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- The secret of how value is created in a business
Dear Investors,
I once witnessed two trainee accountants discussing a business. The first guy threw out a ratio and said it was a great business. The second guy wasn’t having any of it. He countered with a few other ratios and facts. The first guy rebutted. This went on for a few minutes. Finally, the debate was over, each guy straightened his pompadour and strutted away, as the victor.
Problem is… we still don’t know if the company was any good or not.
When looking at an investment, it’s quite easy to get bogged down amongst a gazillion numbers and facts and never reach a conclusion.
So this is the start of a two part newsletter. This week, we look at how companies create value. Next week, we look at how investments create value.
Let’s dive in.
The Cake Business
You bake cakes using Grandma’s old recipe and people love them. Your neighbours and friends rave about it. So you decide to start a cake business. You’re going to bake cakes and supply them to a local store.
You start by buying the ingredients, then head home and lovingly bake your first cake. All-in-all, the ingredients and inputs cost you 50 bucks. So, you sell the cake to the store for 100 bucks. That makes you 50 bucks in profit.
You now take that 100 bucks and bake two more cakes. You then sell them for 200 bucks. That’s enough to buy ingredients and bake 4 cakes, so you do it. You sell them for 400 bucks.
You quickly realise that you can keep doing this for a long time because there is a market for 30 cakes a day. You might need to invest in a bigger oven to make that many cakes.
That is okay, it will pay back because people love cakes. They never go out of style, people eat them for birthday’s and tea parties and treats.
Now let’s break down how this business creates value for you.
Step 1: you invest 50 bucks in the business
Step 2: you added value with Grandma’s recipe
Step 3: you sold the cake at profit
Step 4: you reinvest the profit into making more cakes
Plot twist
Let’s make one change and assume that first 50 bucks that went into the business was a loan from me and I wanted 10 bucks interest on that loan. Then the business would have gone differently. You would have sold that first cake for 100, then had to repay me 50 for the loan and 10 for interest (total = 60). That would have left you with 40 bucks, which is not enough to bake your next cake, so if you couldn’t get another loan, the business would have been dead.
The Value Creation Cycle
Here’s how I think of value creation in a business. Let’s call it the Value Creation Cycle. It goes like this: first you invest, then add value, then make a profit and then reinvest to create a virtuous circle. As you repeat loops around the circle, business value is created.
The Value Creation Cycle
The value creation cycle is the engine of every business. But in addition to that, we have to be aware of how a business is financed. Too much debt can ruin even a good business. In our plot twist above, you were 100% debt financed and when I collected my capital and interest, your business did not have the cash flow to continue.
Conclusion
Now let’s take these ideas and make them into a framework that we can apply in our search for Extraordinary companies. In finance parlance, we are looking for companies with:
A strong balance sheet (i.e. to ensure that the company is adequately financed)
Good returns on investment (i.e. profits and cash flow)
Adequate reinvestment rates (i.e. putting money back into the business to grow it)
I alluded to this cycle in a previous newsletter under our 10-point investment philosophy. But I wanted to present it here simply, on a standalone basis, because it is the most powerful concept in investing. If you can find a business that has this value creation engine revving, you have a winner.
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