What’s A Good Business, What’s A Mediocre Business, What’s A Bad Business And Why by Sanjay Bakshi, Slide Share
“Time is a friend of the good business and the enemy of the mediocre”. – Warren Buffett
Measures of Economic Performance
- Growth in revenues?
- Market share?
- Growth in Profits?
- Growth EPS?
- Profit Margin?
- Capital Efficiency?
- Return on Capital?
Proof by contradiction.
Model a small time vendor
The Case of Five Companies
Relation between returns on capital, dividend policy, and stockholder returns
Key Principle # 1
Assets are worth more than book value when they are expected to earn a return on capital employed which is more than market rates of return. And Vice Versa…
Implication: Many assets are logically worth LESS than book value.Implication: Don’t assume an asset is cheap simply because its selling forless than book value.
Key Principle # 2
Assets lodged in the hands of a manager who thinks and acts in the interests of the owners are worth more than identical assets lodged in the hands of a self-interested manager.
Implication: Dividend Policy Matters. While the value of a ?rm may be independent of dividend policy (in an efficient market – bad assumption),the wealth of owners is NOT independent of dividend policy. In bad earnings retention, every Rs 100 earned should deliver LESS than Rs 100 in increment market value.
Key Principle # 3
All growth is not good. There is good growth and there is bad growth. Good growth creates value. Bad growth destroys it.
Buffett on Best Businesses
Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.
Key Principle # 4
Some businesses can grow WITHOUT requiring any incremental capital. They are a very special class of businesses
Key Principle # 5
None of these, in isolation, are accurate measures of the greatness of a business: Growth in revenues, Market share, Growth in Profits, Growth EPS, Profit Margin, Capital Efficiency, Return on Capital
Key Principle # 6
Price, like Love, Changes Everything*
*Conditions Apply
Time is a friend of the great business, enemy of the mediocre.
Measures of Economic Performance
“Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share.”
“After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”
“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”
“In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.”
Buffett on Best Businesses
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return”
“The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return.”
“The business is wonderful if it gives you more and more money every year without putting up anything – or by putting up very little. And we have some businesses like that. A business is also wonderful if it takes money, but where the rate at which you re-invest the money is very satisfactory.”
Scott-Fetzer
Berkshire purchased Scott Fetzer at the beginning of 1986. At the time, the company was a collection of 22 businesses
Acquisition cost: $315.2 million for Scott Fetzer, against book value of $172.6 million.
“The $142.6 million premium we handed over indicated our belief that the company’s intrinsic value was close to double its book value.”
Earnings per share = Asset turnover x Return on sales x leverage x Book value per share
EPS=(Sales/Assets) x (Net Income/Sales) x (Assets/Net worth) x (Net worth/Shares outstanding)
Why is time a friend of the wonderful business?
EPS will not grow simply because of sales growth because sales ?gure is numerator in component1 and denominator in component 2. Only through increase in any component, or a reduction in shares outstanding will result in an increase in EPS
Aggressive management can boost turnover only up to a point
Return on sales (margin) cannot be increased indefinitely because of regulation and competition.Leverage too has a limit.
Only book value per share which can rise unceasingly through earnings retention can be a source of sustainable growth in EPS.
But we’ve already seen that not all earnings-retention-caused EPS growth is good.
You also need high incremental return on capital
“Time is a friend of the good business and the enemy of the mediocre”
Why? Importance of Earnings Retention
“Because it had excess cash when our deal was made, Scott Fetzer was able to pay Berkshire dividends of $125 million in 1986, though it earned only $40.3 million.
“Scott Fetzer’s earnings have increased steadily since we bought it, but book value has not grown commensurately. Consequently, return on equity, which was exceptional at the time of our purchase, has now become truly extraordinary.”
See full slides below.
