Episode 6 | The Business in GWII's BMPB Framework

In Episode 6 of "Market News with Rodney Lake," Rodney Lake, the Director of the GW Investment Institute (GWII), explains the business aspect of GWII's BMPB framework (Business, Management, Price/Valuation, and Balance Sheet). He explores the practical applications of the DuPont formula in evaluating business quality, underscores the importance of understanding the utility of products and services, and delves into key financial metrics like Return on Equity. Using examples like Apple (NASDAQ: AAPL), he demonstrates how high profit margins and customer loyalty contribute to business value. Tune in to learn more!

Transcript

Thank you for joining Market News with Rodney Lake. This is a regular show from the GW Investment Institute, where we discuss timely market topics. I'm Rodney Lake, serving as Vice Dean for Undergraduate Programs at George Washington University School of Business. Let's get started.

Welcome back to Market News with Rodney Lake. This is episode six, and I'm your host, Rodney Lake.

Today, we're covering the GW Investment Institute framework: BMPB (Business Management, Price/Valuation, and Balance Sheet). The focus for today is on the business aspect. We'll discuss other components in future episodes, but today, we'll dive into what makes a good business and how an analyst should approach business analysis.

At the GW Investment Institute, we score companies from 1 to 10, with 1 being undesirable and 10 being highly desirable. For example, Apple is a fantastic company that would score a 10 due to its strong brand, solid balance sheet, and high profit margins.

When evaluating businesses, consider Peter Lynch’s approach: look at what’s in your refrigerator. This helps calibrate what makes a good, average, or poor business. As an investor, you have the flexibility to invest in anything, so it’s crucial to understand the type of business you're investing in and its fundamentals.

For instance, if an industry has high profit margins, a company matching or exceeding those margins is performing well. Conversely, if a company underperforms, there may be issues with its management. We'll discuss management in other episodes, but today, we're focusing on the business aspect of the BMP framework.

We ask our analysts at the GW Investment Institute to score companies on a 1 to 10 scale and weigh each component (Business, Management, Price Valuation, Balance Sheet) equally at 25%. This composite score allows us to compare companies across various sectors.

A good business has several characteristics. For example, Apple’s ability to raise iPhone prices without losing many customers shows its pricing power and brand loyalty, resulting in higher profit margins. On the other hand, commoditized industries, like oil and gas, tend to have lower profit margins due to the lack of brand differentiation.

High-quality businesses usually compound at better rates over time. We encourage our students to find well-run, high-quality businesses with attractive prices and rock-solid balance sheets. Look for indicators like high profit margins and pricing power, which suggest brand loyalty and a strong business model.

Amazon Web Services (AWS) is another example of a great business. It started as a byproduct of Amazon’s excess compute capacity and became a high-growth, high-value part of the company. Large-scale infrastructure and security make AWS a trusted provider, unlike smaller competitors.

Commoditized companies can still be profitable, but we prefer businesses with high margins and growth potential. For example, Starbucks is a publicly traded company. If you enjoy their products and services, consider their business model and profitability.

Anecdotal evidence should be supplemented with thorough research. Look at publicly listed companies, like Tesla or GM, and analyze their brand loyalty and profit margins.

Consider the nature of the business: is it commoditized or high-margin? Microsoft, a software company, has high profit margins due to the near-zero marginal cost of delivering additional software.

Think critically about how businesses operate, their profit margins, and their customer base. For example, an iPhone may be expensive, but relative to an individual’s overall budget, its cost is manageable when amortized over its lifespan.

By analyzing these aspects, you can identify high-quality businesses with strong fundamentals and growth potential.

So possibly if they find great utility in having that iPhone and it's really useful for them, then they'll pay up, because it's useful, it's valuable. It helps them do things. It helps get them through their day and make sure that they make their meetings on time because they have their calendar and their schedule and everything else on there.

So you have to really think about the underlying products and services that are being delivered. When you're thinking about the business summary, another metric that I want you to consider as an analyst, if you're thinking about doing this on the fundamental research side, is return on equity. So in class, we typically use the DuPont formula.

I want all of our students to really think about the DuPont formula. And what is that? That's the profit margin times the asset turnover times the leverage in the business. So the equity multiplier, in other words. Those three components help you really understand a business. So you can do a very quick exercise and say, okay, what's the return on equity for this company?

You break it down to these three components. Does it have a high profit margin? That tells you something about the business. If it has a high profit margin, that's excellent. It's very likely going to be a good business. Asset turnover tells you the efficiency of the management team. Are they doing a good job for the business? Are they turning over the assets? The equity multiplier tells you what is the leverage in the business. If all else is equal and the company has a low profit margin and high leverage, maybe it has a high return on equity, but maybe that's not such a good thing because it has a lot of risk associated in the balance sheet.

So when you're thinking about that, those three components: higher profit margin, very good; asset turnover, and low leverage is you can have it for the highest return on equity with the lowest amount of risk. So again, for us, we're talking about how do we get ourselves involved with high-quality businesses. How do we make sure that we're not taking excessive risk to acquire those businesses and hold those businesses?

This is a simple formula that helps you get started. It's not an end-all-be-all. It has limitations, but it is a very good start. The first component of that is the business, which is the profit margin. That metric helps you do that. So I think it's a critical formula to memorize. Even for our students, I encourage them to memorize it. It is not a difficult formula to memorize, and you can quickly make an assessment, whether maybe this company is a pass, maybe I don't want to do any more work on this. The allocation of time as an analyst is a critical decision for yourself as well. So you have to think about, am I going to spend time on these ten companies, these five companies, these four, three, two, or one?

The more time you spend on a specific company, probably the better you're going to know. So sometimes if you get to the point where you think, well, there's a lot of risk baked into this business, maybe it's just a pass. We encourage our students to do that as well. If you're looking at a business, for example, and you cannot understand it, and you do quick work on it for the DuPont formula, that might be in the too hard pile, as Warren Buffett calls it.

Just move it over there. That's okay. Maybe we'll get back to it one day. Maybe you won't. But after some effort of trying to understand the business and you can't really understand it, then it's time to move on. A qualifier there is if you're looking at a chip company, like Nvidia, as we talked about in the last episode, it doesn't mean that you have to be an electrical engineer or chip designer to really understand their business.

Sometimes that can be helpful, especially in biotech companies, for example. But it's not necessary. If you understand who their customers are, you can understand the business if you spend the time to understand the components. I encourage you to do that. Another thing to think about is the businesses and the customers. Who are the customers for the business? Not just the percentage of their budget, which we just mentioned, but who are their customers?

Are their customers companies? Are their customers individuals? When you talk about B2C or B2B, sometimes each one has its advantages, but you have to think about the underlying dynamics. Who has the leverage in that situation? Porter's Five Forces can help you do that. We utilize that framework in class as well.

If their customers are, like we talked about in the last episode, Microsoft, Meta, and Google as an example, they probably have the pockets to support more buying for their products. Obviously, that's an extreme example with Nvidia. But you can look through and see who their customers are. Do you think they're weak customers? Do you think that they're going to have trouble buying the next batch of products and services from this company? Maybe that puts into question the quality of their business because they've attracted these clients. But to retain these clients and keep them going could be challenging and difficult. So let's work on wrapping up here. We talked about the framework overall very briefly.

The business, the management, the price valuation, the balance sheet. We weight those 25% each to come up with a composite score. We rate each one individually, 1 to 10, ten being the best. So when you think about a company like Apple, you're going to say, okay, that's a 9 or 10. That's a high-quality business that has very good profit margins, and people are very loyal to that.

It has pricing power, and its underlying customer base is very solid. A billion phones installed and growing, and very loyal. So that's a very quick assessment about Apple. But that gets you to the nine or the ten. We'll talk about the other components. But I encourage you to do the work. Think about these businesses like Peter Lynch.

What's in your refrigerator? If you go to Starbucks, if you take an escalator, those are publicly traded companies too. Think about, are they doing a good job? Maybe I want to investigate a little bit more, but put the work in. Put your thinking cap on. Start viewing the world as an analyst in all that you do.

When you walk into Starbucks, are you getting good service? Are you getting a good product? Do you enjoy it? Does it delight you? Well, that's a good place to start for new businesses and business ideas. Then you got to put the work in. Use the DuPont formula. I encourage all of you to have a great day and see you back in episode seven.

Thank you.

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