“It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” -Warren Buffett
Great Businesses Have A Competitive Advantage
As famed investor and business expert Warren Buffett will tell you, what makes an ordinary business a wonderful business is its competitive advantage. The bigger the competitive advantage, the bigger the moat that surrounds the company which will fend off threats from new competitors. A business with a competitive advantage may not be easily replicated, and consists of a company’s ability to sell differentiated products or services more cheaply or better than competitors by virtue of a superior cost structure, brand, quality, distribution network, or customer service.
Characteristics of Great Businesses
A business with a strong competitive advantage generally has high net margins, a history of consistent growth, and customers with high switching costs. Evidence of a company’s competitive advantage may be gathered from analyzing the business and closely scrutinizing the company’s financials. Business buyers can and should pay a premium for a wonderful business with a competitive advantage because the future cash flows of a wonderful business with a competitive advantage will be far higher than a similarly situated average business lacking a competitive advantage. It is thus critical to identify a company’s competitive advantage (if it exists), and it is the job of a professional business broker to highlight the company’s competitive advantage when presenting the business to buyers.
High Net Margins A Characteristic of A Great Business
- Perhaps the most tell-tale sign of a wonderful business with a strong competitive advantage is its net margins.
- The net margin (or profit margin) of a business refers to the adjusted owner benefit (or actual monetary benefit derived by the owner from the business) divided by the gross sales of the business.
- A net margin of at least 10% is typically considered a very strong net margin, and some businesses with very lean cost structures and/or very high pricing power will have significantly higher net margins.
- Remember, companies with a strong competitive advantage do not simply reduce prices in order to attract customers.
- Rather, their differentiated product or service allows them to raise prices (if warranted) since its customers need or want their unique products or services.
- Often times, a company with a competitive advantage allows them to sell products or services more cheaply than its competitors because the company’s own cost structure is low.
- This may come about because of a unique method of offering the service or a unique method of making the product in a cost-advantaged way (such as a factory utilizing uniquely made manufacturing equipment).
- High net margins will result, and a business with consistently high net margins probably has a strong competitive advantage.
Consistent Growth A Key Trait of A Wonderful Business
Every business buyer wants to purchase a business that will grow over time. The best way to determine if a company will grow over time is by analyzing the company’s financials. This will show the growth in gross sales and net profit (or adjusted owner benefit) over the company’s history, and should include ‘hidden assets’ such as unrecorded sales or personal expenses that the seller runs through the business. Typically, a business buyer will want to see at least three years of consistent growth in order to be convinced that the growth is sustainable. A business buyer must be wary that a company’s growth is not caused by a ‘one-time event’ such as a competitor going out of business or a temporary growth spurt in the company’s industry.
Example of Two Growing Businesses
- Let us assume that Joe is wishing to purchase a South Florida restaurant.
- One candidate is a well known chain of Italian restaurants that has shown compounded sales and profit growth of 15% over the last five years.
- Upon exploring this excellent opportunity with the help of a professional business broker, Joe learns that this restaurant chain has a ‘secret spaghetti sauce’ formulated by the company’s owner which allows it to dazzle the taste buds of its customers like no other competing restaurant.
- The Italian restaurant chain makes this ‘secret spaghetti sauce’ in its own commissary and thus has lower food costs as a percentage of sales (with higher net margins) than its competitors.
- Joe is also considering the purchase of a seafood restaurant located in a nearby town that has been established for ten years.
- The seafood restaurant had no growth in its sales and profits until the only other seafood restaurant in town closed its doors a year ago.
- In fact, in the past year the seafood restaurant has grown its sales and profits by 50%!
- If Joe wishes to purchase the restaurant with a strong sustainable growth profile that demonstrates its competitive advantages, he should buy the Italian restaurant chain.
- This is seen in examining the the historical growth rates of the two restaurants.
- The Italian restaurant chain has shown an ability to grow its sales and profits at a healthy 15% rate over a sustainable period time of five years.
- The ‘secret spaghetti sauce’ allows it to sell a unique product that people desire (with also a leaner cost structure) and has resulted in a very high organic (without acquisitions) growth rate over a sustained period of time..
- By contrast, the seafood restaurant has had tremendous growth of 50%, but it has not proven that such growth is sustainable.
- Moreover, the seafood restaurant’s growth came about from a one-time event (competitor leaving town), and there is nothing to stop another seafood restaurant from opening as well.
- Such an eventuality will return the seafood restaurant to its no-growth history, which Joe correctly believes is compelling evidence that the seafood restaurant lacks a strong competitive advantage.
Customers with High Switching Costs: Trait of Wonderful Business
A relatively simple exercise to conduct before buying a business is asking how easy it would be for its customers to switch their allegiance and use a competing product or service. The higher the ‘switching cost’ for a customer to switch their allegiance, then the stronger the company’s competitive advantage. Customers that depend upon or truly enjoy (because of its price or service) a company’s products or services will have high switching costs. The ‘switching cost’ for the customer is taking a risk that the added utility of choosing the competitor’s products or services is worth the hassle of switching. Examples of customers with especially high switching costs are those that pay recurring monthly charges or have signed contracts with a business.
Selling a wonderful business at a premium price is the job of a professional business broker. In order to do so, the business buyer must be clearly informed of the competitive advantage of a business, along with the key traits that make the business truly wonderful.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.