Friday, September 24, 2010

Starting/investing in the right business

I was reading Tony Hsieh’s (The CEO of Zappos) book “Delivering Happiness,” and one of the things that really stood out to me in the book so far was one of the lessons from poker that Tony said could be applied to business as well. That lesson was: Choosing which table to sit at is very important, or in business terms, choosing which business to go into is very important.

A mediocre management team can achieve great returns running a company in a great industry, while a great management team running a company in a bad industry can actually lose money for shareholders. Choosing which industry to go into or to have investments in can have a huge influence on how successful a business venture turns out or how good (or bad) the returns a stock generates. 

Here are some of the things I generally look at before deciding whether or not it makes good financial sense starting a business in a certain industry or buying the stock of a company that’s in a certain industry:

Operating profit margin

We should invest in companies or start businesses in industries with high operating margins as these industries are more resistant to bad economic conditions and the companies in these industries, on average, convert a higher percentage of their sales to profits, leaving them with more money to pay out dividends or reinvest in their operations.

Return on equity

While I think the profit margin is important, return on equity is king, as it is the return that management is able to generate on the money belonging to their shareholders. A company with a 40% operating profit margin but with only a 10% return on equity creates less value for its shareholders than a company with a 5% profit margin but with a 30% return on equity.

So, investors should look to invest in companies in industries that are conducive to the companies achieving a high return on equity. Similarly, entrepreneurs should aim to start businesses in industries where they can enjoy good returns on their capital.

Market potential

Whether you are thinking about investing in a certain stock or planning to embark on your business venture, you might want to think about the market potential of the industry the company you want to invest in or the business you’re going to start will be in. The larger the market potential, the more room there is for the stock you invested in to increase its earnings or for your private business to expand.

Asset light   

Investors and aspiring business owners should try and identify industries where it’s possible to invest in or start companies that are asset light and don’t require much capital expenditure to maintain and expand their operations. Companies like these are generally able to grow faster, generate higher returns for their shareholders, and pay out more cash dividends to their shareholders.

One way investors can identify asset-light companies is by looking at the return on assets of a company, a company with a high return on assets can generally be said to be an asset-light company. For entrepreneurs, they can start businesses that they project can generate good returns on assets.

Whether you are an investor or an entrepreneur, the industry or the type of business matters as it plays a significant part in determining the ultimate success of your investment. If you have any questions or have anything you like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio.