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The business world is full of incredible investing success stories, whether we look at the lives of Warren Buffett, Bill Ackman, Cathy Wood or Peter Lynch. Success isn’t about lucky choices and odds or being in the right place at the right time. Expert investors understand the rules and trends that create sound business strategies and ideal investment opportunities.
There may be a few mistakes along the way, but you can weed out a lot of bad decision-making and avoid financial ruin by knowing how to tell if a business investment will be worth it in the long run.
1. Conduct a strong analysis of the business documents and data
It’s safe to assume that if you’ve already decided which areas of industry or opportunity you want to put your money in, you need help on which specific business investments will be the most profitable for your money. Keep in mind there is a difference between a business opportunity and a business investment, as business opportunities fall under the broad category of investments. A business opportunity often deals with buying the business outright or maintaining enough stock in the company so your direct input guides operations. Buying a business has variables that are under your control; you are buying an investment into yourself.
On the other hand, if you are investing in a business, whether a startup or other venture, you are investing in yourself by profiting from the success of the investment. In order to make a wise decision, you need to know everything you can about the business, the market, the competition, the leadership, the finances and so on. This is one of the most tedious but most important parts of researching potential investment opportunities. A solid business plan should be the first thing you ask for, and a comprehensive, well-thought plan will include:
- SWOT analysis
- Financial projections
- Sales channels
- Marketing plans
- Market data on consumers and competitors
2. Make sure you understand the financial ratios
You need a strong understanding of the financial truths of a company or opportunity before you decide to put your own cash into it. Public financial disclosures are the bread and butter of a company’s financial health and using the cash flow statement, profit-and-loss statement and balance sheet, you are able to do the calculations that reveal the past, present and potential future of the investment. These documents will show the company’s ability to manage growth, increase profit and remain financially stable.
Make comparisons across several years and conduct similar evaluations with peers in a similar area of market capitalization across the industry. The financial ratios to pay attention to include:
- Liquidity: Current, quick and cash ratios
- Leverage: Interest coverage and debt-to-equity ratios
- Market value: Earnings per share, price-earnings, book value per share
- Profitability: Operating margin, gross margin, return-on-equity and return-on-assets
- Efficiency: Asset and inventory turnover ratios
3. Evaluate the current and future trends in the industry
A company may seem to be doing well at the moment, given the novelty of a product or service or the entrance into a niche market. A solid business investment will be able to grow and adapt to the changes the industry may experience. Part of a company’s ability to navigate these changes depends on the experience of the entrepreneur or management team. Although your money is going into a business, you are actually investing in the experience and background of those in leadership and trusting that there is a vision to capitalize on new opportunities or adjust to uncontrollable variables.
If a company has a proprietary feature, it gives them a competitive advantage so long as there is protection in place for the intellectual property. Entrepreneurs or companies with exclusive distribution networks or marketing contracts, as well as licenses, patents or trademarks, create some security as the industry or market grows. A large market with limited competition is an added bonus when assessing long-term value, as a large, stable consumer base supports growth as the industry changes.
4. Be comfortable with the industry and the team
It’s one thing to have all the reports on your desk and understand the numbers, but if you don’t have an interest in the industry or truly appreciate the value of the product or services, you aren’t making a wise choice for an investment. Consumers think critically about spending their money; they aren’t robots who buy whatever parades in front of them. If you aren’t convinced with the product, it’s likely it will be a hard sale to the consumers. You need to feel confident about where you are placing your funds beyond just a financial position.
You need to fully vet the management team for passion, experience, skill and good decision-making. You also want the team to be flexible, teachable and open to change when the industry determines it’s necessary. Investors tend to make decisions either on a gut feeling, on the numbers or a combination of both influences. You will factor dozens of different pain points or intangible metrics of criteria into your decision-making, but at the end of the day, you need to be confident in who you trust with your money.
5. Determine business readiness
If you are meeting with an entrepreneur or you want to invest in a startup, evaluate the business readiness. It involves more risk if you are working with a venture that hasn’t proven itself in the industry, but that doesn’t mean the investment will fail. This is where the factors of leadership, experience, product uniqueness, market size and financials come together to give you the big picture of business potential. You want a return on your investment sooner rather than later, and business readiness gives you insight into how long you will wait for a payout.
The bottom line of investing is to make money. Not every opportunity that comes along will be a good fit for you and your portfolio, just as some opportunities will look too good to be true. Following these five tips can help you critically evaluate which investments are worthwhile.