Every company wishes to have sustainable competitive advantage, high-quality management, predictable earnings, significant free cash flows, strong balance sheet and high return on capital.
These are indeed the items that make up a quality business model. Below there is a more detailed description of each of them:
Competitive Advantage
The value of any asset is the present value of its future cash flows. A confident estimate of a company’s cash flow can be made by looking into the future if the company is a valuable firm.
A sustainable competitive advantage is like a protective wall around cash flows that enables the company to protect them from competition and to provide a higher confidence level.
It is worth noting, in terms of competitive advantage, that strong brands are not created equally and do not guarantee competitive advantage as many may think. Although they serve as great moats to deter competitors from entering the market, they sometimes do not give the right to charge premium prices.
Management
Management has to be analyzed to the same extent as the balance sheet.
Management’s pay and incentives go hand in hand with stock performance and put pressure to maintain a rising stock price.
It is also closely related to competitive advantage. It is management who is the one in charge of enhancing a long-term sustainable competitive advantage, apart from its duty to create and execute a sound strategy.
There are a few tips worth considering in this case. First of all, an investor should always have skepticism regarding comments made by management. They are sometimes driven by interests. In the second place, it has to be analyzed whether the company has the right management team focused on long-term shareholder value creation. To really see this, it is necessary to talk to the team, read their annual reports and check if they are honest with shareholders and with themselves. The latter is very important because it means that the manager is able to admit his own mistakes.
How can good management be assessed?
â– By making research; sometimes analysts are wrong and an investor should not base his decisions on them;
â– By listening to what management is saying and comparing it to reality. A grain of common sense should always be considered.
â– When management doesn’t recognize a problem that is staring in their face, it is better not to invest in the company.
Predictable Earnings
To find truly predictable earnings, it is necessary to dig deeper and look at the actual business to identify the qualities that make a company's earnings predictable.
Companies with a sustained purchase by customers show lower earnings volatility.
Strong Balance Sheet
A strong balance sheet involves two things, to wit:
1. Having a low debt level. This gives companies more room to make mistakes. Debt is good when it is used with stable and predictable cash flow.
2. Not permanently turning to stock buybacks. They usually distorts the balance sheet's appearance.
Furthermore, companies with strong balance sheets make great acquisitions.
Significance of Free Cash Flows
Companies with significant free cash flows and shareholder-oriented management will take advantage of the market’s volatility.
There are some additional benefits of high free cash flows:
â– Companies that generate significant free cash flows are not capital intensive due to low capital expenditures.
â– Significant free cash flows lower the risk of the business. The company is not outside-financing dependent.
â– In times of economic difficulties, the buying power of cash increases exponentially.
Despite the fact that free cash flow is extremely important, there are a few points to consider. An investor should bear in mind that not all capital expenditures are equal. A distinction has to be made between future growth and maintenance capital expenditures. While the former are necessary to increase sales, the latter are necessary to keep the company’s current sales level.
If a company stopped making growth capital expenditures, its sales growth would decelerate but sales would not decline.
A company with low maintenance capital expenditures will see a substantial increase in free cash flows once it stops growing sales as its capital expenditures will decline and free cash flows and income will rise.
This is not all. Free cash flow volatility can be higher than net income volatility. Volatility can be dealt with by averaging cumulative operating cash flows over a period of time and reducing them to cumulative capital expenditures of that same period.
Least but not last, an investor must pay attention to what the company expects to do with free cash flows because it can destroy value if it is not correctly used. Free cash flow can be used for instance to pay debts, buy back stock, increase or pay dividends, among other things.
High Return on Capital
ROC shows how capital is working for shareholders.
Return on capital far exceeding cost is a great driver of how much a company can increase shareholder value.
The earnings growth formula has two elements: high return on capital and opportunities to grow.
The higher the return on invested capital, the less equity or debt a company must issue to grow. In addition, consistent high return on capital is a good indication of the presence of a strong competitive advantage.
“These six elements are crucial for investors. All of them have the same importance and are closely related. The lack of one of them or a poor result in any bring a domino effect,” says Ben Schachter, CEO of Macquarie Research Equities.
These are indeed the items that make up a quality business model. Below there is a more detailed description of each of them:
Competitive Advantage
The value of any asset is the present value of its future cash flows. A confident estimate of a company’s cash flow can be made by looking into the future if the company is a valuable firm.
A sustainable competitive advantage is like a protective wall around cash flows that enables the company to protect them from competition and to provide a higher confidence level.
It is worth noting, in terms of competitive advantage, that strong brands are not created equally and do not guarantee competitive advantage as many may think. Although they serve as great moats to deter competitors from entering the market, they sometimes do not give the right to charge premium prices.
Management
Management has to be analyzed to the same extent as the balance sheet.
Management’s pay and incentives go hand in hand with stock performance and put pressure to maintain a rising stock price.
It is also closely related to competitive advantage. It is management who is the one in charge of enhancing a long-term sustainable competitive advantage, apart from its duty to create and execute a sound strategy.
There are a few tips worth considering in this case. First of all, an investor should always have skepticism regarding comments made by management. They are sometimes driven by interests. In the second place, it has to be analyzed whether the company has the right management team focused on long-term shareholder value creation. To really see this, it is necessary to talk to the team, read their annual reports and check if they are honest with shareholders and with themselves. The latter is very important because it means that the manager is able to admit his own mistakes.
How can good management be assessed?
â– By making research; sometimes analysts are wrong and an investor should not base his decisions on them;
â– By listening to what management is saying and comparing it to reality. A grain of common sense should always be considered.
â– When management doesn’t recognize a problem that is staring in their face, it is better not to invest in the company.
Predictable Earnings
To find truly predictable earnings, it is necessary to dig deeper and look at the actual business to identify the qualities that make a company's earnings predictable.
Companies with a sustained purchase by customers show lower earnings volatility.
Strong Balance Sheet
A strong balance sheet involves two things, to wit:
1. Having a low debt level. This gives companies more room to make mistakes. Debt is good when it is used with stable and predictable cash flow.
2. Not permanently turning to stock buybacks. They usually distorts the balance sheet's appearance.
Furthermore, companies with strong balance sheets make great acquisitions.
Significance of Free Cash Flows
Companies with significant free cash flows and shareholder-oriented management will take advantage of the market’s volatility.
There are some additional benefits of high free cash flows:
â– Companies that generate significant free cash flows are not capital intensive due to low capital expenditures.
â– Significant free cash flows lower the risk of the business. The company is not outside-financing dependent.
â– In times of economic difficulties, the buying power of cash increases exponentially.
Despite the fact that free cash flow is extremely important, there are a few points to consider. An investor should bear in mind that not all capital expenditures are equal. A distinction has to be made between future growth and maintenance capital expenditures. While the former are necessary to increase sales, the latter are necessary to keep the company’s current sales level.
If a company stopped making growth capital expenditures, its sales growth would decelerate but sales would not decline.
A company with low maintenance capital expenditures will see a substantial increase in free cash flows once it stops growing sales as its capital expenditures will decline and free cash flows and income will rise.
This is not all. Free cash flow volatility can be higher than net income volatility. Volatility can be dealt with by averaging cumulative operating cash flows over a period of time and reducing them to cumulative capital expenditures of that same period.
Least but not last, an investor must pay attention to what the company expects to do with free cash flows because it can destroy value if it is not correctly used. Free cash flow can be used for instance to pay debts, buy back stock, increase or pay dividends, among other things.
High Return on Capital
ROC shows how capital is working for shareholders.
Return on capital far exceeding cost is a great driver of how much a company can increase shareholder value.
The earnings growth formula has two elements: high return on capital and opportunities to grow.
The higher the return on invested capital, the less equity or debt a company must issue to grow. In addition, consistent high return on capital is a good indication of the presence of a strong competitive advantage.
“These six elements are crucial for investors. All of them have the same importance and are closely related. The lack of one of them or a poor result in any bring a domino effect,” says Ben Schachter, CEO of Macquarie Research Equities.
