If you read financial writing for any length of time, the jargon and acronyms will overwhelm you. Consider the many tools used to value a business: P/E ratios, enterprise value (EV), free cash flow (FCF)… The list is endless — and confusing.
Fortunately, there is a real-world, common-sense method for evaluating businesses. Use it the next time you consider an investment.
These are the only four rules I follow when evaluating a business.
Rule No. 1: I must understand — and be comfortable with — the way the business works.
First and foremost, I have to understand and be comfortable with how the business acquires (or, in the case of startups, intends to acquire) new customers. I need to know what media it will be using, what kind of advertising campaign, what sorts of offers and copy approaches it will be using, and what all this will cost on a per-customer basis.
And all of that needs to make sense.
Next, I need to know — and be comfortable with — how it plans to optimize those customers, what sort of additional products and services it will offer them (at what price points), and the timing.
I’m looking for an estimated value of each customer, depending on media and advertising strategies, in the first and subsequent years. I also have to understand the product, why there is a demand for it, and how the company can sell that product better than its competition.
Rule No. 2: I have to understand the industry and believe it is trending up.
This is as important as the first rule — maybe more.
Understanding an industry is a challenge. Every industry has its own dynamics. Retail, manufacturing, and wholesale businesses all operate differently from one another. And within each industry, each sector has its own rules.
Clothing stores and bars, for example, are both retail businesses, but they require very different approaches. Inventory (what you have in stock) is a complex and critically important decision for clothing stores. But, it’s a rather minor and obvious factor in running a successful bar.
Here’s the thing about industry knowledge: You can’t find the most important factors in spreadsheets or in books on business. (Not even in For Dummies guides.) You have to have experience — actual experience — in the industry.
That’s why I very seldom invest outside the half-dozen industries I know. And when I do break this rule, I almost always lose money.
If I understand the industry, it’s relatively easy for me to know which way it’s trending. I will already know the major players and be aware of how they are doing. I will have an idea about what new products and companies are coming into the market and what older products and companies are moribund.
What I want is an upwardly trending industry or sector within an industry. That’s important because, as the saying goes, a rising tide lifts all boats.
I don’t rely on data compiled by analysts for this. It’s often created and paid for by companies with a vested interest in the results.
Rule No. 3: I have to understand the financials, and they have to be solid.
If I’m comfortable with the business plan and the industry trend, I look at the profit and loss (P&L) statement, the balance sheet, and the marketing data/projections.
Since I have no formal education in finance, I’m not particularly adept at analyzing numbers. But, if they are related to businesses I know, I feel comfortable looking at them because I know what to look for.
If, for example, I’m looking at an Internet marketing or publishing business, I have a very good idea about what the revenues, expenses, and profit margins should be. I will also have a good idea of what normal growth looks like… and where the dangers may be lurking.
For example, with a subscription-based publishing business, something called “deferred subscription liability” will show up in the balance sheet. This is a very important number. An accountant may have no idea whether it is an actual liability or a hidden asset unless he or she knows the business and industry.
If I’m looking at a company from another industry, I won’t understand. And if I don’t understand, I’m likely to overlook something.
Another thing I look for is cash and cash-flow. I want to feel sure the business has sufficient cash to sustain itself while growing. The first few years of any startup are always a challenge in terms of cash flow. And what is needed often exceeds what you believe you will need when you begin.
I don’t believe in overfunding startup businesses. I like when the leadership team is very careful about its spending. But I don’t want the business to fail simply because it runs out of cash too soon.
Rule No. 4: I have to believe in the people running the business and believe they will allow me to have some input into their key decisions.
The business plan can be strong. The industry can be trending up. And the numbers can be solid. But, if I feel even the slightest bit unsure about the principal players, I will pass.
This is a very important rule. It’s also a rule I have broken in the past. Every time I’ve broken it, I’ve come to regret it.
I’m looking for proven experience, emotional intelligence, healthy ambition, and, most of all, good character. For me, character counts most because, as an investor (rather than a controlling partner), I need to trust these key people to develop the kind of business I can be proud of.
Also, I want a say in how they are going to build the business. I don’t want to be the boss, but I want to know they would at least listen if I felt they needed my advice about product development and marketing. In the early stages, especially.
These rules have worked for me as an investor on the private side. And so, I was happy to learn from my reading that they were similar to the rules Warren Buffett used in making decisions about investing in public companies.