Business Analysis

Business analysis is the cornerstone of Value Investing. It's the detective work an investor does to truly understand a company before ever looking at its stock price. Forget the squiggly lines on a chart or the hot tips from your cousin; this is about becoming an expert on the business itself. Think of it like buying a whole company, not just a piece of paper. You'd want to know exactly how it makes money, who its customers are, what keeps competitors at bay, and whether the people in charge are smart and honest. This qualitative investigation provides the critical context for any financial numbers. Without it, you're just guessing. A solid business analysis is what separates investing from speculation and is the foundation upon which you can confidently estimate a company's intrinsic value.

Many people think investing is about crunching numbers in a spreadsheet. While financial analysis is important, it's only half the story. The numbers tell you what has happened, but a deep business analysis tells you why it happened and whether it's likely to continue. Legendary investors like Warren Buffett and Charlie Munger have built their fortunes not by being financial wizards, but by being brilliant business analysts. Their guiding principle is to buy wonderful companies at fair prices. You can't know if a company is “wonderful” just by looking at its Price-to-Earnings (P/E) Ratio. You have to roll up your sleeves and understand the business. This approach is about developing a long-term perspective and investing within your circle of competence—that is, only in businesses you can genuinely understand.

A thorough business analysis can be broken down into three key areas. Getting a good handle on these will put you light years ahead of the average investor.

This is the most fundamental question: How does the company make money? It sounds simple, but you'd be surprised how many investors can't answer it clearly for the stocks they own. You need to investigate:

• Products and Services: What does the company sell? Is there real, durable demand for it?
• Customers: Who are they? Are they diversified, or is the company dangerously reliant on a single large customer?
• Revenue Streams: Does money come from one-time sales, recurring subscriptions (which are often more stable), licensing fees, or advertising? A company like Microsoft has successfully shifted from one-time software sales to a more predictable subscription model with its Office 365 and Azure cloud services.

A great business needs a defense system to protect its profits from competitors. In investing, this is called an Economic Moat. It's a durable competitive advantage that makes it difficult for rivals to steal market share and erode profitability. There are several types of moats to look for:

• Intangible Assets: Powerful brand loyalty (like Coca-Cola or Apple), patents, or regulatory licenses that keep others out.
• Switching Costs: The hassle or expense a customer would face to change from one provider to another. Think of how much work it would be for a large company to switch all its computers and databases from Microsoft Windows to another operating system.
• Network Effects: When a product or service becomes more valuable as more people use it. Social media platforms like Facebook or professional networks like LinkedIn are classic examples. The more of your friends or colleagues are on it, the more useful it is for you.
• Cost Advantages: The ability to produce goods or services cheaper than competitors due to scale, location, or a unique process. Retailers like Walmart and Costco use their immense size to negotiate lower prices from suppliers, a benefit they pass on to customers.

A wonderful business can be ruined by a terrible management team. You are entrusting your capital to these people, so you need to be sure they are both skilled and shareholder-friendly. Key questions to ask are:

• Capital Allocation: How does management use the company's profits? Do they reinvest it wisely in high-return projects? Do they pay a sensible dividend? Do they buy back shares at attractive prices? Or do they waste money on foolish, ego-driven acquisitions? The skill of capital allocation is arguably a CEO's most important job.
• Integrity and Transparency: Are the managers honest in their communications with shareholders? Read the CEO's annual letter to shareholders. Is it clear and candid, or is it full of jargon and excuses? Compare it to the gold standard: Warren Buffett's letters for Berkshire Hathaway.
• Compensation: Are executives rewarded for long-term value creation or for short-term stock price bumps? A well-designed compensation plan aligns the interests of management with those of long-term owners like you.

To get started, try answering these simple questions for any company you're considering. If you can't, you haven't done enough homework.

• Can I explain what this company does and how it makes money to a ten-year-old in two minutes?
• If I had unlimited money and talent, how would I try to compete with this company? What makes that difficult? (This helps identify the moat).
• Is this business in a growing or shrinking industry?
• Does the company have a long history of consistent profitability?
• Has management been a wise steward of shareholders' capital over the past 5-10 years?

Business analysis is the art and science of understanding what a company is, what it does, and what makes it special. It's what gives you the confidence to hold on during a scary market downturn and what protects you from buying into a popular story stock with no real substance. It turns investing from a casino game into a disciplined, thoughtful pursuit of owning pieces of excellent businesses.