A new perspective to assessing the quality of a business

Reading books andanalyzing companies, I have come up with some ideas. I am penning them down, please help me in taking themforwardandrefining


  1. **CAGR application to sales and earnings: **We all know the concept ofcompounding.In nut shell it means the interest of one year gets added to the principal and the new sum is considered to be the principal for the next year. Now coming to weather CAGR is applicable in calculating growth rate in sales and earnings of all companies. let me ask you a question:do you buy a car every year or more frequently? obviously a significant number you will straight away say “no” and the same is true for all products which either last longer than a year (durable goods) or do not satisfy a recurring need.For such products the customers are different in different time periods.Where as for companies that make products that satisfy a recurring need like cigarette,toothpaste,sanitary napkin etc, the same customer comes back again and again because of consumer monopoly that the company has and the new ones get added to the existing customer base just like interest of one year gets added to the principal and thecumulative becomes the principal for next year. So, CAGR is logicallyappropriate for measuring sales growth of companies that satisfy a recurring want and if the cost structure remains more or less stable the CAGR can be extended to measure earnings growth.
  2. **Gross Margin: **gross margin can be maintained or expanded in the following four ways:
    Increasing price of the product in line with inflation:if the company can do so without loosing volume the company has pricing power. Eg: colgate,P&G etc.


_Establishing a Unique raw material sourcing network: _some companies build a unique raw material source to supply them quality and cheap raw material. eg: ITC(E-Choupal), Nestle(Monga district collection points) etc.


_Changing product mix: _some companies changetheirproduct mix to increase the contribution of high realization products in total revenue. eg: Prestige etc.


_Degrading the quality of the product: _this is obviously the most inferior way to improve gross margins. eg: Milkman :smiley: etc.

The above mentioned ways are indescendingorder. All else equal a company which maintains or improves its gross margin by increasing price in line with inflation is the best and one that degrades the quality of the product to maintain or improve itsgrossmargin is most inferior. Some times a mix of these can be observed. Eg: ITC( unique raw material source and changing product mix) etc.

3). **liquidityand solvency:**The traditional ways to look at liquidity and solvency is to look if the current assets and equity respectively are enough to take care of the liabilities. But in reality it is the earnings that are used to retire the short term and long term liabilities.It is analogous to the case of personal loans, while loaning a mortgage provides the security(backing) in case the person defaults,but mostly it is the income of the individual which takes care of the loan payments and hence the quality of income source is important.If the company has a durable competitive advantage and hence has a high quality(through recurring customers) and increasing earning power enough with acushion over and above its current liabilities then the company can be expected to meet its liquidity even in troubled times. If the long term debt divided by net earnings is below 5 or some more conservative measure, it gives a sense of comfort that if the company wants the company can become debt free in 5 or less years.

4.**Research &development:**Philip Fisher in his book common stock uncommon profits has said a company needs to have proper research anddevelopment in place to ensure future growth andprofitability.Buffet is said to be 20% Fisher and 80% Graham, differs from Fisher on this point.He prefers companies with a product history which is long enough towarrant that the product is going to remain same over years to come. Eg: Colgate, (ITC) cigarette etc. The point i am trying to make here is one has to look for companies with stable products(contributing maximum revenue of the company), which is supported by a low spending on R&D as a percentage of gross margin.

Another aspect of R&D which should be considered is the fact that all else equal the company that centers its R&D around related products has higher subjectiveprobability of coming up with a break through product than a company that has R&D scattered across various unrelated products.

5.**capitalexpenditure: **one of Buffett’s investingtenets is the total CAPEX over last 10 years divided by total Net Income over the same period should be less than 50% for the company to have a durable competitive advantage. By this he means to say the company should not be incurring more than 50% of its cost in revamping itsexistingoperations. This CAPEX should not include spending on expansions(provided there is high or above average market potential in the new market) andacquisitions(provided the business is not buying a price competitive business).Eg: Colgate including its spending on new plant has spent a mere 20% of its net income in last 10 years!

6.**Quality of earnings: **it depends a great deal on the type of product a company sells. ie: how frequently its demand reoccurs,how much affinity the consumer has for the product and what portion of the consumer budget does the product form. How frequently its demand reoccurs: if one is running a tea shop, an average Indian drinks teaat leasttwice a day and for a company likeColgatethe customer uses toothpaste a 100 grams toothpaste lasts for 1.5 months. So,the same customer comes back to buy the toothpaste 8 times a year.The general rule is higher the frequency better for the company.

affinity for the product: here we can divide products into addictive,necessity and luxury. A product likecigarette or liquor is addictive and probably the same can be said for chocolate and cool drink to a lesser degree.In this case the target customers may not be the general public as a whole,but a stratum of people.Next comes necessity which people cant go without say food and in today’shygieneaware world toothpaste,sanitary napkin etc. Luxury comes at last in thehierarchy it includes all that which areneither addictive nor necessary (probably an imperfectdefinition as per oxford dictionary, butnonetheless serves our purpose).

portion of consumer’s budget: the smaller portion it forms of the consumers budget the higher is its price elasticity.

7.**Defining a monopoly:**Monopoly can be broadly classified into two types. 1. situational monopoly(by exploiting the situation like Wall Mart) 2. asset based monopoly(a mines or brand name based monopoly).A monopoly has 2 dimensionless time and space. Themost well defined monopoly is through a patent.The company knows for how long it can be the soul producer of the product, where all it can sell the product. For products with brand name the space can be the shelf space occupied by the product in the whole productcategorycan serve as a proxy for space, but in this case time isdifficult to quantify, to which Buffett’s basictenet provides the best solution invest in companies that sell stable products.This way you can’t pin point the time interval,but you can expect it to be long enough.

can someone throw some light on which type of monopoly is better and why?

Hi Shrey,

Great insights and thanks for sharing.

Could not appreciate the CAGR issue. How else would one measure growth in business?

The capex funda was something new for me and looks logical.

Probably you could do this discussion in similar threads like the one below so that we can have all similar discussion in one place.




Hi Vinod,

i just meant to say that CAGR is most applicable to companies with recurring customers. If i see the same CAGR in sales or earnings for say a car company and a toothpaste company, i would rate the toothpaste company higher assuming all else constant.

A way to measure growth of sales of consumer durable goods that last more than a year can be clubbing the sales of a period together (period= economic life of the durable good) and then measure the CAGR that may not give the actual picture,but it will be a closer approximation.for example for car company if we have a 15 year data of sales club the sales of first 5 years and last 5 years and measure the CAGR over the in between 5 year period(assuming the economic life of car to be 5 years).


Shrey :smiley:


Good initiative. It will help you refine and clarify your thoughts in a some ways. Be aware though, that theorising too much has its own problems. I may be wrong, but can already notice a bias towards frequent purchase, consumer staples.

In practice, we see many different kinds of companies doing extremely well. You can/should take any theoretical hypothesis forward by using that first on a number of companies that have done exceedingly well in the past.

Does the hypothesis hold up when we use a few company examples?? What has the market voted for in the past, how consistently? use this framework on different kinds of businesses - Colgate Palmolive, Nestle, Asian Paints, Sun Pharma, ITC, etc.

End of the day, the proof of the pudding is in the eating:)

One should always have some hypothesis/patterns running in the head - good to see you thinking on these lines:). But this has to be concurrent with a lot of exposure in churning through a lot of different businesses.

Theoretical Framework -ideal time for synthesis is when you can confirm/deny the practical manifestation of these more & more thru examples that you have churned yourself.

Also at some point your investigations perhaps will add to the work ongoing in the Tried & Tested blue Chips thread. look forward to your inputs in that thread - for establishing better quality of business - through specific company dissections.

Hi Shrey,

Nice post! Agree with Donald, completely. All this will really value add when one will apply these principles independently to new ideas (or ideas not properly valued by markets) :slight_smile: