We all know the saying, "Looks can be deceiving." This applies to the world of investing, too.
Just because a company boasts high revenue doesn't necessarily mean it's a good investment. Investors who rely solely on a simple price-to-revenue ratio are missing the bigger picture.
So, what separates the winning companies from the also-rans?
The answer lies in the quality of their business. Here are the key traits when evaluating companies for potential superstars:
The web that catches customers
Imagine a product or service that gets better with every new user. That's the power of network effects. Think Facebook - the more people use it, the more valuable it becomes.
Some network effect systems are stronger than others, depending on the decay rate of the incremental user's value. The decay rate refers to how quickly the added value of a new user diminishes as more users join the network. A slow decay rate means the network effect stays strong for long.
But be careful! Not everything is a network effect. Many mistaken network effects for economies of scale, which are far less powerful.
Predictability pays
Investors love predictability. Consistent, predictable revenue streams translate to a rosier investment. Subscription businesses like Salesforce are a great example. Their predictable revenue allows investors to value the company higher.
On the flip side, companies with one-time or unpredictable revenue, like consulting businesses, typically trade at much lower valuation. Their success often relies on a single hit, making their future revenue streams shaky.
Gross margin matters
There's a big difference between companies with high and low gross margins. Remember DCF? It's hard to generate cash flow from revenue swallowed by high, fluctuating costs. As a result, companies with lower gross margins tend to have lower valuations.
The higher the gross margin, the more there is left to contribute to free cash flow, which is what investors love.
The power of marginal profitability
Investors love companies that scale well. In other words, companies with higher revenue lead to even higher profits. Microsoft is a classic example. Selling more software with little to no extra cost is a business that scales beautifully.
Investors look at marginal profitability to measure scaling. This compares the change in revenue to the change in costs, revealing the incremental profit margin. A high number signals great scaling, while a low number might indicate that new growth initiatives aren't delivering as much profit as expected.
"Human capital" businesses, like consulting firms, often struggle to increase marginal profitability.
Don't put all your eggs in one basket
Imagine a company relying on just a few customers for most of its revenue. Those customers have the upper hand when it comes to pricing and service demands. This can hurt the company's bottom line in the long run.
The ideal situation? Lots of small customers who have little bargaining power.
One excellent example of companies with low customer concentration is American Express. This credit card giant processes transactions for millions of merchants and banks, all generating a small fee per transaction. No single customer significantly impacts their overall revenue.
Organic demand vs. marketing mania
A company that relies heavily on marketing to win customers is less attractive to investors. Imagine two stores: one with a beloved product that attracts customers naturally through word-of-mouth and another that constantly advertises. Which one would you rather own?
Amazon founder Jeff Bezos wasn't always a believer in organic growth. He used to spend heavily on marketing but eventually changed course.
"We used to advertise on TV," Bezos explained. "It worked, but not as well as giving customers a better deal." He now focuses on creating a fantastic customer experience, letting positive word-of-mouth do the advertising for him. "We're putting more money into making customers happy and less into shouting about our service," Bezos said.
The allure (and peril) of growth
Investors love companies that zoom ahead like racecars. Fast growth suggests a big future and a hot market with thirsty customers. No wonder investors pay a premium for it!
But growth needs a buddy: profit.
A company losing money to grow fast is like a lemonade stand selling drinks at a loss. Sure, sales soar, but for how long? Customers might flock to the cheap deals, but eventually, everyone catches on. This kind of growth fizzles out fast.
The same goes for companies that stumble into a hot new market. Imagine a gold rush—everyone piles in, chasing the gold. Soon, there are more miners than gold, and everyone ends up with less treasure.
Growth is fantastic, but it needs to be sustainable. As investors, we aren't looking for a quick sugar rush; we want a company that can turn that growth into long-term profits.
So, the next time you're considering an investment, don't be fooled by flashy marketing or sky-high revenue figures. Dig deeper and uncover the quality of the business. Are they building a strong web that catches customers? Do they have a predictable revenue stream? How efficiently do they turn sales into profits?
As you evaluate potential investments, remember: it's the unseen strengths that truly set high-quality companies apart from the rest.
Comments