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How good is the business? Health of a business is decided by answering following questions:
- Simple and understandable business
- Consistency in Business
- Good Long term prospects
Simple and Understandable Business
In order to analyze the prospects of a particular business, if we can say that a particular business is not so complicated to understand in terms of its customer base and operational requirements, then the business can be considered as good.
Warren Buffett firmly believes that the “investor’s financial success is correlated to the degree in which they understand their investment”.
This understanding about the business differentiates an investor form a trader. A trader just buys shares on basis of its market value but an investor first understands the business and then puts his money into it. The ultimate objective of any investor is that their investment shall sufficiently grow over time and this can happen only if the business itself grows.
To predict the success of the business becomes a lot easier if an investor understands the business. Warren Buffett always advises his followers to “Invest within your circle of competence”. For the new investors developing competence will take some time, till then he can follow “Book Value and P/E Ratio” technique to buy stocks. The question is how to develop this circle of competence? If you can answer the following about a business (even approximately) it means you have started developing competence about that business.
Revenues – How company generates it?
Expenses – What is the total value & its break-up?
Cash Flow – Is it positive or negative?
Labor Relations - How company manages it?
Pricing Flexibility – Can company raise its price when required?
Capital Allocation - how’s the capital allocated to give maximum returns?
Consistency of Business
Warren Buffett likes to own companies that “that he believes will be successful and profitable for the long term”. But as I said earlier, forecasting future profitability of company is not easy, “but a steady track record is a relatively reliable indicator”.
But going by companies past track record is step two. An investor shall spend time to understand the business aspects as discussed above then go to analyze the “Consistency of Business”. “When a company has demonstrated consistent results with the same type of products year after year, it is not unreasonable to assume that those results will continue”. Concentrate on companies’ consistent results like profit,
Warren Buffett suggest that the following companies if avoided will be better
“Companies which are fundamentally changing direction because their previous plans have failed”. Like a company deciding to venture into media, next year into mobile business, then next year into real estate and none seemed to show good results.
Trying too many things without success means that a proper growth plan is not in place and company is only trying hit and trial method to prove its success.
“Companies in the midst of corporate reorganization”. In business it not uncommon to find that “big changes” within company do not result in positive results. Business is an activity that is built on strong fundamentals. Huge changes within organization often call for turmoil than growth.
Good Long term prospects
Warren Buffett has a very easy way of defining a company with a long term business prospects. The product or services of a company gives it a clear advantage over its competitors if they have the following characteristics:
Its product or services is needed or desired
Its product or services has no substitute (unlike commodities)
Its product or services is not regulated (say by government)
In simple terms a company which has a product or services that is going to be sold irrespective of the market situations. Such a situation allows the companies “to raise its prices even when demand is flat and capacity is not fully utilized”.
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