A common trait in all value investors – big and small – is that they see themselves as part owners of a business.
They maintain a micro view of the business by analyzing quarterly earning results. But they also maintain a macro view of the business: an educated estimate of the business’ and the performance in the next five to ten years.
In other words, astute value investors think as promoters should. But most promoters don’t think like this. Little wonder that they struggle to raise capital to enhance their business performance and generate wealth.
If you think, as a promoter, you’re the biggest investor in your business. Equity investors pump capital into a business. But you infuse your time, effort, blood, sweat, and tears along with your own capital. Don’t you think it’s your responsibility to look at your business the way investors do?
Look at Your Business Like Warren Buffett Would
Warren Buffett created tremendous wealth for himself and the stakeholders of Berkshire Hathaway by investing in businesses that generated long-term wealth. Looking at your business through his eyes will help you do the same for yours.
Equity investors look for the potential of a business to multiply its value in terms of future valuation. Since profits dictate valuations, equity investors assess whether the business is currently generating profits and will continue to do so in the future.
Businesses that answer “yes” to both aspects match their criteria. It means such businesses will generate long-term-wealth.
As a promoter, here are three questions to ask yourself if you’d like your business to generate long term wealth:
Q1. “Am I building a sustainable moat for my business?”
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it… protecting a terrific economic castle with an honest lord in charge of the castle.” – Warren Buffett.
A moat around a castle protects it from enemies. Lesser attacks on a kingdom will mean it has more opportunities to grow and become powerful.
In business terms, a moat is a company’s advantage that protects it from its competitors. This advantage doesn’t come from being the largest or best in the industry. It comes from being different.
When your business develops a unique ability to address opportunities, one that competitors struggle to imitate, it differentiates itself and builds a moat. Nestle built moats with Maggi, as Bata did with children’s school shoes.
As a promoter, asking yourself the below questions will guide you towards building a moat:
- Are we relevant as a business?
- What pain points of our customers do we address?
- Do customers perceive us as a differentiated solutions provider?
But merely being different is not enough. Just the pursuit of a moat doesn’t guarantee profits. You must also examine whether your differentiation is useful for customers. The next question shows how to find that out.
Q2. “Are we building robust financials?”
As stated above, a moat is all about building a differentiated quality business. However, a differentiation turns into a competitive advantage only if customers find it useful or novel, and are willing to pay for it.
The below financial ratios will help you track whether customers are willing to pay for your differentiated offering. Working on them will improve the quality and value of your business.
Pricing Power Reflected By:
- Operating Profit Margin: The percentage of revenue left after incurring the cost of goods sold and operating expenses. The higher the percentage, the better.
- Net Profit Margin: The percentage of revenue that remains after deducting all operating expenses, interest, and taxes from the company’s revenue. The higher the percentage, the better.
Capital Efficiency Reflected By:
- Return on Capital Employed: A financial ratio that measures a company’s profitability in terms of all its capital. The higher the ratio, the better.
- Return on Equity: A ratio that measures how much profits the business generates from the equity invested. The higher the percentage, the better.
Discipline and Risk Management Reflected By:
- Debt-Equity (D/E) Ratio: This ratio indicates a company’s financial leverage by measuring the shareholder’s equity against the debt the company services. The lower the ratio, the better.
- Interest Coverage Ratio: The ease with which a company can pay interest on its outstanding debt. A higher ratio is better.
Quality of Business Reflected By:
- Operating Cash Flow: The amount of cash a company’s core business generates. The closer the operating cash flow is to the operating profits, the better.
- Current Ratio: The company’s ability to finance its current liabilities with its current assets. A higher ratio is better.
- Inventory Churn: How well a company generates sales from its inventory. A higher churn is better.
- Receivables Churn: How quickly cash gets collected from debtors. A higher churn is better.
- Fixed Assets Churn: How effectively the business generates sales from its fixed assets. A higher ratio is better.
- Total Assets Churn: How effectively the business generates sales from its total assets. A higher ratio is better.
“It is not necessary to do extraordinary things to get extraordinary results,” Buffett said. Do what’s simple, and do it well.
Fruits change when we work on the roots. Ratios improve when we improve the quality of our business. Focus on the right financial ratios and you’ll build a wonderful, ever-widening moat around your business.
(If you cannot access these metrics easily, ask your CFO to make a dashboard that you can track monthly.)
Focusing on these ratios is important. But you cannot afford to ignore growth in the process. Which leads us to the final question.
Q3. “Are we growing in the right way?”
Small-sized companies can generate good financial ratios. But maintaining that pace when they grow to medium- or large-sized ones is the true test. When businesses cannot grow in streamlined ways, diseconomies of scale occur, where the cost per unit increases as businesses grow.
This happens for various reasons. Some include:
- Businesses acquire their competition for hefty prices.
- They build excess capacities by ignoring the demand-supply situation of the industry.
- They diversify mindlessly in unrelated areas. (Peter Lynch terms such outrageous diversification as Diworsification.)
The result is chaos where nobody knows what they’re doing and why. All the company focuses on is short-term results. In the process, promoters lose sight of whether they’re heading in the right direction.
The right growth trajectory occurs when companies can grow while maintaining their financials. Nestle, Asian Paints, and Page Industries are examples. They went from strength to strength, growing at a wonderful pace while maintaining healthy financial ratios.
Seeing your business through an investor’s eyes doesn’t mean fussing over the balance sheet. It means focusing on the quality of your business.
To enhance the long-term quality and valuation of your business, simply ask yourself three questions:
- “Am I building a sustainable moat for my business?” A moat gets built when your offering is differentiated.
- “Are my financials robust?” Robust financial ratios indicate whether your customers are willing to pay for your differentiation.
- “Are we growing in the right way?” If your business is growing while the financials stay constant, you’re on the right path.
When the growth trajectory goes hand-in-hand with financial ratios and differentiation, your business turns into what you dreamed it would be.