Is it a Good Company?
While determining if the business is good revolves around understanding the nature of the business, determining if the company is good involves assessing the quality of the management.
As a general rule, a good business with bad management is a bad company to invest in. A bad business with good management will not yield fantastic results. A good business with good management is a “home run”.
How can we value the quality of management? A few important areas of assessment would be :
- Track record of the company. What has been the growth record achieved by the company in the past 5 years or more?
- How has the company performed compared to its peers and the industry?
- How did the company fare during an economic crisis?
- What is it that the company is doing that is different from its peers?
- What are the peers doing that the company has yet to do and why?
- How is the management being compensated? Note that we are not pushing for lower compensation. On the contrary, we believe management should be fairly remunerated for the amount of effort they put into the company.
How Much are We Willing to Pay for the Company?
This question refers to the intrinsic value of the company. In investment-industry centric terminology, it is the so-called “valuation” and “target price”. Among the three, this is the most difficult to answer and usually becomes the stumbling block for investment.
One of the most common questions that I’ll ask during any analyst recruitment is this: Assume that your favourite bakery shop is up for sale because the owner will be migrating soon. The owner informs you that the bakery earns RM1 million a year consistently (Let’s assume he is of utmost honesty and clean accounting books). Now, how much are you willing to pay for the business?
I will get very different answers, ranging from five hundred thousand to few million Ringgit. But the fact of the matter is that no one is right and no one is wrong. That is the reality of analysis. How much one is willing to pay depends on their “valuation” of the bakery shop (or some may just pluck a number from the sky). Whatever logic or argument they use to determine the price they are willing to pay, they are actually going through the process of determining how much the company is worth, from the perspective of a business owner who is buying the business.
Just to share an interesting encounter that I had: I was having lunch with an analyst who shared that they liked a company which was trading at a historical Price-to-Earning (“PE”) ratio of 25 times (we will discuss what this ratio is in later chapters). I asked the analyst the same bakery question and the analyst replied that they will pay RM2 million for it. My follow-up question was: why is the analyst willing to pay 25 times PE for that particular listed company that they liked, but only 2 times PE for the bakery?
The analyst was stunned. This is because the analyst viewed the listed company as a listed share – and was willing to pay excessive premium for it – while viewing the other as a business.
Don’t get me wrong. I am not trying to undermine the analyst or imply that one shouldn’t invest in a stock that trades at 25 times PE. I do note that there are a lot of other factors to take into consideration, such as growth rate, etc, not to mention the difference between acquisition price between an unlisted and listed company.
The point that I want to highlight here is that we tend to be unwilling to pay a lot for a business but become generous when it comes to paying for a share.
P.S.: I’ll be changing my recruitment questions.