1. What’s a good business, what’s
a mediocre business, what’s bad
business and why?
“Time is a friend of the good business and
the enemy of the mediocre”. - Warren Buffett

2. Measures of Economic Performance
Growth in revenues?
Market share?
Growth in Profits?
Growth EPS?
Profit Margin?
Capital Efficiency?
Return on Capital?
2
Proof by contradiction.
Model a small time vendor

3. The Case of Five Companies
Relation between returns on
capital, dividend policy, and
stockholder returns
3

4. Key Principle # 1
Assets are worth more than
book value when they are
expected to earn a return on
capital employed which is more
than market rates of return.
And Vice Versa...
4
Implication: Many assets are logically worth LESS than book value.
Implication: Don’t assume an asset is cheap simply because its selling for
less than book value.

5. Key Principle # 2
Assets lodged in the hands of a
manager who thinks and acts
in the interests of the owners
are worth more than identical
assets lodged in the hands of a
self-interested manager.
5
Implication: Dividend Policy Matters. While the value of a firm may be
independent of dividend policy (in an efficient market - bad assumption),
the wealth of owners is NOT independent of dividend policy. In bad
earnings retention, every Rs 100 earned should deliver LESS than Rs 100 in
increment market value.

6. Key Principle # 3
All growth is not good. There is
good growth and there is bad
growth. Good growth creates
value. Bad growth destroys it.
6

7. Buffett on Best Businesses
Growth benefits investors only when the
business in point can invest at incremental
returns that are enticing - in other words, only
when each dollar used to finance the growth
creates over a dollar of long-term market value.
In the case of a low-return business requiring
incremental funds, growth hurts the investor.
7

8. Key Principle # 4
Some businesses can grow
WITHOUT requiring any
incremental capital. They are a
very special class of businesses
8

9. Key Principle # 5
None of these, in isolation, are
accurate measures of the greatness
of a business: Growth in revenues,
Market share, Growth in Profits,
Growth EPS, Profit Margin, Capital
Efficiency, Return on Capital
9

10. Key Principle # 6
Price, like Love, Changes
Everything*
* Conditions Apply
10
Time is a friend of the great business, enemy of the mediocre.

11. Measures of Economic Performance
“Most companies define “record” earnings as a
new high in earnings per share. Since
businesses customarily add from year to year to
their equity base, we find nothing particularly
noteworthy in a management performance
combining, say, a 10% increase in equity capital
and a 5% increase in earnings per share.”
11

12. Measures of Economic Performance
“After all, even a totally dormant savings
account will produce steadily rising interest
earnings each year because of compounding.”
12

13. Measures of Economic Performance
“The primary test of managerial economic
performance is the achievement of a high earnings
rate on equity capital employed (without undue
leverage, accounting gimmickry, etc.) and not the
achievement of consistent gains in earnings per
share.”
13

14. Measures of Economic Performance
“In our view, many businesses would be better
understood by their shareholder owners, as well as
the general public, if managements and financial
analysts modified the primary emphasis they place
upon earnings per share, and upon yearly changes
in that figure.”
14

15. Buffett on Best Businesses
“Leaving the question of price aside, the
best business to own is one that over an
extended period can employ large
amounts of incremental capital at very
high rates of return”
15

16. Buffett on Best Businesses
“The worst business to own is one that
must, or will, do the opposite - that is,
consistently employ ever-greater amounts
of capital at very low rates of return.”
16

17. Buffett on Best Businesses
“The business is wonderful if it gives you more
and more money every year without putting up
anything – or by putting up very little. And we
have some businesses like that. A business is
also wonderful if it takes money, but where the
rate at which you re-invest the money is very
satisfactory.”
17

18. Scott-Fetzer

19. Berkshire purchased Scott Fetzer at the
beginning of 1986. At the time, the company
was a collection of 22 businesses
Acquisition cost: $315.2 million for Scott
Fetzer, against book value of $172.6
million.
“The $142.6 million premium we handed over
indicated our belief that the company's
intrinsic value was close to double its book
value.”

20. What’s Causing This???

21. Earnings per share = Asset turnover x Return
on sales x leverage x Book value per share
EPS=(Sales/Assets) x (Net Income/Sales) x
(Assets/Net worth) x (Net worth/Shares
outstanding)
Why is time a friend of the wonderful
business?
21
EPS will not grow simply because of sales growth because sales figure is numerator in component
1 and denominator in component 2. Only through increase in any component, or a reduction in
shares outstanding will result in an increase in EPS
Aggressive management can boost turnover only up to a point
Return on sales (margin) cannot be increased indefinitely because of regulation and competition.
Leverage too has a limit.
Only book value per share which can rise unceasingly through earnings retention can be a source
of sustainable growth in EPS.
But we’ve already seen that not all earnings-retention-caused EPS growth is good.
You also need high incremental return on capital

22. “Time is a friend of the good business and
the enemy of the mediocre”
Why?
Importance of Earnings Retention
22

23. Return on Capital, Growth Recommended dividend policy
A Low return, high growth potential High
B Low return, low growth potential High
C High return, high growth potential Low
D High return, low growth potential High
23

24. “Because it had excess cash when our deal
was made, Scott Fetzer was able to pay
Berkshire dividends of $125 million in
1986, though it earned only $40.3 million.

25. “Scott Fetzer’s earnings have increased
steadily since we bought it, but book value
has not grown commensurately.
Consequently, return on equity, which
was exceptional at the time of our
purchase, has now become truly
extraordinary.”

26. “Just how extraordinary is illustrated by
comparing Scott Fetzer's performance to
that of the Fortune 500, a group it would
qualify for if it were a stand-alone
company.

27. “Had Scott Fetzer been on the 1993 500 list the
company's return on equity would have ranked
4th. But the top three companies in return on
equity were Insilco, LTV and Gaylord Container,
each of which emerged from bankruptcy in 1993
and none of which achieved meaningful earnings
that year except for those they realized when
they were accorded debt forgiveness in
bankruptcy proceedings.

28. “Leaving aside such non-operating windfalls,
Scott Fetzer's return on equity would have ranked
it first on the Fortune 500, well ahead of number
two. Indeed, Scott Fetzer's return on equity was
double that of the company ranking tenth.”

29. Steven Penman

30. Value = Book Value + Speculative Value
Speculative Value could by +ve or -ve
Why would speculative value be +ve?
Why would speculative value be -ve?

31. Buffett uses the concept of “Economic Earnings”
instead of “Free Cash Flow”

32. For Value to be created, the company has to earn return on capital more
than required rate of return. If ROCE is too low, “Speculative Value”
component will be negative.
Metaphor of Bank account.

33. Buffett’s Equation:
Value of Firm = Value of Net Tangible Assets + Economic Goodwill
“Businesses logically are worth far more than net tangible
assets when they can be expected to produce earnings on
such assets considerably in excess of market rates of
return. The capitalized value of this excess return is
Economic Goodwill.”

34. Reverse Engineering:
By plugging stock price on left hand side, we can derive
the value of speculative growth.
Rule 6: Understand what you know and don't mix what you know with speculation
Rule 7: Anchor a valuation on what you know rather than on speculation
Rule 8: Beware of paying too much for growth
By resisting the temptation to plus a speculative growth rate into a model, we have
heeded Graham’s warning about “formulas out of higher mathematics.” Rather we have
turned the model around to challenge market speculation about growth about which he
was so skeptical.
Another advantage of reverse engineering: We get to isolate where the uncertainty lies.
If a BIG part of stock price is contained in value of speculative growth, BEWARE.

36. Steven Penman

38. Buffett on Best Businesses
“The worst business of all is the one that
grows a lot, where you’re forced to grow just
to stay in the game at all and where you’re re-
investing the capital at a very low rate of
return.”
38

39. Graham’s “Frozen Corporation”
A company whose
charter prohibited it
from ever paying
out anything to its
owners or ever
being liquidated or
sold.
And Graham’s
question was,
“What is such an
enterprise worth?”
39

40. Graham’s “Frozen Corporation”
“I do think that it’s an interesting case
because I think there is a class of business
where the eventual “cash back” part of the
equation tends to be an illusion. There are
businesses like that – where you just
constantly keep-pouring it in and pouring it
in, but where no cash ever comes back.”
40

41. Stock down 96%
Market up 415%
41

42. “If plantings made confidently are
repeatedly followed by disappointing
harvests, something is wrong with the
farmer. (Or perhaps with the farm:
Investors should understand that for
certain companies, and even for some
industries, there simply is no good
long-term strategy.)” - Warren Buffett

43. Shareholder: Did you have a particular
business or investment experience early in
your career which convinced you it was
preferable to invest in high quality
businesses? Or was it simply a matter of
analyzing the effect of owning a high quality
growing company over a long term?
43
“That’s a very intelligent question because we’re all seeking wisdom. I’d like to be able to tell you that I was able just to read the newspapers and come to the correct conclusions based on vicarious experience. And I did get considerable
enlightenment from vicarious experience – because if you can’t learn from vicarious experience, you’re really due for a lot of bumps in this life. “But no, I had bumps. For years, I was a director of an International Harvester dealership in the
Central Valley. That is a really tough business. And there’s never any cash. As the saying goes, at the end of the year, your profit is sitting out in the yard – in the form of your used equipment. And struggling with a business that never
produces any cash – whether it’s winning or losing as a matter of accounting – is no fun. And I watched that being done for many years.”Then I was in an electronic business where we had what I would call style changes. However, they were
really technology changes. Our main product was obsolete by magnetic tape. And nobody told me that magnetic tape was going to be invented and that it was going to obsolete my main product. And I found it s a very unpleasant experience.
So we learned part of what we learned from unpleasant experience.”And the experience Warren Buffett and I had early on in the department store business in Baltimore—we never should have bought into it. It was an investment mistake
caused by youth and ignorance, although we were plenty old enough to know better. We just hadn’t learned enough from vicarious experience.”But we soon realized that we had problems there that we couldn’t fix. In fact, we soon realized
we had problems that nobody could fix. There’s no example in recorded history of anybody fixing the kind of problem we had in Baltimore. There were four big department store chains which sort of equally shared the market. And it just got
tougher and tougher and tougher. And it demanded capital on a massive scale just to stay in the game at all.”Luckily, we were able to exit that business and get our money back. Maybe we even got 2% per annum interest. But we learned a
very valuable lesson. Warren occasionally teaches that lesson in business schools. He used to show students the records of Thompson Publishing, the newspaper company, and AT&T going way back without identifying the companies.”And it
turns out, of course, that for 30 years the telephone company was a lousy investment for shareholders because they just kept issuing shares like crazy and plowing more capital into the business. They were able to get higher earnings only by
reinvesting enormous amounts of cash. There was never any real cash to distribute to AT&T shareholders. This is going way back – before the breakup and before the last few years when they changed it into a different kind of company.”In
contrast, Thompson Publishing had all of these little newspapers that just spewed out cash. They basically never had to put any cash back into the business unless they wanted to buy another newspaper. So, of course, the people who owned
the stock of Thompson became enormously rich, whereas the people who owned AT&T didn’t.”The difference, of course, is that one business grew like crazy without requiring more capital. And the other one grew only by requiring way more
capital than the business made.
Now if the returns on incremental capital are high enough, you welcome the opportunity to pour more capital in. But there are a lot of businesses where the capital requirements are such that it doesn’t really work for shareholders, although
the reported return on equity looks halfway decent.”

44. ”You should seek businesses
that just drown in money if
they just pause for breath…”
44

45. Models for Business Success
Questions to ask:
Why is this company earning high returns on
capital?
Answer lies in the the du-pont formula
High margins and high capital turnover (low capital
intensity)- ITC’s tobacco business
High margins and low capital turnover (high capital
intensity e.g. shipping)
Low margins and high capital turnover e.g. Wal-mart
But see what happened to IBP
45

46. Models for Business Success
Questions to ask:
What models combine to produce its extraordinary
profitability and/or scale?
Why would it continue?
How long can it last?
Is this a fluke, a short-lived first mover advantage, or
is it likely to last very long?
What forces will cause these results to stop
occurring? [backward thinking]
46

47. Moats
47

48. Moats
“What we’re trying to find is a business that for one
reason or another – because it’s the low cost
provider in some area, because it has a natural
franchise due to its service capabilities, because of its
position in the consumer’s mind, because of a
technological advantage or any kind of reason at all –
has this moat around it.
48

49. Moats
“However all moats are subject to
attack in a capitalistic system. If
you have a big castle out there,
people are going to try to figure out
how to get to it. And most moats
aren’t worth a damn in capitalism.”
49

50. Moats
“And we try to figure out why the
castle is still standing and what’s
going to keep it standing or cause it
not to be standing five, ten, or twenty
years from now. What are the key
factors? How permanent are they?
And how much do they depend on the
genius of the lord in the castle?”
50

51. The Franchise-Business Continuum
Weak Business Weak Franchise/Strong Business Strong Franchise
51

52. Buffett on Franchise Value
52

53. 53

54. 54

55. What to look for in a great business?
A high return on capital (not contributed by a
very low margin operation where margins
could fall as happened in IBP) which is
sustainable - pricing power, low cost
advantage etc.
Ability to deploy incremental capital at high
rates of return i.e. growth prospects. (Why
this ability is crucial?)
Ability to self-fund growth (How important is
dilution?)
55

56. What to look for in a bad business?
A low return on capital
Growth (what does high growth do to bad
business?)
Inability to self-fund growth (with
consequential effects on quality of balance
sheet)
56

57. “Time is a friend of the good business and
the enemy of the mediocre”. - Warren Buffett
"If a business earns 18% on capital over
twenty or thirty years, even if you pay an
expensive looking price, you'll end up with
one hell of a result." - Charlie Munger