This was an interesting read that made me think from the point of view of a business owner and not a stock investor that relied on historical multiples. Will I buy a business in real life that are not making profits? Will I buy a business that has poor margins? If this is the case, why am I willing to invest in businesses in the stock market with a looser criteria then?
I used to only focus on “Business with long runway for revenue growth” without giving too much thoughts on its actual ability to deliver operating profits in the long run or the valuation that I am buying it at.
3 key takeaways
Focus on business ROE or ROA
This is a better indication on the quality of business. If ROE is sustained at high levels consistently, this demonstrates that management is able to generate meaningful return on the given capital employed. This could also be due to superior economics of business (think mastercard/visa - a good industry). If that’s the case, this is something you should be willing to pay for - for the same amount of earnings as it can drive higher shareholder value if each growth in operating profits require a small capital base.
i.e Pay more for something that makes $1 with a $2 capital base than something that makes $2 with a $10 capital base.EV/Operating Profits or EV/EBIT = Acquirer’s Multiple
(THE LOWER THE MORE INTERESTING TO LOOK AT)
This screens for “undervalued” companies or companies that operate in favorable economics space with high operating margins - what we are looking for. The next step is to figure out why it is trading at such cheap multiples and how it stacks up against its peers.
Difference between EBIT and Operating profit is that operating profit starts from the top and EBIT starts from net income and adding back I and T. Operating profit is better because it omits one-off gains/losses from sale of assets or lawsuits that was taken up by the company.Zig and Zag theory
Don’t crowd with the masses, when people Zag, you zig. A lot of times investors are willing to pay expensive prices for businesses that have consecutive and rising profits but it is a reminder that great businesses only look great at the top of their business cycle (think Zoom (ZM) or Peleton (PTON))) It is extremely difficult to sustain the growth and paying an expensive multiple means the room for error is very very small as the risk is very high if the company does not sustain its growth trajectory and “grow into the reasonable multiple from its original lofty multiple”
People tend to overreact to stocks/sectors that are down - think cruise industry/oil & gas industry during COVID - always remember cyclicality of businesses and industry dynamics that bad earnings reduce competition which create favourable comps against poor quarterly results to measure against that sets the stage for turnaround stories.
Start
Deciding what is a fair EV/EBIT and why you are paying a certain EV/EBIT for this business - especially if it is above 15x-20x (is there any form of justification for this premium?)
Stop
Looking at bad economics industry (very low profit margins) - if an industry is broken - even the best management can’t fix it (shipping/airlines etc)
Continue
Looking for companies that have:
Product/Service that is needed or desired
Thought by customers to be the best option, with no close substitute or viable option
Not subject to cyclicality - i.e favourable results due to a shortage, low supply.
Not in an industry with regulatory risks on price or fierce price competition