Effective Business Valuation 123Profi ts and earnings growth are vital. But what businesses are
able to do to with those profi ts sets apart great businesses from
good ones.
In 1978, Warren Buffett wrote an article for Fortune magazine
titled “ How Infl ation Swindles the Equity Investor. ” In it, he noted
that there are only fi ve ways to improve return on equity:- Higher turnover, that is, sales
- Cheaper leverage
- More leverage
- Lower taxes
- Wider margins on sales
Companies have the least control over tax levels, although man-
agement certainly can use creative accounting to alter the tax rate
temporarily. Investors would do better focusing on the other four
ways, as improved sales, prudent use of leverage, or cost - cutting ini-
tiatives can indicate excellent businesses.
All else equal, sales increase should create an increase in prof-
its. Of course, you should carefully examine the quality of sales. As
sales increase, the accounts receivable level should naturally follow
suit. However, if receivables are demonstrating a trend of growing
much faster than sales future, troubles may lie ahead when it ’ s time
to collect. Additionally, inventory management is important. The
application of last in, fi rst out or fi rst in, fi rst out inventory valu-
ation methods will affect the profi t statement differently during
infl ationary or defl ationary periods.
When used prudently and wisely, leverage can increase returns on
equity. Similarly, if a business can lower its cost of debt, the correspond-
ing effect is a higher return on equity. Today we are seeing exactly how
the mismanagement of leverage has affected those businesses partici-
pating in the credit markets. The painful lesson is similar to buying
stocks on margin. If you are leveraged 5 to 1, a 10 percent return onCH006.indd 123CH006.indd 123 9/2/09 6:58:11 PM9/2/09 6:58:11 PM