In our last blog post, we introduced the notion that a company’s overall investment performance is driven by the orchestration of three different types of performance—business performance, shareholder performance, and investor performance. It takes a masterful, symphonic arrangement of all three to produce sustainable investment returns. In the next three posts, we take a deep dive into these three performances to provide an understanding of how investors can evaluate the potential investment performance of a company. It starts with business performance, which is the most important indicator of a company’s health and investment potential.
What Exactly is Business Performance?
I’ve often asserted that when you invest in a stock, you are essentially becoming a part-owner of a business, and, as such, you should know how the business is doing. That starts with a clear understanding of what the business does to generate revenues. If you can’t understand how a business makes money—including the products or services it sells or the market in which it competes—you would have a difficult time evaluating its business performance.
Measuring Business Performance
At the core of business performance is the performance of a company’s management team because they have the most control over the business’s performance. They are the ones that make critical decisions, such as how to best allocate capital to drive productivity, profits, and growth. The key measures of their performance can be found in the financial statements, including the income statement and the balance sheet, and how they interact with one another.
Breaking Down the Income Statement
The income statement, also known as the profit and loss (P&L) statement, is simply the total revenue generated from products or services sold in a given period minus the expenses required to run the business. The income figure is further adjusted to account for taxes and interest paid on borrowed capital to show net income.
The net income number tells us a lot about how well the business is doing, but we need to look at the balance sheet for a complete picture.
Understanding the Balance Sheet
The balance sheet is relatively straightforward, taking the company’s assets in the form of property, plants, and equipment and subtracting its debt and other liabilities, which may include such things as pension obligations. The total liabilities are subtracted from its total assets to show the company’s net worth. The net worth is shareholders’ net investment in the company.
Zeroing in on Return on Equity
For more targeted measurements, the two financial statements are combined to create ratios. Using ratios, you can measure trends and whether a company’s performance is improving or getting worse. In my view, the most important ratio for evaluating the long-term health of a company is the return on equity (ROE). ROE is a measure of a company’s financial performance calculated by dividing net income (from the income statement) by shareholder’s equity (from the balance sheet). ROE is also considered the return on net assets (assets minus debt).
In our blog post, A Company’s Return on Equity is Key to Long-Term Stock Performance – But is it Reliable?, we make the case that ROE is a critical measure of a company’s profitability. More importantly, it measures how well a company’s leadership manages its shareholder’s money. When a company’s ROE increases over time, it’s a strong indication of management’s efficiency in deploying shareholder capital to create long-term value.
The Lemonade Stand Analogy
For many professional investors, including Warren Buffett, the amount of capital shareholders place in the hands of management is a vital indicator of a company’s overall health as determined by the income statement and the balance sheet and how they interact together. This is more easily understood with my lemonade stand analogy.
You’re probably familiar with the theme: It’s a hot summer day, and your kids want to open up a lemonade stand in the front yard. They’re absolutely convinced they can sell a lot of lemonade, and you want to feed their entrepreneurial spirit. So, you tell them you’ll foot the bill to get them established—including the actual stand, signage, cups, jugs of purified water, and lemonade mix. You invest $100—all in.
At the end of the day, your kids excitedly report they sold $20 of lemonade and pocketed $10 after accounting for the cost of the water, cups, and lemonade. Think about that. The management of the venture in which you invested $100 made a net income of $10. That’s a 10% return on equity in just one day! You start thinking about expansion or even franchising. Maybe not, but it does clearly illustrate how to evaluate a company’s health through the income statement and balance sheet and how shareholders’ at-risk capital translates into profits.
Focus First on Business Performance
The benefit of focusing squarely on business performance to evaluate a company’s investment potential is you don’t have to worry about the stock market, or the fiscal policies of the new administration, or trade tensions with China. All that has little if any impact on the decisions management makes to allocate capital. Nor does it affect the company’s ability to develop new products, build its brand, and expand its markets, and do so profitably. It’s a pure and objective look at the company’s performance and whether it warrants a more in-depth look into its shareholder performance, which we explore in our next post, and investor performance, to be examined more closely in a future post.
