In order to analyze investments, an eclectic investor needs to be able to identify the key drivers of a business. Understanding how an investment makes money is essential to be successful at investing. If you are going to participate in any business, whether it is a small or large, you should understand how it makes money.
Let’s take a doughnut shop as an example. You might be buying a single store, or buying shares of a national doughnut chain. Regardless of the size of the investment you should identify its profit and cost drivers. On a conceptual model, the doughnut shop transforms raw materials which are flour, sugar and water, into a final product; in this case, the doughnuts. The profit of the shop is revenue minus costs.
The main drivers of the doughnut shop revenues are a function of number of doughnuts sold and the price of each doughnut. These variables are, in turn, dependent on the number o customers that come to the store and the number or doughnuts purchased by each customer.
Revenues = Doughnuts X Price/Doughnut
Revenues = Customers X (Doughnuts/Customer) X (Price/Doughnut)
The main cost drivers are a function of the direct and indirect costs. The direct costs are the ingredients (sugar, water and flour), energy and labor. The indirect costs are rent, advertising, depreciation of the furniture and machinery.
Costs = Direct + Indirect Costs
Direct Costs = Cost of a doughnut = F(cost of ingredients, energy and labor)
Indirect Costs = F(rent, depreciation, advertising)
Why knowing the key drivers is useful to you?
It allows you to identify challenges and values. Once you have identified the revenue and cost levers, find out what their weights are. For example, let’s assume that ingredients (flour and sugar) are 25% and labor is 75% of the direct costs. If you know this and you know that the minimum wage is going to go up by 20%, you’ll recognize that the costs of the doughnuts are going to go up significantly, by 15% (i.e. 75% x 20%)
Another example, let’s say that you know from reading a research published in “Doughnut Times Magazine” that “jalapeno and peanut butter” flavored doughnuts in coastal neighborhoods increases average number of doughnuts bought per customer by 20%. Say you are buying a chain of doughnut shops along the Florida Gold Coast, and you know that they don’t offer the “jalapeno and peanut butter” doughnuts. You can quickly identify an opportunity to increase sales by updating the menu.
Therefore, I encourage you to understand the businesses you are investing in. Make sure you conceptualize it and isolate the key drivers. This will allow you to quickly identify opportunities and threats to the business. Being able to identify key business drivers is a fundamental ability of eclectic investors which allows them to participate in a wide range of business.
As an exercise, I’d suggest you go to finance.yahoo.com and look up the symbol KKD. It should give you information about Krispy Kreme Doughnuts. Read about them. Go to their website. Go to their investor relations section. Explore. Find out if they are making money. Ask why or why not. Would you invest in this company?
Do you know the key drivers of your business?
Have a profitable day! Thanks for reading.