Sharing the PART 2 of the Business Quality checklist process. Click here to read the PART 1 of the Business Quality checklist.
UNDERSTANDING THE BUSINESS:
CORE OPERATIONS
» What does the company do? Is the company doing something unique?
» Can I understand their business and estimate their future cash flows reliably?
» What is the revenue mix? What product sells the most and why? Where are they used?
» How many plants do they have and where are they located? Does that give any kind of geographical advantage/disadvantage?
» Is company running in full capacity? How has been the utilization historically?
» How has the company been utilising the cash flows that it generates annually? What kind of returns are they generating on their incremental cash flows?
» Who are the company’s clients or end users? Do any of them contribute more than 10% of the total revenues? What all factors affect the demand and supply of the product/service? How is the elasticity of the product/service?
» What kind of raw material is required? Is it accessible easily? Or can potential problems related to procurement occur?
» Do they plan to launch a new product? Is the product related to core business?
» Is the business labor intensive? Is there any chance of potential labor strike happening in the future? What kind of disruption will happen?
» What is the percentage fixed cost of the business and the industry? Would that somehow lead to an advantage/disadvantage to the company? What about the operating leverage? Is it possible that margins will collapse in bad times?
» What are the factors, both internal and external that affect the company? What percentage do they each contribute to the company revenues?
RISK FACTORS
» What are all the possible threats/problems that the company face or will face in the future? In what all scenarios can my investment prove to be wrong?
» Will the company still be relevant after 50 years down the line?
» How volatile are the prices of the product/services it sells? Can it be estimated reliably?
» Can the business be affected by tech. shifts or changing consumer preference?
» Is the company growth higher than industry growth? If yes, is it very high? (suspicious) If no, is the management incapable etc.?
» Do they operate under heavy regulation? Is it good or bad?
» Has there been any recent event that has affected the company in any way?
» What all likely changes can happen structurally in the company and the industry? How likely is it and how will it affect the company profits?
» Has the company grown abnormally? Will it experience diminishing returns from now? Will it attract competition because of this?
» Does the business gets affected by any kind of external event/factor which can’t be controlled? How will it impact the profitability of the business?
» What are the characteristics of a good player in the industry? How does the company stand in relation to it? For ex, compared to industry leader, what all does it lag?
» What are the reasons that the company won’t be a good candidate for takeover? Is the stock up/down due to cyclical reasons or is it going through a structural change?
HOLDING STRUCTURE AND OTHERS
» Who are the promoters? How much do their hold? What is their background?
» How many subsidiaries do they have? Or are they having a holding company?
» Is it too many subsidiaries for one business? Are the related party transactions carried on an arm’s length basis? Who are the major shareholders?
» Who are the competitors? Is the competition fierce?
» How easy it is to start a similar business?
» How is the company performance in relation to its peers? What are the reasons for this differential performance with its peers?
» Who are their bankers and auditors? Have they resigned historically? Why?
» Is there any catalyst that would unlock company value? If not, then why are you buying the stock? What do you expect from the business?
» What are the weakest points of the investment you have been researching?
IDENTIFYING THE TYPE OF GROWTH:
It is important to assess the market conditions in which the business is operating. You need to see if there is market potential and demand for their products/services and if there is room for the business to grow in multiples in the coming years. Also, check the level of penetration of products for the particular industry. High growth can largely happen in two ways. One, either the industry is growing at a very fast pace or two, the company is growing at a fast pace.
INDUSTRY GROWING AT A FAST PACE
In this case, it is very crucial to check at what rate the competitors are growing. If the competitors are growing at a faster pace than yours, then you might be losing out market share. You need to find out the reason why competitors are growing faster than you.
COMPANY GROWING AT A FAST PACE
In the second case where you are specifically growing faster than others, you need to check if it is because of something unique about your product/services that is making you grow faster than others or is it because competitors are exiting the industry leaving a higher market share potential capture for you. You would also need to keep in mind the potential of the company that it can grow to and capture the market share. For example, if the company size is too small and if their offering is somewhat better than the competitors, it will have a potential to grow at a tremendous rate and for a longer period of time. (depending upon the company moat characteristics and industry specific characteristics)
You have to consider how growth will happen in the future because that will impact your valuations and make the stock less/more worthy of buying at prevailing market prices. High growth is attainable if industry size is small enough or market penetration is low enough to create demand or if the product/service itself will be in demand no matter what happens 50 years for now. High growth will also come if company product/services are good enough to eat out competitor’s market share. Never pay extra valuation for low growth companies. Such companies are value traps which will fail to generate even a decent amount of profit.
ESTIMATING FUTURE GROWTH RATE
First, we need to check how much of the revenues the company is earning in cash. Higher the accrual, lower (and lowering exponentially faster) the growth rate. It is also very important to calculate estimated market size still left to be penetrated (using raw calculations), use your own judgement of the product and management quality and estimate a rough expected growth rate without checking historical growth rate. Compare this expected number with historical growth rate and list down the reasons for deviations. Historical numbers might give you a clue about the what might be coming, but it is the future earnings that give valuation to the company. For example, you can calculate future potential for middle class people buying cars in the coming years * market share of the company while analysing auto sector.
MATHEMATICAL FORMULA FOR GROWTH
Growth can also be judged using the formula (G = Retention Ratio * Return on Capital) provided the company is running in near full capacity. It can give a fair idea on the rate of growth that will be applicable in the long run. But, you need to make sure that the growth is always measured on cash flows instead of profits as accruals have a big negative impact on the valuation of the business.
FACTORS AFFECTING DEMAND OF THE PRODUCT/SERVICE
The below mentioned factors must be used to determine the demand elasticity of the product/service the company is offering. This will also help in determining the growth rate business can achieve in the coming years, the risks that are linked to the business, how management is dealing with the pricing of the product/service etc.
NATURE OF THE PRODUCT/SERVICE -
Is it luxury or a necessity? If the goods are a luxury, their consumption will be highly elastic and their demand will be directly related to how the businesses perform in the economy. The opposite is true for necessity goods.
INCOME OF THE CONSUMER GROUP
Are they rich? Or are they middle class or poor? In case they can’t afford higher prices, the company directly loses out on pricing power.
EASE OF SUBSTITUTES
Is there any substitute in the market? Is it available easily? If yes, then again the business loses out on pricing power and is subject to threat of substitution.
PRICE OF RELATED GOODS
There are 2 related goods, one is complementary good which is directly related to the product in question and the other is substitute good whose price has an inverse relation with the demand of the product in question.
EXPECTATION OF FUTURE PRICES
If consumers affect the prices of the goods to increase in the future, they will try to purchase as quickly as they can. Same is true for the opposite case.
TASTES AND PREFERENCES
Consumer tastes can change drastically within no time. For example, in clothing, one particular style goes out quickly and is soon replaced by another style. Businesses facing this threat will have an uncertain and risky demand.
SHARE IN TOTAL EXPENDITURE
This is one of the major factors affecting demand. For example, car makes up a large portion of consumer expenditure and thus will have high elasticity as compared to biscuits.
NUMBER OF CONSUMERS
If a market is controlled by a few consumers who can stop buying anytime, the business will be an uncertain one. If market is full of consumers, even if some customers stop buying the product, the demand will not get affected that much.
POSTPONEMENT OF CONSUMPTION
If consumers are able to postpone the purchase of the good, this will make revenue coming slower and demand more elastic in bad economic times.
HABITS
Goods like cigarettes have loyal habitual customers with certain demand. They will most likely not be affected by downturns and will continue to buy the product/service.
PORTER’S 5 FORCES:
LEVEL OF COMPETITION
» What is the industry structure? Is it perfect competition?
» Does brand loyalty matter here? How fierce is the effect?
» What is our strategy: differentiation or low cost? What do competitors follow?
» Is heavy advertising required for the product/service to be sold?
» What has been the historical growth rate of the industry?
» Is the industry or company profits that lucrative that it attracts competition?
» How fierce is the competition? What is their product quality compared to ours?
THREAT OF NEW ENTRANTS
» How much time and money will it take to replicate the business?
» What can existing firms do about new entrants?
» How tightly is the sector regulated? Is it good/bad?
» Does my business have any moat which protects me from competition/entrants?
» In what ways cost advantage can be achieved independent of size?
» Does the industry offers high returns so as to attract new entrants?
THREAT OF SUBSTITUTES
» How close substitutes are available for the product/service?
» Will there be any material effect on the lives of people if the product/service production stops tomorrow? In short, what is the demand elasticity?
» What is the buying propensity of the substitute product/service?
» How easily available is the substitute to the consumers?
POWER OF SUPPLIERS
» How many suppliers are there in the industry? Is supply < demand?
» How easily can suppliers increase my raw material cost?
» How unique my raw material is? Is it difficult to obtain raw material myself?
» Do they charge switching cost from the buyer?
» Do I have the ability to do vertical integration and cut out the supplier?
POWER OF BUYERS
» Is the product really needed or one can survive without it? Is demand elastic?
» Is my product specifically expensive? What is the price sensitivity? Do people have to spend large amount of money to get it? Can demand be postponed/delayed?
» Does my business has price setting power? Can buyer drive my price down?
» Is the switching and searching cost for the buyer high or low?
» Is my product unique or homogeneous?
» Is backward integration possible from the buyer’s perspective?
Do not consider this list as exhaustive. This is just one check for understanding one of the most important operations of the business. Apart from finding out the answers to these questions, it is very important for the investor to connect the dots himself and really understand the complete flow of the business ranging from procurement (start of the cycle) to sales and the process afterwards. Ensure that you understand the business in and out. If you feel that you are unable to understand its operations, do not invest. Always know your circle of competence.
With this we come to an end with the checklist we use to analyse businesses. We try to get as much information (but only important) as possible and try to process it systematically in order to make informed decisions. We strive to get better in this domain and also help the investing community along with it so that everyone benefits from everyone's expertise.
Happy Investing!