The Difference Between a Good Business and a Good Investment

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.

To explain the difference, it must be said that a business is an organization which provides a product or service. Common stock, which grants one ownership of a company, is a financial instrument wholly separate and different from the company. Stocks are traded on a stock exchange between parties of investors, and can be traded at any price. The price paid for a stock depends on the intersection of supply and demand. So if demand for a stock is high, it will trade at a high price and vice versa. Technically speaking, there is no anchor that ensures that stock must trade at a reasonable price. It certainly is the case that stocks can trade at unreasonable prices for long periods of time, but the magic of investing is that in the long run stock prices and intrinsic business values usually align.

A stock is in theory supposed to trade at the present value of all future cash flows of the company- so a reasonable investor would attempt to predict the amount of cash the company will generate in the future, and then 'discount' that cash at a reasonable rate due to the fact that cash owned in the future is worth less than cash owned now. The sum of these cash flows would represent an estimate as to the intrinsic value of the company, or a share of the company.

The problem is that stocks of course, do not always trade at reasonable valuations in the short-run. There are a few main reasons for this.

Firstly, humans are incredibly emotional. The stock market is a market with highly volatile asset prices, and it makes one believe that they are losing or making money in very short periods of time depending on changes in stock prices. If you don't understand that these stock price fluctuations are simply changes in demand for stocks, you may mistake them for actual changes in the values of those stocks, and you can do unreasonable things. People work hard for their money, and understandably would be worried if they believed they just lost a significant amount of their net worth in the period of only a few days. Conversely, if people believe they can make significant sums of money in short periods of time then they usually become greedy and can also act irrationally. The wise investor exploits such market emotion to purchase companies at low prices.

Secondly, the future is always hazy and uncertain. For some industries and companies in particular, it is extremely difficult or impossible to predict what will happen 5, 10 or 20 years out. This can lead to massive differences between investor expectations and reality. This effect can be particularly dramatic in high-growth companies which provide exceptional and innovative products. Investors have the tendency to forecast current performance indefinitely and postpone reasonable skepticism. 

Thirdly, I don't know if the average investor understands the relationship between the price paid for a stock and its future returns. It usually is the case that if a company is exceptional, the average investor would be willing to pay nearly any price to become an owner. Of course, being separate entities, stocks and the companies they represent can have vastly differing performance in the short-run.

By the end of 2000, the stock price of Amazon dropped more than 80%- from around $90 to $15. At the time, Amazon was an unprofitable but rapidly growing company. Sales that year increased almost 70%, and gross profit increased over 100%. Despite a larger operating loss, it was clear that the company if anything, was worth more in 2000 than it was in 1999. The problem was not the business, it was the price the stock was trading at in 1999. The stock was significantly overpriced relative to the intrinsic value of the business, and despite having a bright future, Amazon investors suffered a major loss. The stock price of Amazon didn't reach $90 again until 2007. I think nowadays, investors in good companies such as Amazon and Facebook are faced with the same issue- they own a great business, but the price at which the business is selling is extremely high relative to the performance and intrinsic value of the business. If these grand expectations implied by the stock price aren't met, investors will be hurt.

On the other hand, stock prices can be too low in comparison to the value and performance of the business. When this happens, a shrewd investor can do well by purchasing shares and waiting for public demand of ownership of the company to increase.

All companies increase their value at the rate at which they increase earnings. The increase in earnings is determined by two things- the company's return on invested capital (ROIC), and the reinvestment rate (RR). Like all concepts in finance and business, it sounds complicated but it's quite simple.

Earnings Growth Rate = ROIC x RR

A company's return on invested capital is a measure of the earnings it generates for each dollar reinvested in the company. If for every dollar invested back into the company (to buy inventory, factories, etc) the company makes $0.20, then the ROIC is 20%. ROIC is a great measure to help determine the profitability of the firm's operations and how quickly it can increase earnings over time. The reinvestment rate is simply how much of the company's earnings are reinvested in the firm- if all is reinvested, then the RR is 100%, if none of it is, then 0%.

Technically speaking, ROIC measures profits generated by all of the company's assets, while the return on incremental invested capital (ROIIC) measures the profitability of all future investments. So as an example, it is possible that in the past, a company has benefited from a high ROIC of 30%, but as it grew large and its new investments generated lower profits, the ROIIC declined to 15%, and so the total ROIC would also decline. The total ROIC would be = annual profits / total invested capital, while the ROIIC would be = profits generated by new investments / $ amount of new investments. 

To illustrate these phenomena, below are presented the intrinsic values and stock prices for two different companies. Both companies are reinvesting all profits back into the business at all times. The first business - 'Good Business' has a ROIC of 20%, and so is growing earnings as well as its value at 20% a year. The second business - 'Poor Business' has a ROIC of 3%, and as a result is only growing earnings and value at 3% a year. The orange lines represent the intrinsic value  of each business, and the blue lines are the stock prices.

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As we can see, the performance of the good business is much better than that of the poor business- it compounded its earnings and intrinsic value from $50 to around $125 per share over 5 years. The value per share of the poor business only increased from $20 to $23 over those 5 years. Clearly you would have done better by purchasing the good business at $50 in year 1, which would have been at fair value rather than the poor business at $20. If you purchase a business at fair value, your annual return will be the rate at which the firm grows earnings. This is why Buffett tells us to purchase great businesses at fair prices. 

The thing is, depending on when you purchased shares, investors in the good business could have had poor returns, and those in the poor business could have had great returns- it all depends on price paid versus intrinsic value.

For example, if you purchased the good business in year 2 at $125, over the next four years you would have had a 0% total return. If you purchased the poor business in year 4 at $10, your return would have been 100% over two years.

The lesson here is that you can achieve fantastic returns in either great or poor companies, depending on the price paid to own the company. If you overpay for a great business, you may have to wait a long time for the value of the business to catch up to the price you paid. If you are so unfortunate to overpay for a poor business, you will certainly do poorly as the value of the company may never catch up to the price you paid. So either pay fair or low prices for a great company, and pay very low prices for poor companies if you would like to do well.

In Buffett's early years he did extremely well purchasing mediocre companies at low prices. Since mediocre companies don't compound earnings over time, generating high returns depends on buying them for far lower than fair value and selling once they reach fair value. If you purchase a great business at a fair price however, you can do well by holding forever as it compounds value and earnings over time.