Investment Diary #13: Taking an investor's view of the business you work for

Most bottom-feeders, as wage earners, don’t pay much attention to much other information about a business, including its finances, industry and business attributes, customer composition, competitive landscape and future growth, and the direction of capital allocation.

But as a manager of a business, often these are the core issues they have to consider.

How does the average worker change his or her perspective, from the point of view of buying a business, or having to buy shares in a company, you analyse a business and find some different points.

These points help you to see your usual work from a larger perspective. If you’re a middle manager, that should be beneficial.

Today I’ll talk about what I’ve learnt, what are the points to focus on when looking at a business from an investor’s point of view.

First of all, we have to have good quality information, that is, we should always read the annual report of the company, the industry data, and even if you have the opportunity to communicate with people in the industry, gossip, as the book “How to choose growth stocks” said.

Of course, our core is still to read the annual report, some news reports of the industry is not first-hand information.

First: Industry Insights 🔗︎

Firstly, we need to look at an industry from a macro perspective, that is, what is the business, what are the characteristics, customer composition, competitive landscape? And what are the future trends of the industry?

Here is a case that Warren Buffett has invested in as a prototype for analysis.

Sanborn Maps is in the business of mapping urban buildings. The characteristics of this business are: the initial investment in mapping will be very high, but the later investment will be very little. That is, if a competitor wants to enter the market, the initial investment cost will be very high, and need to share customers with Sanborn Maps, and will not be able to recover the capital investment in the short term. Once the maps are created, the later costs are low, which means it will have a high profit margin

North Burlington, which will have a high initial investment in laying the railway network, but once it is laid, the later capital investment will be low for the company that operates the railway network. It often takes a lot of capital to operate a rail network, and in addition to allocating capital sensibly and maintaining the appropriate competitive landscape, it is also important to grasp regulatory issues such as track laying rights.

Consumer goods make up 90% of the container business. Customer composition: 2/3 of the company’s revenues are contributed by single-customer contracts with varying service periods, and another 1/3 comes from customers who pay ordinary freight rates. Fuel costs increased by $1.7bn, while freight revenues increased by $3bn, suggesting some degree of pricing power.

Competing operating nodes include the level of service pricing, on-time service, and quality of service. Northridge has added slightly better route rights or freight volumes than its peers. The fact that the industry can all increase prices suggests a good pricing environment, no undercutting competition, a duopoly with price self-regulation and respectability, and that the point of competition should be placed on the railway’s larger share of the national freight cake.

Hissy Candy sells candy, has very strong brand value, user stickiness, will be there for a long time, with independent pricing power.

Coca-Cola’s core business is to sell soft drink syrups and concentrates to such customers as canneries, creating a franchise brand. To summarise, this type of business is to have structural advantages.

IBM, the core business is: global technology services and a software division. The software is characterised by: high stickiness to customers and low capital intensity. The complexity of the business is high. A big company changing auditors and law firms is a big deal. The IT department of a large company is inextricably linked to its vendors and has a strong ongoing relationship. That’s what IBM’s business is about.

MidAmerican Energy, which does power generation, is one of the most heavily regulated by the government, and the profitability of power generation companies is closely tied to the regulatory environment. It is a capital-intensive business (look at the ratio of revenue to assets).

Americas Aviation Group, business is capital intensive, with the amount of aircraft and other equipment owned exceeding the company’s annual revenues. The ultimate capital margin, even in good years (less than 8%) did not exceed its cost of capital (the margin on commercial paper issued in 1988 was 9.5 - 9.9), suggesting that it had little structural advantage.

Nebraska Furniture Outlets, its regional branding influence, including Government Employees Insurance Company, have a cost advantage in their business that is far below that of their peers.

The Buffalo Evening News has local subscriber stickiness, and their business has room for significant price increases in terms of higher-than-peer salary structures, low margins, and lavish office costs.

Simply put, focus on core business metrics: such as enrolment growth, or daily learning hours, pricing power, whether costs are well below peers, etc. to assess the quality of the business.

Second, future trends.

North Burlington, because of the American system, the United States may be 100 years, there are 15 years bad, 15 years average, 70 years good years, but the population of the United States will increase, whether it is cost-efficient, fuel-efficient or environmentally friendly efficiency, the future of the railway industry will be a much bigger cake, the industry will not disappear, and the industry is on the side of the good for society, society will give great support.

Of course Warren Buffett has had cases of misreading the industry landscape, buying American Airlines Group, which Warren Buffett admits was influenced by: a long history of profitable operations, and the protection afforded by owning preferred securities. Both of these were influences. But with the deregulation of the airline industry, Air America’s revenues will be negatively impacted by an increasingly competitive marketplace, and the cost structure that has developed under the profit shield of regulation will not be changed for a while.

Point 2: Data Validation 🔗︎

Macro judgement is mainly about looking at the inner workings of the business from a general perspective.

Then we have to verify this connotation through data.

From the macro analysis above, we are more concerned about their capital investment or marginal capital investment.

There is a specialised financial indicator for this: Return on Tangible Capital Employed ROTCE (Net Profit / Total Capital Employed or Marginal Capital Employed, Total Capital Employed: Fixed Assets + Intangible Assets before Goodwill + Inventories + Accounts Receivable - Accounts Payable). This is an important indicator of a company’s ability to show the quality of its business and whether it is a “compound growth machine”.

It is an indicator that the business is generating a rate of return that far exceeds its cost of capital, implying a franchise value or structural advantage, and also implying that very little additional capital needs to be invested to grow the business, and that the majority of the cash can be returned to shareholders or used for acquisitions.

It is important to note in the calculation that it is definitely not possible to use a particular year for profits, and it is important to look at long-term annual reports to calculate this average. Net profit can be based on the average of past profits.

Here is a list of the ROTCE of the following companies that have used the return on tangible capital:

Cissy’s Candy: 26 per cent

American Express: 78% (financial institutions are a bit unique)

Washington Post: 17.9% (generated a 43% after-tax return on tangible capital in 1977)

Metropolitan Broadcasting Company: 26.4%

Coca-Cola: 55.5% (well above 20%, bull)

American Airlines Domestic: 7.9% (after taxes it was 5.2)

MidAmerican Energy: 7.2 percent

North Burlington: 7.6% (marginal used tangible is about 15)

IBM: 36% after taxes

From the data above, basically 15% or more pre-tax is best.

The second point is that we focus on the future growth of the business.

Generally look at the long term 5-10 years, operating profit margin and net profit margin. Here profit growth should exclude the effect of inflation leading to a significant increase in revenue.

As usual, let’s look at a data set:

North Burlington: 7 years of data shows revenue, EBITDA, and net profit growth of about 8%, 7%, and 9%.

MidAmerican Energy: the EBITDA margin is 19.2% and the net margin is 5%

Coca-Cola: EBITDA is growing at a rate of 20% per year Hershey’s Candies: revenues, after-tax operating income to single-store revenues have been growing every year from ‘72-76 (except for ‘73), and after-tax net operating profit has been growing at an average of 16% per year. Indicates good growth potential.

Solomon: net profit margins of 11, 15, down to 5 Metro Broadcasting: publishing business revenues and operating profits have grown at a compound annual growth rate of 20% or more, 21% operating profit margins

Washington Post: 11% annual growth over the last 10 years, 16% operating margin in 1977 American Express: over the last nine years, Express has had a 12% compound annual growth rate in revenues and a 10% compound annual growth rate in net profit. At the end of the fiscal year then, it was 16% operating margin and 11% net margin, pretty good profitability.

Buffalo Evening News: it was only a 4% operating margin. (And of course we said from earlier that the margins would have been significantly higher with the price increase)

Sanborn Maps: remained a juggernaut for more than a decade, still profitable in the later years, but net profit declined by 10% each year

Overall, around 10% net margin growth is very good. 20%+ is outstanding.

IBM is a profitable and cash-flow rich company, the only shortcoming is that the revenue growth is too moderate, the business is in the structural transformation phase

The third point is that we focus on the liabilities of the business.

Air America: operating expenses have increased more than revenues by 97%. $1.5 billion of huge financial debt, $6.4 billion of non-cancellable operating leases, huge liabilities compared to $434 million of operating profit. There is a lot of financial risk.

American Express: the salad oil incident will pay roughly $40 million in cash liabilities, currently has $267 million in cash so this side of the debt is capable of being repaid. But that means a higher cost than the debt, and the cost per share increases: 4,000/446 shares, which would make it a 20x P/E. That is, you’re buying at 16x P/E but it actually equates to 20x P/E. And of course the enterprise value multiple becomes larger.

But also consider the value of this company’s float. A $470 million traveller’s cheque with a 2-month repayment period can be calculated to yield a continuous float of (47/12)*2 = $80 million, which, assuming a 5% return on this investment, would yield $4 million a year.

Assuming that the $4.4 million in annual earnings are added to net income, and calculating the cost of the $40 million in liabilities, then Buffett ended up with a 14.2 times P/E ratio, 8.5 times the enterprise value of the multiple to buy.

IBM: the pension plan added $1.5 billion in new liabilities.

Point 3: Focus on the management of the company 🔗︎

The value of an enterprise can not be achieved without the human factor, talent is the core assets of an enterprise, management is the most important.

Buffett evaluates management standards:

① A successful business experience. Successful business experience shows that managers have the ability to balance income (growth) and assets (risk).

② Especially valued boss-type managers. Either they are the owner or they have been promoted from within after many years of service. The key is passion. Only these types of people have passion. Passion brings something special beyond the day-to-day work and decision-making.

③ Integrity

④ Ability to allocate funds wisely

Summing up the above 4 points, you can evaluate a business well.

Of course, this is not enough.

How does an investor determine at what price to buy this business.

Financial institutions look at P/E and P/B ratios more, so we won’t describe them too much. In general, valuation looks at enterprise value multiples and P/E ratios.

As usual, let’s start with a data set:

Hershey’s Candy, which Warren Buffett bought at a P/E of 11.9x and an enterprise value/EBITDA multiple of 6.3 (2,500/400). Not a cheap price, paying a consideration for growth, as this company’s products can raise prices and are worth more than book value.

Buffalo Evening News: 19x Enterprise Value Multiple Nebraska Furniture: Buffett paid less than nine times after-tax earnings and less than five times enterprise value/EBITDA. And there’s no sign that growth is ostensibly going to stop. Not only does this valuation underestimate the intrinsic ability of the business to generate cash surpluses, but this valuation is also completely covered by the net asset value.

American Express: 16x P/E, 8x enterprise value. Not cheap. Considering primarily the value of the float, it’s probably a 14.2x P/E, 8.5x enterprise value multiple buy.

Washington Post: 5.3x enterprise value, 10.9x P/E Metro Broadcasting: 10x after-tax profit valuation investment

Coca-Cola: 11.9x enterprise value multiple. General Reinsurance Company: 23.5x P/E, 2.7x par price, overpriced. There is a float factor involved.

North Burlington: at the time, it was an 11x enterprise value multiple. But Buffett purchased it at 13.2x, privatised the business and paid a reasonable 25% premium.

IBM: 11.9x enterprise value multiple, 14.7x P/E. Too high. But IBM has a cash profit yield of over 80%, and generally 8% is a very healthy performance. This cash flow is particularly attractive when used for share buybacks and dividend payouts. Buffett argues that: because IBM keeps buying back, even if the share price languishes, it doesn’t matter because IBM will accrue more shares at the same price and shareholders’ share weighting will increase.

How are these two metrics calculated? What is the general valuation watermark?

Enterprise Value (EV) = Total Market Capitalisation + Long and Short Term Liabilities + Lease Liabilities - Cash as well as Cash Equivalents (look for it in the statement of cash flows, Cash + Transferable Securities, excluding Accounts Receivable, Inventory, Fixed Assets, Collateralised Notes Receivable, and Amortisation). 5x or less is considered to be extremely undervalued, and purchases are generally not made above a 7x multiple of the enterprise value.

P/E ratio = current share price / net profit. 5x up or down is best, and 6.6 or so is not expensive. Without considering growth, a P/E of 10 is reasonable.

You can see from the company, P/E ratio and enterprise value because both use market capitalisation, you can see if a company is reasonably priced.

PS: Here is an additional introduction to the margin of safety 🔗︎

Buffett has three types of investment: long-term investment target, this target is generally associated with the market, because it is the enterprise value is underestimated so there is a greater margin of safety, but the time is uncertain, can only sit and wait for the long term to see always profit; a type of arbitrage, such as the purchase of preferred shares, buy the acquisition of the enterprise before the bond, liquidation value is higher than the market value of the; a kind of holding to improve profits.

The basic principle is: invest with the lowest capital gains requirement. Here comes the margin of safety: Warren Buffett said “When building a bridge, you insist on a load of 30,000 pounds, but you only allow 10,000 pounds of trucks to shuttle during the same reasoning applies to the field of investment”. In other words, buying at reasonably low prices (valuations below intrinsic value) effectively prevents errors in judgement and provides a guarantee of safety of principal and even a guarantee of basic profitability.

Let’s assume that we need a 30% margin of safety on every investment, which is intrinsic value * 70%. Suppose Company A is bought at the margin of safety and Company B is bought at full price. Then Company B would have to grow somewhat to make up for that 30% requirement.

In the case of Hissy Candy, for example, in 1972, it had a net profit of $2.1 million, and without paying a consideration for growth, the price paid by the investor would be $14.7 million (2100 x 0.7), assuming a fair P/E ratio (generally the P/E ratio of the current business) of 10 times the margin of safety requirement of 30%. Assuming another investor is willing to pay full price, the embedded value of the business is 2100x1.43 = $30 million. How do you calculate the net profit increase from this value? You can use the perpetual annuity formula: present value = C/(r-g) r is the discount rate Assuming it is 0.1 , 30 = 2.1 / (0.1 - g) so that the calculated g is 0.03. Getting an annual growth rate of 3%. The premise of 10% discount rate, and no additional costs under the perpetual growth of 3% can get 30% margin of safety, in fact, including the requirement for additional capital, 3% growth is not enough. This means that if the company’s net profit continues to grow at 3% per annum, the investor will be able to make a satisfactory return on his investment at the current price.

In short, the margin of safety is very important.

Source of Information:

• Warren Buffett’s Valuation Logic - An In-Depth Review of 20 Investment Cases
• A Walk Down Wall Street
• ChatGPT
• How to Choose Growth Stocks