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How to Recognize a Good Business

Updated: Apr 4, 2023


Summary

Investing in the stock market can be scary and challenging, especially for beginners. But don't worry, understanding the basics of investing and what to look for in a good business can help you make informed investment decisions and increase your chances of success. In this post, we will explore the key characteristics of a good business using the examples of two contrasting entrepreneurs: Peter, the successful businessman with a shoe-making company, and Larry, the struggling entrepreneur with an ununderstandable business. We will evaluate their businesses in terms of understandability, financial health, profitability, consistency, value, and management. By the end of this post, you will learn what makes a good business and what to look for when investing in a company. So, let's dive in and learn how to separate the wheat from the chaff when investing in the stock market!

In my book From Novice to Investor: Your 10-Day Stock Investing Guide, you'll learn how to find the perfect business to invest in and you'll discover how to become a confident investor in the stock market.


The Business must be understandable

Remember our friend Peter whom you met in our pervious post Understand The Basics of Stock Markets first day of this course! as an example. Peter owns a shoe-making company that produces high-quality shoes at affordable prices. His business model is straightforward, making it easy for investors to understand how the company operates and generates profits. The company's financial statements are also easy to read and provide clear information about the company's performance. This makes it easy for investors to decide whether to invest in Peter's company.

On the other hand, Larry runs a business that is not easy to understand for investors. His business is a cryptocurrency-based lending platform that uses blockchain technology. The platform enables borrowers to use cryptocurrencies as collateral to obtain loans, and lenders can earn interest on their holdings. However, the process is complicated and involves technical terms that the average investor may not understand, making it difficult to evaluate the business's potential for success. The financial statements of Larry's

business are confusing, and it is unclear what the company's primary source of income is.


Understanding a company's business model is essential for investors because it allows them to assess the company's potential for success and make informed investment decisions. An investor who understands the business model can evaluate the company's financial statements, identify its sources of revenue, and assess its profitability.

Moreover, understanding the business model enables investors to determine if a company has a competitive advantage or a unique selling proposition. This can help investors to identify companies with long-term growth potential, leading to better investment returns.

However, investing in a business that is not understandable and difficult can be risky. Suppose the investor cannot understand how the company generates revenue or assess its financial statements. In that case, they may make a wrong investment decision. The investor may also find it challenging to predict the company's future performance or identify risks that could affect its growth potential.

In summary, understanding a company's business model is critical for investors to make informed investment decisions, identify growth potential, and mitigate risks. On the other hand, investing in a company that is not understandable and difficult can lead to significant investment losses.


Business Financial Health

The financial health of a business indicates its capacity to generate enough money to pay bills, meet financial obligations, and grow. It refers to the good financial shape of a company, with a positive cash flow, manageable debt, and sufficient assets to handle economic downturns. This measures how well the business is doing financially.

Investors consider financial health an essential factor in their investment decisions, reflecting a company's potential to generate profits and cash flow. A financially healthy business is more likely to withstand economic downturns, make timely payments to creditors, and have enough reserves to reinvest or pay dividends. It also has a good reputation and is more attractive to lenders, suppliers, and customers. Therefore, understanding a business's financial health is crucial for investors to make informed decisions.

Assets and Liabilities are crucial to assess the financial health of a business; it is vital to first understand what assets and liabilities are. Assets refer to anything that can generate cash for the business. In contrast, liabilities refer to any business obligation that consumes cash. To determine whether a business is in a healthy financial situation, you can check the ratio of its assets to its liabilities. If a business has more assets than liabilities, this will be one of the good signs of its financial health. Assets can include things like cash, inventory, equipment, and property. In contrast, liabilities can consist of loans, rent payments, and taxes owed.

Assets

Cash

$25,000

Inventory

$50,000

Property

$100,000

Equipment

$150,000

Total Assets

$325,000

Liabilities

Loans for equipment purchases

$25,000

Rent payments for its storefront

$25,000

Tax owed

$5,000

Total Liabilities

$55,000

Peter's shoe-making company has inventory worth $50,000, equipment worth $150,000, property assessed at $100,000, and $25,000 in cash. However, the company has liabilities, including $25,000 in rent payments for its storefront, $25,000 in loans for equipment purchases, and $5,000 in taxes owed.

Peter's company has more assets than liabilities, with a ratio of 3:1 which can be considered financially healthy in this regard. The company also has what is called Equity which is the total amount of assets minus the total amount of liabilities.


Peter’s Company Equity = $325,000 (Total Assets) – $55,000 (Total Liabilities)

Peter’s Company Equity = $270,000


On the other hand, Larry's company has $20,000 worth of cryptocurrencies as collateral for loans. Still, it owes $45,000 in loans taken out to lend to borrowers and $5,000 in fees owed to platform users. Additionally, it owes $10,000 in taxes. Here's the breakdown:

Assets

Cryptocurrencies held as collateral

$20,000

Inventory

$0

Property

$0

Equipment

$0

Total Assets

$20,000

Liabilities

Loans were taken out to lend to borrowers

$45,000

Fees owed to users of the platform

$5,000

Tax owed

$10,000

Total Liabilities

$60,000

In this case, Larry's company has more liabilities than assets, with an an Assets/Liabilities ratio of 1/3, which indicates an unhealthy financial situation. With a negative company equity of $(40,000).


Larry’s Company Equity = $20,000 (Total Assets) – $60,000 (Total Liabilities)

Larry’s Company Equity = - $40,000


Profitability is a measure of how well a company can generate profits over a period. This is important for investors because they want to invest in profitable companies. To evaluate a company's profitability, investors can look at its profit and loss statement, also known as its income statement. This statement shows the company's revenues, expenses, and net income.

Consistency is another measure of business financial health. It refers to a company's ability to maintain stable financial performance over time. It's important to remember that past performance does not guarantee future results. However, Investors can compare the company's financial statements over multiple periods to evaluate its consistency. A consistent business is more reliable and predictable regarding future earnings and less risky for investors. It also indicates that the company has effective management and operational strategies. On the other hand, a business that shows a lot of fluctuations in its financial performance is less reliable and less attractive to investors.


Business Should Be Undervalued

Remember what you were taught on one second day of this course? Price and value are two concepts often used interchangeably but differ. Price is what the market is willing to pay for an asset, while value is what the asset is worth. A business is considered undervalued when its market price is lower than its fair value.

What is Fair Value?

Fair value for a business estimates its worth based on many factors, including financial health, future prospects, industry trends, and market conditions. It's important to note that fair value is not an exact science and can vary depending on who is doing the analysis.

Undervalued Business

An undervalued business means its stock is trading at a lower price than it is worth based on its financial performance, growth prospects, and other relevant factors. In other words, the market is not giving the business the recognition it deserves, and the stock is priced lower than its fair value.

There are several reasons why a business may be undervalued. For instance, it may not be on the radar of many investors, perhaps because it operates in a less popular industry or has a small market cap. Additionally, a business may have a negative insight among investors, such as being in a struggling industry or having a history of poor financial performance. Finally, investors who focus on other stocks may overlook some undervalued businesses, resulting in an undervaluation of the company's stock price.

Overvalued Business

On the other hand, an overvalued business is one whose stock trades at a higher price than its actual worth based on its financial performance, growth prospects, and other relevant factors. This situation can arise if investors become overly optimistic about a business and its predictions, leading to excessive demand for its stock and driving its price to unsustainable levels. Alternatively, a business may be overvalued if there is a lot of hype surrounding it, such as when investors are overly excited about a new product or service the company is launching, leading to a temporary spike in the stock price.

Peter's shoe-making company is undervalued as the market is unaware of its robust financial health and future prospects. Once the market recognizes the true value of Peter's business, its price will increase, providing a good return for its investors.

In contrast, Larry's cryptocurrency-based lending platform is overvalued due to hype and unrealistic expectations. Suppose the market corrects itself and recognizes the true value of the business. In that case, its price could decrease, resulting in a loss for investors who bought in at a high price.

A business being undervalued or overvalued can significantly impact investment returns. Therefore, it's crucial for investors to perform a thorough analysis to determine the fair value of a business before making investment decisions. That's what you will learn from this book, just be patient and enjoy your learning.

Sincerely,

Aladdin Abdulkareem

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