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Let's Explore the Core of Understanding Businesses

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Let’s Understand Businesses

Whether you’re looking at a deal or a stock, the key to value is to understand the business.

Spend some time thinking about it.

It’s simple, but not easy.

Today, we cover:

  • Understanding Business

  • Studying Key Business Financials

  • Moat + Management


Understanding Business

First, understand the underlying business. Before being a private equity analyst, an investment banker, or an equity research analyst, it is most important to be a business analyst.

It’s very helpful to visualize a business in order to understand the key levers that largely affect performance. And there will only be a few.

Say we’re talking about a furniture retailer.

Now, I’ll head to google images, type “furniture retailer”, and see the images.

What I see: Retail space, and a lot of furniture

What I think: The operating assets that drive returns include PPE (Property, Plant, and Equipment), and NWC (Net Working Capital). Does this business own/lease its real estate? How good is inventory management? How short is the cash conversion cycle to overturn the inventory?

This gives me two things to deep dive into: cash and inventory management.

Let’s try this again for a barber shop.

What I see: Retail space, limited spots for grooming, and equipment

What I think: Again, do they own/lease the real estate? There are limited seats for customers. What is their average utilization? It’s likely that to increase utilization, you have to expand capacity and hire another worker. How are turnaround times between haircuts?

Try doing this with any business you see around you, and it really helps you think more.

Understand what moves the model and focus on that.


Studying Key Business Financials

Once you understand what to look at, you should see how it has historically trended in the business.

More often than not, this will be cash management.

But, before that, you need to see if this business is actually growing.

What I like to do is create a chart of Revenues, EBIT and EBITDA to see if the business has grown. If it has, it warrants further investigation. If not, I move on.

A few questions to ask:

  1. Is cash flow generation consistent?

  2. Do cash flows grow with revenues?

  3. Is CAPEX predictable and consistent?

  4. Does the CAPEX justify the cash flow growth?

Then, you look at the balance sheet.

In an environment with expectations of higher rates for longer, you’re only looking at debt. How serviceable is the debt? I’d also look at the trends in working capital to see if the business can grow revenues faster than working capital.

Look at what matters; everything else is just noise.


Moat + Management

A business will persist if it has a large addressable market, a durable competitive advantage and great capital allocators at its helm.

Focus on management teams. Read their history, and read between the numbers to see if they have made a better business. Ask how they look at capital deployment. Based on your visualization of the business, is management looking at the same levers as you?

A moat is a competitive advantage that allows a business to earn greater returns than its peers over extended periods of time.

Sometimes it's due to a monopoly, product differentiation, or just better cost management. Compare margins across competitors to understand where one business gets the upper hand over another.

It’s simple, but not easy.

Focus on what matters.

See you next week.