law, that we see here with both Google and Apple. It is actually a universal law, which can be shown to be a consequence of the classical breakeven analysis for the profitability of a company. In the real world, this manifests itself as a simple linear law y = hx + c where x is revenues and y is profits and h and c are constants that can be deduced from the financial data, as just discussed. The constant c can be related to the fixed costs and the constant h to the unit variable cost in the breakeven model. Depending on the numerical values of h and c (positive or negative), we have three types of profits-revenues graphs, which lead to what may be called Type I, Type II, and Type III behavior. Thus, ALL businesses can be evaluated in terms of three basic types of profits-revenue graphs. Examples of these three types of behavior have been provided in the other articles on this topic (all written since the Facebook IPO on May 18, 2012), see http://www.scribd.com/vjlaxmanan Consider a company making and selling N units of a product. Let a denote the fixed costs and b the unit variable costs. The total costs C is the sum of the fixed and the variable costs and is given by C = a + bN. If p is the unit price, the total revenues R generated by the sales is given by R = pN. This also means N = R/p, a relation we will use shortly. The Profits P can now be deduced using the universal statement that applies to all companies, big and small, viz., Profits = Revenues - Costs. Thus, we get, P = R - C = pN - bN - a = (p -b)N - a = [(p - b)/p] R - a = hR - a This implies a linear relation between profits P and revenues R, and follows when we eliminate N using N = R/p. It can be rewritten as y = hx + c where x is revenues and y is profits and h and c are constants whose values can be deduced from the (a, b, p) triplet for each product. More generally, the numerical values of h and c can be deduced from the financial statements (the 10-K and the 10-Q) filed with the SEC every quarter and also readily available at various internet sources,

Page 11 of 31

such as MSN Money, which provided the impetus for this article. All of the data for Annie's Inc. is compiled in the tables to facilitate further study and analysis.

Slope h = 1 - (b/p) Determined by the unit variable cost b and unit price p Intercept c = - a Determined by the fixed cost, a

The linear law y = hx + c, quite interestingly, also suggests three different possibilities, depending on the numerical values of the constants h and c. This gives rise to what may be called Type I, Type II, and Type III companies. Examples of all three behaviors may be found in the real world, and have been discussed in the earlier articles (see www.scribd.com/). The three types can be described, briefly, as follows: 1. Type I (h > 0, c < 0, positive slope, negative intercept which also means a positive intercept on the x-axis, or the revenues-axis). Profits increase with increasing revenues. This is usually the case for all companies in the very early stages of growth and emergence into profitability. 2. Type II (h > 0, c > 0, positive slope, positive intercept). Profits increase with increasing revenues, but at a lower rate than in the Type I stage. 3. Type III (h < 0, c > 0, negative slope, positive intercept). Profits decrease with increasing revenues, or vice versa, i.e., profits increase with decreasing revenues. (Rarely negative intercepts on both axes.) As shown in the other related articles the profits-revenues data shows transitions between Type I to Type II to Type III behavior. Microsoft is a good example of a company that made the transition from Type I to Type II and then back again to Type I, in recent years. This is discussed separately (see bibliography list). Quite surprisingly, Type III behavior appears to be quite common and is observed with several companies in the Fortune 500 list of 2012. The consequence of these three types of behavior, taken together, is the maximum point on the graph of profits versus revenues for a company. This too has been observed with several companies, but alas, is not widely known to date. The most important and the largest of these is Ford Motor Company. Others are Verizon Communications,
Page 12 of 31

Yahoo, Kroger, Air Tran, Southwest Airlines, and the list seems to be growing. That is a total of 6 out of 24 (give and take) companies that I have studied since May 18, 2012.

4. Brief Discussion
The Line of Excellence and Einsteins Work Function
There are many different ways to fit a straight line through more than two points that seem to be lying approximately, but not exactly, on a straight line, as seen in Figure 1. A cursory examination suggests three groupings which yield different slopes, one of which (h = 0.362 for 2004 to 2006) happens to be highest slope. The slope and intercept of the best fit line, on the other hand, are determined using the method of least squares, first suggested by the French mathematician Legendre in a famous paper published in 1805. The best fit line always passes through point (xm, ym) where xm and ym denote the average or mean values of x and y in the data set. Thus, ym = hxm + c. Since the mean values of x and y are known, the intercept c can be fixed if the slope h is fixed. The Legendre formula for the slope h is as follows. h = (x xm)(y ym) / (x xm)2 (1)

To determine h, we first determine the mean values. Then find the (x, y) deviations of each point from the mean, (x xm) and (y ym). Take the product of the (x, y) deviations and sum up these products. This gives the numerator in the expression for h. Then determine the squares of the deviations of x from the mean and sum up all the squares. This gives the denominator. The ratio yields the slope h. Then the intercept is determined as already mentioned. As we see from our graphs, the data points still deviate from the best-fit line. Some points lie above the best-fit line and some are below the line. The deviations from the best-fit line (y yb) can be calculated. The sum of all such deviations will, of course, be zero, just like the sum of the deviations (x xm) and (y ym) is always equal to zero. (Young readers are encouraged to verify this by writing their own computer programs, using Microsoft Excel for example, to perform the
Page 13 of 31

calculations being described here instead of allowing the computer to choose the trend line for us.) Although the sum of all the deviations (y yb) is zero, the square of each deviation, (y yb)2, is always a positive quantity and hence the sum of all these squares is also positive. The best-fit line is also called the least squares line since it minimizes, mathematically, the sum of the squares of these deviations. This is the theoretical argument first was used by Legendre to arrive at the mathematical formula for the slope h given above. However, as Legendre himself recognized, there is nothing sacrosanct about this method, or the best-fit line. Any line is as good as another. Legendres exact words are, Of all the principles which can be proposed for that purpose, I think there is none more general, more exact, and more easy of application, that of which we made use in the preceding researches, and which consists of rendering the sum of squares of the errors a minimum. http://www.stat.ucla.edu/history/legendre.pdf English translation of the original paper. This is a really short paper, with a worked example and became the standard method in statistics within the decade (see Stigler, Stephen M. (1986). The History of Statistics: The Measurement of Uncertainty Before 1900. Cambridge, MA: Belknap Press of Harvard University Press. ISBN 0-674-40340-1.) This means that we are indeed free to choose any other line that we wish. The line with the highest slope suggested in Figure 5 is just as good as the best-fit line. We can refer to this as the Line of Excellence (LOE). Notice that the great majority of the data points (the only exceptions are the 2002 and 2003 data with very low profits and revenues) fall below this line with the highest slope. After making an initial guess for the LOE, and preparing the graph, the data can be re-examined to see if any other line, with a slightly higher slope, exists to ensure that all points fall below the revised (if any) LOE. Since the purpose of a business enterprise is to maximize its profits, highlighting the LOE as done here appears like a good way to call attention to the lost profits when a business does not perform at the same level as in its best years. Let yE
Page 14 of 31

denote the value predicted by the LOE for any revenue level. An interesting property of the LOE is that the deviation from the LOE is always positive and is equal to (yE y). For Google, it can be readily shown that sum of all the deviations from this LOE is equal to $8.91 billion. The calculations, quite straightforward, are summarized in the Table 4. (The negative deviations for 2002 and 2003 are examples of a few rare exceptions for reasons already discussed.)

18 16

Profits, y [$, billions]

14 12

The Line of Excellence yE = 0.363x 0.759 Joining 2004 and 2005 data Einsteins Work Function

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

Legendres Best-fit Line yb = 0.276x 0.172 With r2 = 0.9876

Revenues, x [$, billions]

Figure 5: Profits-revenues data for Google reconsidered again. The dashed (red) line is the best-fit line through the data, y = 0.27x 0.277. The solid blue line, with the equation y = hx + c = 0.363x 0.759, joining the data for 2004 and 2005 has a higher slope. We get nearly the same result, y = 0.362 0.755, if we join the data for 2004 and 2006. Google was able to convert about 36% of the additional revenues, between these years, into profits. The best-fit line yields a lower rate for revenues to profits conversion. The straight line with the highest slope, determine easily, yields the highest rate of conversion of revenues to profits and so can be
Page 15 of 31

called the Line of Excellence (LOE). This is unique to each company and its operations.

Table 4: Lost Profits for Google Due to the Deviations from the Line of Excellence
Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sums Revenues, x 0.43951 1.47 3.19 6.14 10.6 16.59 21.8 23.65 29.32 37.91 151.11 Profits, y 0.09966 0.10565 0.39912 1.47 3.08 4.2 4.23 6.52 8.51 9.74 38.35 Line of Excellence, yE -0.59934 -0.22526 0.39912 1.47 3.089 5.263 7.155 7.826 9.885 13.003 47.26 Deviations from yE -0.699 -0.331 0 0 0.009 1.063 2.925 1.306 1.375 3.263 8.911

Note: The difference of the sums in the bottom row (47.26 38.35) = 8.91. The sum of all the deviations in the last column also adds up to the same 8.91. Exactly similar calculation has also been demonstrated also for Air Tran in another recent article. The idea of the LOE, the line with the highest slope on the profits-revenues graph, proposed here can be compared to the idea of the maximum kinetic energy K of an electron which was emphasized by Einstein in the development of his photoelectric law. In this famous paper, published in 1905 (which actually fetched him the Nobel Prize), Einstein first shows rigorously (he discusses a property called the entropy of radiation) that light can be viewed as being made up of microscopic particles (we now call them photons) each having a fixed energy E = hf where f is the frequency and h is a universal constant (now we call it the Planck constant). This fixed quantum of energy was then a novel idea in physics and had been proposed by Planck in December 1900 in his analysis of the radiation emitted by heated

Page 16 of 31

bodies. Einstein was extending Plancks idea to light. (Some additional points regarding the photoelectric law are covered in the Annies Inc. article.) Thus, according to Einstein, when light shines on the surface of a metal, photons with the energy E are bombarding its surface. The photons thus knock out electrons from within the metal (these can be collected and made to flow in an electrical circuit, modern photocells work on this principle). The maximum energy of the electron K must obviously be less than E. Some of the energy E must be given up in order to do the work needed to overcome the forces that bind the electron to the metal. Einstein called this difference the work function W of the metal. Thus, Einstein arrives at the remarkably simple expression for the photoelectric law. K = E W = hf W = h [ f (W/h)] = h(f f0) (2)

The graph of K versus f must therefore be a straight line with a slope h, the Planck constant, which had been proposed as being a universal constant of nature in December 1900. Einsteins explanation of the photoelectric effect thus provided the first direct method of determining this fundamental constant of nature. The experiment, as described conceptually by Einstein in his 1905 paper, was indeed performed by Millikan, in 1916. Needless to say, Millikans experiments (with two metals, lithium and sodium, and with light of different frequencies, five in the lithium experiments, six in the sodium experiments) provided a stunning confirmation for Einsteins linear K-f relation. However, as noted by Millikan in the introduction to his experiments, and also emphasized by Einstein, it is extremely important to determine the maximum kinetic energy K. An accurate determination of h is only possible if the experiment is designed to determine the maximum K. The method of determining the maximum value of K is described clearly by Einstein in the 1905 paper. We are dealing with an exactly analogous situation here. Just as some of the energy E must be given up to produce the electron with energy K, a company is forced to give up some of its revenues R in order to produce what we call profits P. The difference, the costs C, is exactly analogous to Einsteins work function W. Thus, we arrive at exactly identical expression for the profits-revenues problem.
Page 17 of 31

P = R C = y = hx + c = h [x + (c/h)] = h(x x0)

(3)

The exactly analogous nature of equations 2 and 3 above is too compelling to overlook or ignore. Indeed, it appears that energy in physics is exactly analogous to money in economics. What we refer to as revenues, profits and costs, are renamed energy quantum E, the maximum kinetic energy K, and the work function W. The cut-off frequency f0 below which no electrons are emitted by the metal is exactly analogous to the minimum revenues x = x0 that must be exceeded before profits will appear (like an electron with energy K). If we appreciate this analogy, we can take this a step further. Just as it is important in physics to determine the maximum kinetic energy of the electron K, to permit an accurate determination of the universal constant h, it is important that we pay attention to the maximum slope h in the profits-revenues graph. This might provide us with valuable insights about the workings of the financial world by considering its smallest unit a single company. Based on my studies to date on many many companies (since about 1998-2000), it appears that the Line of Excellence (LOE) is usually determined very early in the life of a company. A loss is usually reported in the first few quarters before the company turns the corner. For example, Southwest Airlines, which has reported a profits for 39 years in a row, reported a loss in its first full year of operation (in 1972) and also in the partial year of operation in 1971. It reported its first profit in 1973. The highest slope h on its profits-revenues graph was also established very early between 1971 and 1974 (see bibliography for more details). After this, as we see with Google, profits were always lower. The same goes for Air Tran, which merged with Southwest Airlines in 2011. This then is the significance of the profound idea of a work function W which was conceived by Einstein, in 1905, to explain the photoelectric effect. A similar work function appears in many problems. The costs C in the universal equation applicable to all companies, P = R C, is indeed the work function in economics, business, and the financial world. Thus, money in economics can be treated like energy in physics. And, costs C can be treated like the work function W in physics.

Page 18 of 31

0.40

Line of Excellence (LOE)

Profit margin, y/x = h + (c/x)

0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 -0.05 -0.10 0 10 20 30 40 50 60

Best-fit lines

Revenues, x [$, billions]

Figure 6: The apparently erratic variation of the profit margins from a low of 0.72 in 2003 to a high of 0.291 in 2006 and the recent value of 0.257 is seen to be a consequence of the universal law y = hx + c which implies profit margin y/x = h + (c/x). Since the numerical value of c deduced from the linear regression analysis (h = 0.276, c = -0.172 and h = 0.271, c = -0.277) are negative, profit margins will increase with increasing revenues. The numerical value of the slope h is actually the theoretical highest value of the profit margin if revenues keep increasing and the present cost structure continues as reflected in the constants h and c. The two curves in blue are the predictions based on the best-fit lines. The curve in red represents the predictions based on the line of excellence (LOE), with h = 0.363, c = - 0.7589. All reported profit margins can be seen to be lower than the predictions based on the LOE. The data for 2008 is again seen to be an outlier. Finally, let us consider again the apparently erratic variation in the profit margins at different revenue levels, in the light of the universal law y = hx + c relating profits and revenues.
Page 19 of 31

If Then,

y = hx + c y/x = h + (c/x)

Profits-revenues relation Profit margin relation, with increasing revenues

The profit margins data can, therefore, be represented graphically and compared with the predictions of the universal law, see Figures 6 to 8. In Figure 6 we consider the Google data and in Figure 7 the annual data for Apple. The quarterly profits margin data for Apple is considered in Figure 8. The figure captions tell the story. The constants h and c used to prepare this plot were deduced as already discussed. The (red) squares in Figure 6 and the solid (blue) dots in Figures 7 and 8 are the actual profit margin data for various revenue levels.
0.30

Profit margin, y/x = h + (c/x)

0.25 0.20 0.15 0.10 0.05 0.00 0

y/x = h = 0.278

y/x = 0.278 (4.282/x)

20

40

60

80

100

120

140

160

Revenues, x [$, billions]

Figure 7: A PERFECT agreement between theoretical predictions, based on the universal law y = hx + c, and the actual observations, is seen here for the profit margins data for Apple (2007-2011). If y = hx + c, then profit margin y/x = h + (c/x). The graph of profit margins, with increasing revenues, is therefore a rising hyperbola (for c < 0, a falling hyperbola if c > 0). The profit margin y/x will
Page 20 of 31

approach the theoretical maximum value of h, the slope of the profits-revenues graph, when revenues become very large (assuming no change in the constants h and c which are related to the cost structure). The blue dots are the actual profit margins and fall smack on the hyperbola predicted by the universal law. The agreement here is remarkable and takes on the aura of a carefully planned scientific experiment.
0.35

y/x = h = 0.301 Profit margin, y/x = h + (c/x)

0.30 0.25

y/x = 0.301 (1.242/x)

0.20
0.15 0.10 0.05 0.00 0 10 20 30 40 50 60 70 80

Revenues, x [$, billions]

Figure 8: The quarterly profit margins (the ratio y/x) data for Apple Inc. (1Q2007 to 1Q2012) are seen to fall along the rising hyperbola predicted by the universal law y = hx + c = 0.3015x 1.242 relating profits and revenues, which implies that the profit margin y/x = h + c/x = 0.302 1.242/x will increase with increasing revenues. The theoretical maximum value of the profits margin (quarterly basis) is equal to the slope h of the profits-revenue graph and is indicated by the horizontal red line. The quarterly profit margins are now approaching this mathematical asymptotic limit.

Page 21 of 31

 5. Summary and Conclusions

1. The classical breakeven analysis for the profitability of a company making and selling N units of a single product can be shown to imply a simple linear relation between revenues x and profits y. Three constants, which will be called the (a, b, p) triplet, appear in this breakeven analysis for a single product. These are related to the fixed cost, a, the unit variable cost b, and the unit price p. In the real world (with many different products and different values for the basic triplet), this manifests itself as a simple linear law, y = hx + c with just two constants h and c which can be related to the (a, b, p) triplet. This gives rise to three types of behavior which can be called Type I, Type II, and Type III, depending on the numerical values of h and c (which may either positive or negative). 2. A careful analysis of the ten-years profits-revenues data (2002-2011) leads to the conclusion that Google Inc. is a Type I company (h > 0, c < 0), with profits increasing as revenues. Type I behavior also means that the profit margins (the ratio y/x) will increase continuously as revenues increase. The numerical value of the slope h is also the theoretical maximum profit margin that can be achieved by a company, assuming the present cost structure (reflected in the numerical values of the constants h and c) is preserved without any adverse impacts. 3. The well-known method of least squares (the classical linear regression analysis due to Legendre) can be used to determine the numerical values of the constants h and c in the universal law y = hx + c. This yields the best-fit line on the x-y profits-revenues graph. The constant h tells us how additional revenues, beyond the breakeven value, are converted into profits. When revenues increase by a fixed amount x, profits always increase by the same fixed amount y = hx. Hence, the higher the value of h, the higher the conversion rate of the additional revenues into profits. The numerical value of h, deduced using the best-fit line, yields the most conservative estimate for this rate of conversion of additional revenues into profits. For Google, the best-fit line yields h 0.27 which means a 27% conversion rate of revenues into profits.

Page 22 of 31

4. By regrouping the data (the same applies for any company) and performing a more careful analysis, it can be shown that Google Inc. has actually been able to convert additional revenues into profits at a higher rate, about 35% between 2004-2011. This leads us to the conception of what has been proposed here as the Line of Excellence (LOE), the line with the highest slope which joins any two (or more) data points on the profits-revenues graph. The significance of LOE may be appreciated further as follows: a) All data points on the profits-revenues graph will fall below the LOE. Hence, deviations from the LOE, unlike the deviations from the Legendre best-fit line, are always positive. The sum total of all such deviations represents the lost profits for a company when it fails to convert profits into revenues at the same high rate given by the LOE. b) All data points on the graph of profit margin (y/x) versus revenues (x) will also fall below the profit margins predicted by the universal law. c) The numerical value of slope h given by the LOE is theoretical maximum value of the profit margin of a company (if the present cost structure is preserved with no adverse impacts) as revenues increase. 5. The universal profits-revenues law P = R C, or y = hx + c, is shown to be exactly analogous to Einsteins photoelectric law K = E W = hf W from quantum theory. Money in economics behaves very much like energy in physics. What we call profits, revenues, and costs are exactly analogous to the maximum kinetic energy K of an electron, the energy E of the photon that produces the electron and the work function W, or that part of the energy E that must be given up to produce an electron with the maximum energy K. In an exactly similar way, a company has to give up some of its revenues R, in the form of costs C, to produce the profits P. The search for the LOE can thus be compared to the search for the electrons with the maximum kinetic energy K in the experiments by Millikan, which confirmed Einsteins theoretical predictions. 6. Interestingly, it is shown here that the numerical value of h 0.27 deduced here for Google Inc. (2002-2011), is also very close to being exactly the numerical value of h deduced for Apple Inc. (for 2007-2011). This may not be a mere fortuitous coincidence. Perhaps, and this needs more careful
Page 23 of 31

study, there is a universal value of h that all good or successful companies possess in any given economy (subject, of course, to tax laws which can vary and is the only variable, a socio-political one, which lies outside the control of the laws of supply and demand that govern the financial world and the economy as a whole). As noted under no. 5 above, the conversion of revenues into profits can be compared to the conversion of the energy of a photon into the energy of an electron in the photoelectric effect. A fixed universal value of h (Plancks constant) has been shown to apply in physics. Money in economics is just like energy in physics. 7. A more general nonlinear law, y = mxn [e-ax / (1 + be-ax)] + c, which is a generalized statement of Plancks radiation law (which was used by Einstein to deduce his simpler, linear, photoelectric law) can be used to describe the transitions from Type I to Type II to Type III behavior. This also implies a maximum point on the profits-revenues graph of a company. Such a maximum point has indeed been observed with several companies (the most notable ones are Ford Motor Company, Southwest Airlines, Air Tran which merged with Southwest in 2011, General Motors, which filed bankruptcy in June 2009, Yahoo, Verizon Communications, and Kroger). This point is being mentioned here for completeness and has been discussed in detail in other separate articles. 8. By considering a single-product, or a simple company, it is easy to clarify the basic concepts relating to the universal law relating profits and revenues, and the three types of companies, the Type I, Type II, and Type III companies. The same can be shown to apply in the real world with companies offering multiple products, each with its own (a, b, p) triplet, the constants in the breakeven analysis. It is hoped that investors and analysts, business leaders, including day-to-day practitioners, as well as academic scholars, might all find this simple classification scheme to be of value.

Page 24 of 31

Appendix 1 The Big Bang Event at Google Inc.

For completeness, since we have pursued the evolution of profits and revenues at Google Inc. from the earliest stages of its profitability, starting with 2002 to the present, it is of interest to note the following transition from Type II to Type I behavior made by Google. Type II behavior usually means decreasing profit margins although both profits and revenues are increasing. (Here y/x = 0.0058 + 0.0971/x .) Type I behavior means increasing profit margins with increases profits and revenues. (Here y/x = 0.362 0.755/x.)
0.120

0.115

Profits, y [$, billions]

Type II behavior y = 0.0058x + 0.0971 h > 0, c > 0 decreasing y/x

0.110

0.105

0.100

0.095

Type I behavior y = 0.362x - 0.755 h > 0, c < 0 increasing y/x

0.50 1.00 1.50 2.00 2.50 3.00

0.090 0.00

Revenues, x [$, billions]

Figure 9: Type II to Type I transition between 2002 and 2004. The solid blue line with a small slope is the line joining 2002 and 2003 data. Google then started
Page 25 of 31

operating along the dashed line with a steeper line (Type I) from 2004 to 2006. Google then took off after this Big Bang event. Going back to Table 1, between 2002 to 2003 revenues increased by x = 1.03 or almost $1 billion. The profits, however, increased only slightly by y = 0.00599 or $5.99 million. Thus, the slope h = y/x = 0.005813 and this straight line segment makes a positive intercept c = 0.097 on the y-axis, see Figure 9. This is Type II behavior. Notice that the profit margin dropped from 22.7% in 2002 to 7.2% in 2003 although revenues increased dramatically. This was then followed quickly with a transition to Type I behavior, as indicated by the dashed line Figure 9 and with the lines of high positive slope in earlier figures. The profits-revenues equation for 2004-2006 is y = hx + c = 0.362x 0.755 as also discussed earlier. Why Type II at the very start? Actually, if we dig deeper we find the following additional information from the 2004 Google Annual Report, see http://investor.google.com/pdf/2004_google_annual_report.pdf It starts as follows: Google was born in 1998. If it were a person, it would have started elementary school late last year (around August 19) and just about finished first grade. Of course, companies are not people. Among other obvious differences, they must be responsible and self-sufficient at a very early age. But, a long perspective, like that of a human lifespan, is useful in assessing year-to-year developments. While it may seem like we have come far already, this is just the beginning of a lifetime. And while Google is not a single person, it does embody the effort, ability, commitment of thousands of individuals. Together we strive towards a common mission ..etc. The following financial data are available from the 10-K SEC filings on page 30 of this pdf file.

Table 5: Selected Financial Data for Google (2000-2004)

Year 2000 2001 2002 2003 2004 Revenues, x $, millions 19.108 86.426 439.508 1465.934 3189.223 Profits, y $, millions -14.690 6.985 99.656 105.648 399.119 Profit Margin%, 100(y/x) -76.9% 8.1% 22.7% 7.2% 12.5%
Page 26 of 31

Like most companies, Google actually reported a loss early on in 2000 and showed Type I behavior between 2000 to 2002, then a transition to Type II and a quick transition back to Type I starting 2003.

1.8 1.6

Profits, y [$, billions]

1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 0

Type I behavior (2000-2002) y = 0.272x - 0.0199 h > 0, c < 0 increasing y/x

Type I behavior (2004-2006) y = 0.362x - 0.755 h > 0, c < 0 increasing y/x

Revenues, x [$, billions]

Figure 10: Type I to Type II and back to Type I transition by Google between 2000 and 2004. The solid blue line is the initial Type I when Google first reports a profit. This is followed by a Type II transition (reduced rate of conversion of revenues into profits and then back to a Type I behavior from 2004 to 2006. Notice however, that this also means the fixed cost went up and the line of excellence (LOE) established during 2004-2006 has continued to date. All profits reported since this transition have been lower than the LOE discussed earlier This actually provides a nice addition to the story of the birth of Google as discussed in their 2004 Annual Report and the Big Bang event in its early life that has led to expanding profits and revenues, although at a lower rate.
Page 27 of 31

 6. Bibliography
Related Internet articles posted at this website Since the Facebook IPO on May 18, 2012
1. http://www.scribd.com/doc/95906902/Simple-Mathematical-Laws-GovernCorporate-Financial-Behavior-A-Brief-Compilation-of-Profits-RevenuesData Current article with all others above cited for completeness, Published June 4, 2012 with several revisions incorporating more examples. 2. http://www.scribd.com/doc/94647467/Three-Types-of-Companies-FromQuantum-Physics-to-Economics Basic discussion of three types of companies, Published May 24, 2012. Examples of Google, Facebook, ExxonMobil, Best Buy, Ford, Universal Insurance Holdings 3. http://www.scribd.com/doc/96228131/The-Perfect-Apple-How-it-can-bedestroyed Detailed discussion of Apple Inc. data. Published June 7, 2012. 4. http://www.scribd.com/doc/95140101/Ford-Motor-Company-Data-RevealsMount-Profit Ford Motor Company graph illustrating pronounced maximum point, Published May 29, 2012. 5. http://www.scribd.com/doc/95329905/Planck-s-Blackbody-Radiation-LawRederived-for-more-General-Case Generalization of Plancks law, Published May 30, 2012. 6. http://www.scribd.com/doc/94325593/The-Future-of-Facebook-I Facebook and Google data are compared here. Published May 21, 2012. 7. http://www.scribd.com/doc/94103265/The-FaceBook-Future Published May 19, 2012 (the day after IPO launch on Friday May 18, 2012). 8. http://www.scribd.com/doc/95728457/What-is-Entropy Discussion of the meaning of entropy (using example given by Boltzmann in 1877, later also used by Planck to develop quantum physics in 1900). The example here shows the concepts of entropy S and energy U (and the derivative T = dU/dS) can be extended beyond physics with energy = money, or any property of interest. Published June 3, 2012. 9. The Future of Southwest Airlines, Completed June 14, 2012 (to be published).
Page 28 of 31

10.The Air Tran Story: An Important Link to the Future of Southwest Airlines, Completed June 27, 2012 (to be published). 11.Annies Inc. A Single-Product Company Analyzed using a New Methodology, http://www.scribd.com/doc/98652561/Annie-s-Inc-A-SingleProduct-Company-Analyzed-Using-a-New-Methodology Published June 29, 2012 12.Google Inc. A Lovable One-Trick Pony Another Single-product Company Analyzed using the New Methodology. http://www.scribd.com/doc/98825141/Google-A-Lovable-One-Trick-PonyAnother-Single-Product-Company-Analyzed-Using-the-New-Methodology, Published July 1, 2012.

Page 29 of 31

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 Planck, referred to here as the generalized power-exponential law, might actually
Page 30 of 31

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.

Cover page of AirTran 2000 Annual Report

Acknowledgements
With sincere thanks to the 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. All of them have cited and are liberally and profusely acknowledged.
Page 31 of 31