Chapter 2 — Indicators of a Good Business
You’ll be able to answer:
- What is an indicator of a good business?
- What is return on capital?
- How to put it all together.
Digging Deeper into Johnny’s Lemon Empire
As you already know, Johnny is a tremendous businessman, and luckily for him, his business is still thriving. Johnny’s success has allowed him to expand his empire by opening new lemon stores across the country. Now, Johnny owns over 10 stores. 🍋
The Numbers Behind Johnny’s Success:
- On average, Johnny spends $100,000 to open a new lemon store.
- Each store generates $15,000 yearly in profit. 💸
Introducing Diego’s Padelmania
Diego is also a businessman (it seems that entrepreneurial spirit runs in the family!). However, Diego’s business is very different from Johnny’s. Diego is capitalizing on a rapidly growing sport called padel by building courts and renting them out to customers. 🎾
The Numbers Behind Diego’s Venture:
- Each padel court costs Diego $160,000 to build.
- On average, each court generates $40,000 yearly in profit. 🌟
Comparing Johnny’s Empire vs. Diego’s Courts
Good news! You’re also a businessman. Johnny's business is generating $15,000 profit per store per year while Diego's court generates $40,000. But it's way cheaper to open a lemon store. 🤔
What if we compare 2 lemon stores with 1 of Diego's courts? Or analyze what happens if profits drop by 30%? Let’s break it down! ✌️
Johnny’s 2 Stores vs Diego’s Court
Diego’s Court:
- Total investment: $160,000
- Total yearly profit: $40,000
Johnny’s 2 Stores:
- Total investment: $200,000
- Total yearly profit: $30,000
With less investment, Diego’s court is generating more profit.
What Happens if Profits Drop by 30%?
Johnny’s Lemon Empire:
- New profit per store: $10,500
- Return on capital per store: 10.5% 🤔
Diego’s Padelmania:
- New profit per court: $28,000
- Return on capital per court: 17.5%
What Does This Mean? 🌟
- Diego's business generates more money with less investment. His product is rarer and more valued.
- Johnny's business is less resilient when profits decline, but Diego's business remains profitable.
Return on Capital (ROC): A Key Indicator
What is return on capital? Return on capital (ROC) measures how effectively a business uses its money to generate profits. It’s calculated as:
Return on Capital = Profit ÷ (Debt + Equity) × 100
Which Business Would You Invest In?
- A. A business that has higher earnings yield (from Chapter 1).
- B. A business with a high return on capital.
- C. Both A and B.
Guessed it? Yes, the answer is C.
🔍 Getting it Real!
It's fun to play with imaginary businesses like Johnny's Lemon Empire and Diego's Padelmania, but isn't it more fun to look at real businesses? Let’s get down to it!
Explored metrics:
- Net Income
- Total Debt
- Equity
- Invested Capital
- Return on Capital
If digging through financial reports feels overwhelming, don’t worry. Use the tool below to explore your favorite companies and find the magic in the market.
Next Steps
Now that we’ve cracked the code for spotting bargains 🏷️ and identifying great businesses 💼, it’s time to move forward with purpose! Here’s what’s coming next:
- Combine the Strategies: Merge what you’ve learned into a single, powerful methodology.
- Prove It Works: Test this approach with historical data and real-world scenarios.
- Discover Today’s Winners: Apply the magic formula to find the best businesses to invest in now.
The strategies are in place, and the tools are ready. Now it’s your time to act—get ready to unlock the secrets of successful investing!
Let’s go to Chapter 3 and build the ultimate strategy! 🚀