The value of a business is the present value of all future cash flows that it will produce. Determining these future cash flows is the serious work of a securities analyst. Ratios that look at past and present performance often reveal little about a business’s future prospects. Thinking is required, and that can’t be automated or delegated.
Frequently, these future cash flows simply cannot be determined with precision. One risk that you must be on guard against is whether a business is subject to disruption. You need to consider what could kill the business? This is a foundational question, perhaps the most important.
If the business is generating a good return on capital – and these are the types of businesses you should be looking at – you can be certain that there are those who would love to storm the castle and steal the gold.
One of the biggest disruptors is the Internet. We all know that it’s a game changer for many businesses. Before making any investment, you need to think long and hard about whether your prospective investment is subject to Internet disruption and, if so, to what degree. It’s the difference between investing in businesses like Borders or Circuit City that were massively affected by the Internet and BNSF that is largely impervious to Internet disruption.
So how do you think about Internet disruption? A checklist is a good tool here. Make a list of the issues and factors you need to think about and then run it down when contemplating a purchase.
I just came across a good one in Bill Ackman’s analysis of Lowe’s. Ackman is considering the impact of online shopping on home centers such as Lowes and Home Depot.
Here’s Ackman’s checklist of conditions that render on-line shopping most appealing:
- Product is relatively high-priced (i.e., sales tax savings are more material)
- Product is not needed immediately
- Shipping cost is low
- Shipping is unlikely to damage the product
- Professional installation is not needed
- Item is not purchased as part of a larger project
- End-user of the product is making the purchasing decision
If you want to beat the market, carefully and systematically think about how your investments could be disrupted. Use a checklist to capture the issues and then have the discipline to put your checklist into practice. You’ll be richer for it.