Before I start this piece on valuation, I just want to say that nothing in business or finance is as complicated as it looks, and nearly all of it is much simpler than you think. I’m going to get a bit wonky in explaining some terms here but what’s important is that the concepts are understood.
In this post I would like to summarize my thoughts on how one goes about analyzing an investment. I will focus on the situation where one is analyzing a potential 'good business' which is expected to compound value over time and which you can hold for the long run.
In any lecture or interview about investing, Warren Buffett often says that you should buy great businesses at fair prices. The idea being that as long as you purchase a great business at a reasonable price, the firm will generate higher earnings in the future than it does now, increasing potential future dividends while using retained earnings to increase the asset base and further improve earnings.
In my last post, I discussed the basics of what gives companies competitive advantage and what makes good businesses. In this post, I want to move from the analysis of a business towards the analysis of an investment. The difference between the two? The price one pays to become an owner of the business.
Why do some companies do well, while others struggle? It's a simple question with a large number of potential answers, all depending on the situation. To broadly answer this question, I'd like to briefly discuss the nature of competitive advantage and why it matters so much.