The characteristics of a high-quality business
The economics of the business · Investor Foundations Blueprint
In economic terms, a business is an entity that deploys capital in productive activity with the objective of generating cash flows to its providers of capital. The analysis of any business therefore begins with two questions: what return does the business earn on the capital it employs, and can that return be sustained?
Return on invested capital
Return on invested capital (ROIC) measures after-tax operating profit as a proportion of the capital employed in the business. A company that invests $100 and generates $20 of annual after-tax operating profit earns an ROIC of 20%.
The value of that return depends on the opportunity to reinvest. A company that can deploy additional capital at 20% compounds its value over time. A company that earns 20% on its existing base but has limited opportunities for incremental investment is still a sound business, but its value derives from distributions to shareholders rather than from reinvestment.
Where ROIC falls below the weighted average cost of capital (WACC), the business destroys value, and growth accelerates that destruction. A company earning 6% on capital that costs 8% becomes less valuable as it expands. Growth increases value only when the return on incremental capital exceeds its cost.
Revenue growth is not in itself evidence of business quality. The effect of growth on value is determined by the spread between ROIC and the cost of capital.
The persistence of excess returns
Economic theory predicts that returns in excess of the cost of capital will attract new entrants and be competed away over time. When a business sustains returns above its cost of capital over an extended period, the analyst must identify the source of that competitive advantage.
The sources of durable competitive advantage are generally classified as follows:
- Economies of scale: the largest participant operates at a structurally lower unit cost, and the advantage increases with relative size
- Switching costs: the financial, operational or risk cost to a customer of changing supplier exceeds the benefit of doing so
- Network effects: the value of the product to each user increases with the total number of users
- Intangible assets: brands that command a price premium, patents, licences and regulatory positions
- Cost advantages: proprietary processes, favourable locations or privileged access to inputs
Management quality, operational effort, product quality and first-mover status are not included. Each may contribute to performance, but none is durable in isolation, because each can be replicated by a competitor.
The quality of earnings
Two businesses may report identical profit while differing substantially in value. A subscription business with 95% annual renewal across ten thousand customers and a business dependent on two large contracts that expire in the following year may report the same earnings, yet the former carries materially lower risk. The analyst should therefore assess the degree to which earnings are recurring, the concentration of the customer base, the sensitivity of earnings to the economic cycle, and the proportion of earnings realised in cash.
Maintenance reinvestment
Finally, the analyst must estimate the reinvestment required to maintain the existing competitive position. A software company may require reinvestment of 5% of revenue; a steel producer may reinvest 15% and still lose ground to competitors. Cash flow remaining after maintenance reinvestment, rather than reported net income, represents the economic return available to owners and is the appropriate basis for valuation.
Work it through
2 exercises · nothing is recordedDurable competitive advantage or replicable effort
Returns above the cost of capital attract competition and tend to erode. Classify each characteristic according to whether it constitutes a durable competitive advantage or an attribute a competitor could replicate through additional effort.
Pick an item, then the box you think it belongs in.
Review questions
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A company earns a 6% return on invested capital against a cost of capital of 8%, and grows revenue at 20% per annum. What is the effect on value?
Growth amplifies the effect of the spread between ROIC and the cost of capital. Where that spread is negative, growth increases the rate of value destruction.
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Two companies report identical operating profit. The first sells a subscription with a 95% annual renewal rate; the second has recently won two large contracts that expire next year. Which conclusion follows?
The quality of earnings differs substantially. The degree of recurrence, customer concentration and cyclicality determine the value of reported profit, which is why profit alone does not settle a comparison.
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Which measure most closely represents the economic return available to owners?
Maintenance reinvestment is not discretionary, so any measure of cash before it overstates the amount available to owners. EBITDA in particular disregards the capital intensity that determines whether earnings are converted into cash.
Work this through
Select a company whose products you use regularly. Without reference to its financial statements, prepare a written assessment of approximately half a page addressing the following:
- What does the company sell, to which customers, and with what frequency of repeat purchase?
- What obstacles would a competitor face in attracting its customers?
- Does that obstacle correspond to one of the five sources of competitive advantage described above?
- Does the business require substantial ongoing capital expenditure to maintain its position?
Retain this assessment. In the following module it will be compared against the company's reported financial statements.
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Exercises like the one above run through every module — calculators you can push, checks that explain the reasoning, and tasks that make you apply it. The rest of them, the workshops, your progress and your notes are included with Visitor membership.