What Makes a Strong Business?

Fundamentals are at the foundation of every business and at the very core of each valuation.

No investor should enter a position without knowing what makes up that foundation, so let’s answer the question: What makes a strong business?

EBITDA and Free Cash Flow

There are two main metrics used to express earnings. EBITDA and free cash flow are both very different things, each with their own unique strengths and weaknesses. Earnings before interest, tax, depreciation, and amortization, or EBITDA, is fairly self-explanatory. It’s simply a company’s earnings before taking anything else into account which affects real, usable cash. EBITDA is best-used when comparing very different companies, as industries and companies from different nations may face different taxation, require spending more or less on capital expenses, as well as varying levels of interest and depreciation. All of this makes EBITDA a very good universal benchmark.

Free cash flow or FCF is the portion of a company’s earnings that remain after depreciation, amortization, etcetera are accounted for. FCF works better for investors looking to understand the financial position of an enterprise on its own legs. It is specifically the cash flow that is available to the entire company as an entity before being divided amongst various financial stakeholders.

Earnings

A company’s earnings are most-important when it comes to market valuation. Book value, as opposed to market value, is the total liabilities deducted from the total assets on-paper. A company’s market value is usually much higher than the book value due to investors’ expectations of future profits. The best way to get an idea of where the company is headed is to see where the company is at, and that’s why earnings reports are so useful. They are so useful, in fact, that we’ve come up with a name for the value of a company in relation to its earnings, and its called the price-to-earnings or P/E ratio.

Apple Inc.’ posted earnings of $55 billion in its most recent fiscal year. The market cap, or the total value of all of its 4.6 billion outstanding shares is $1,056 billion. This means that Apple Inc. has a P/E ratio of 19.2 or an earnings per share (EPS) of $11.96. Another common way of saying this is that Apple is trading at a P/E multiple of 19.2.

Different industries have different average P/E ratios. With regular retail clothing stores, you can expect P/E ratios in the single digits, but in the tech sector, it’s not uncommon to see companies above 100. Some companies are even below zero, meaning that they are posting losses, yet still worth a fair bit. This is because investors expect to see the company post profits in the future, and wish to buy-in early. Negative P/E ratios may also be listed as N/A. Now that we’ve covered the basics, we can go into how you’d actually go about analyzing earnings. There are three main things to look at: growth, quality, and stability

Growth

Measured as a percentage increase or decrease over a time period like year-over-year (YoY), or quarter-over-quarter (QoQ). You may also see it written as Y/Y and Q/Q. Investors expect earnings to continuously grow from one period to the next, and when this expectation is not met, then the share price faces the consequences. Share prices also commonly fall when earnings grow but not as much as investors may have predicted or hoped for. Even when companies post very strong earnings, the stock may only see a modest increase in value, as investors value the quality and stability of earnings as well.

Quality

Earnings quality itself cannot be quantitatively measured, but many of the things that go into it can. Earnings quality is determined based upon how a company posts a profit, rather than how much the profit is. High-quality earnings are usually characterized by revenue and profit from common operations and sales and safe investments. Low-quality earnings are built on one-off deals, long-term asset liquidation, and panic selling. These earnings are also often accompanied by falling sales, revenues, and increasing expenses. This means these earnings won’t last into the future.

Stability

Earnings stability measures how steady and how steadily increasing earnings are. A long-standing business, like one in the energy sector, would have a much higher earnings stability than Tesla for example, because it’s likely not innovating at the same pace and has become an established player in its market. Earnings can grow in the long-term through increasing revenue, known as top-line growth, or decreasing expenses through streamlining for example, known as bottom-line growth.

Recurring Revenue

One of the most important parts of a company’s earnings is the portion of those earnings that are expected to continue moving forward. This portion is called recurring revenue. Recurring revenue can be found in a company’s income statements under “revenues”. It’s expected that a company’s top-line recurring revenue is, at the very least, above its recurring bottom-line, or fixed expenses. If this is not the case, the company has a much higher risk of default or insolvency. Recurring revenue is a major concern for investors, and ergo the market as a whole. It’s not uncommon that a business posts higher earnings than the market expected, though still sees a share price due to falling recurring revenue. An example may illustrate why recurring revenue is so important.

Walter White runs a candy factory with his business partner Jesse Pinkman. Mr.White has been selling $40,000 worth of candy each month for the past year, of which $30,000 comes from consistent monthly orders made by nation-wide candy store chains, and the other $10,000 comes from locals coming to buy straight from the factory. The consistent sales would be considered Mr.White’s recurring revenue.

Now let’s say that this month, the demand for candy is very high and his sales to locals skyrocket to $30,000, with total sales now at $50,000. Mr.White is very happy with his higher total earnings, but Jesse points out that his recurring sales are now down to only $10,000 due to candy stores switching to other suppliers. Mr.White dismisses Jesse’s comment, telling him to focus on the higher overall earnings.

The next month, locals become very sick from eating so much candy, ergo local sales drop all the way down to $5,000. Now, Mr.White’s total sales sit at a measly $15,000. After a few months of consistently low sales, Mr.White isn’t able to afford rent on the factory and has to file for bankruptcy.

Jesse was right, recurring revenue is not something to be overlooked.

Customer Acquisition Cost

Although it’s cheaper to retain customers that drive recurring revenue, investors want to see businesses growing through acquiring new customers as well. All costs associated with acquiring new customers are labelled under customer acquisition costs. They are calculated by dividing all costs related to attracting new customers by the number of customers gained over a period of time.

Costs related to attracting new customers can include everything from opening a store in a new area to spending money on advertising and public relations. This is an especially important metric when it is compared with on average how much the company actually makes per customer it acquires. Intuitively, the goal is to have the lowest acquisition cost for the highest customer return.

Management and Compensation

A business is only as strong as its leadership. Different companies may find different forms of leadership more effective, depending on their industry, goals, and work environment. Before investing in a business, you should always take the CEO as well as other executives into your decision-making process. No matter how profitable a company looks or how much potential its industry has, a weak leader means a weak company.

The next thing to consider is employee and executive compensation. When a company pays its employees well and offers many benefits, it's a good sign that it's doing well, just because it can afford to do so. Not to mention, employees have higher levels of morale and are more efficient and effective when they are incentivized to work harder.

This system works the same way for employees in executive positions. Often, chief executives have compensation packages that are either proportional to the company’s earnings, or contingent on them hitting a certain mark. This makes the company’s financial success directly correlate with their own, which is good for them, the company, and investors. An executive who gets the same amount of money regardless of how well the company does will be much less motivated to manage the company as effectively as possible.

At the same time, it's important to ensure that compensation packages aren’t outrageously large, to the point where it's taking away from capital that could be reinvested into the business and actually hindering growth. Revenue-based compensation plans can also come with risks relating to sustainability, overleveraging, and debt financing. When an executive’s compensation is based upon sales, it can also incentivize unintended behaviour like making high-risk and short-term decisions, grabbing their paycheque, and jumping ship. An executive may, for example, have the company take on large amounts of debt to drive short-term sales, but leave the company much worse-off in the long run.

Suffice to say, incentive compensation plans can be very tricky. Investors want executives to be motivated to push for higher revenues, but they also don’t want them to make decisions that will end up ultimately hurting the company.

Business Drivers

Factors that effect or “drive” a business’s financial performance can be used to highlight specific areas of growth for a business or develop financial models to better predict future financial results. The definition is fairly loose as core drivers can vary greatly from business to business. Some common examples include the number of employees, employee compensation, sales volumes, industry demand, commodity rates, and tariffs + duties.

Business drivers are not simply written-out, as it’s subjective whether something is or is not a core driver for a specific company. It’s up to each investor to identify what is driving each business. The best way for you to determine this is to go through companies’ financial statements and single out each piece. Many times, company financial statements will come with a “supplemental package” that breaks down each element further. Search up what most-directly affects every item and make a note of it. Eventually, you’ll begin making these associations naturally, and recognize them without thinking twice.

Enbridge Inc.’s quarterly earnings reports mention “Gas distribution sales”. Running a quick Google search reveals that these are fees for natural gas paid by homeowners, and are mandated by the Ontario Energy Board, where Enbridge charges the least of 3 different suppliers.

Business drivers are broken down into macro and micro drivers. Macro drivers are those that affect entire industries or nations (like tariffs), whilst micro drivers affect only one company.

Conclusion

Fundamentals are at the foundation of a business and at the very core of its valuation. Now you understand what to look for in that foundation and how to find it.

Hopefully this article helped you learn what to search for in a business before investing to ensure strength and longevity. If so, be sure to review key takeaways and take a look at some next steps you can take to support us and further your learning.

Key Takeaways

1. EBITDA is earnings before interest, tax, depreciation, and amortization. It is best used when comparing very different companies.
2. Free cash flow, or FCF, is the portion of a company’s earnings that remain after factoring in everything that affects real, working capital. It is best when looking at a business on its own merits.
3. Company earnings directly affect market valuation, and should be evaluated based on sequential growth, quality, and stability.
4. Top-line growth is when net profit increases through revenue increases, and bottom-line growth is when profit increases come from expense decreases.
5. Recurring revenue is the portion of earnings that are expected to repeat each period. A business’s recurring revenue should be above their fixed expenses at the very least.
6. Customer acquisition cost refers to how much it costs a business to attain one extra customer. This number is useful when compared to how much the business earns per customer.
7. An important aspect of understanding business strength and potential is through employee and executive compensation, as it reflects overall company health and profit incentives respectively.
8. Each business has its own unique “business drivers” that affect its financial performance.

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