The Stability Principle

What does The Stability Principle state?

This principle holds that a company’s earnings are much more stable than we
would expect. Net income is frequently a modest amount that remains when
charges are offset against revenues. Net income represents an equilibrium that is
not necessarily upset by external factors. Let’s consider, for instance, a supermarket
chain, whose net income is roughly equal to its net financial income. It would be a
mistake to say that if interest rates decline the company’s earnings will be wiped
out. The key issue here is whether the company will be able to slightly raise its
prices to offset the impact of lower interest rates, without eroding its competitive-
ness. It probably will be able to do so if all its rivals are in the same boat. But the
company may be doomed to fail if more efficient distribution channels exist.
The situation is very similar for champagne houses. A poor harvest drives up
the cost of grapes and pushes up the selling price of champagne bottles. Here the
key issue is when prices should be increased in view of the competition from
sparkling wines, the likely emergence of an alternative product at some point in
the future and consumers’ ability to make do without champagne, if it is too
expensive.
It is important not to repeat the common mistake of establishing a direct link
between two parameters and explaining one by trends in the other.

Click here for government certification in Accounting, Banking & Finance