3 Important Things To Consider With Every Investment You Make…
Yesterday, I told readers about how I almost bought a bad business… almost.
I was excited about the idea of buying it, as well as the prospect of building it up and eventually handing it over to my two boys one day.
But at the end of the day, I said “no”. And it was a good decision.
My point in telling it was to highlight that sometimes the best decisions when it comes to business or investing is just that… saying “no”.
It sounds simple enough, but it’s tough to actually do – because all too often, we get emotionally invested in the idea of striking it rich.
As I hinted in the article, there were a few things from my background in the market that helped in my process to eventually come to that tough decision. This includes a set of criteria I look for with each and every business and investment decision I make.
And today, I want to dive a little deeper into the key things I look for when investing in a business…
3 Tips For Success
1. Look For Momentum
Just like I do when searching for stocks, when I’m investigating a private business, I want to see “momentum.”
Over at my Maximum Profit premium service, for example, it’s much easier to spot the momentum. It’s reflected right there in share price. I also look for this in cash flow, but we’ll spend some time on that in a second, too.
When looking at private businesses, I’m mainly looking for momentum in topline sales, or “gross revenue.” I like to see that a company has continually grown sales over the years. It doesn’t have to be massive leaps in year-over-year growth, just a continued ascent.
After all, momentum is a very powerful force… once it gets going, it’s hard to stop.
When looking at private companies it’s easy to see dwindling sales and point out some areas where you think you could turn it around. And you very well could. But it takes a lot more effort and time to turn falling sales around than if you had just bought a business that already has momentum.
Again, it can be done. But in my case, I don’t want to sink a lot of time and effort into a failing business. Can you blame me?
2. What’s My Exit Plan?
Just like trading stocks… before, during, and even after the purchase of a business… I’m always thinking about an exit. If things go south, how quickly and for what price can I unload this business. What’s my risk? What’s my stop-loss?
Going into deals, I always look at my worst-case scenario. Granted, the worst case is I lose all my money. However, most of the time the businesses I’m looking for have some sort of hard asset, whether it’s real estate, equipment, or inventory, that I could sell to recoup at least some of my money.
While keeping my exit plan in mind, I also want to know how quickly I can get my money back. How long until my initial investment is returned to me. This will depend on the business and industry, so a little research is required to find that number (this will also help in determining the valuation).
For instance, in real estate, when looking at purchasing a rental property, a quick rule of thumb was to only pay 8x-10x the annual gross rental income, or “gross rent multiplier.” So, if you could charge $1,500 a month for rent that’s $18,000 annually. That means you should pay anywhere between $144,000 and $180,000 for that property.
You can also do this in reverse to figure out how long it’ll take for the property to pay for itself. For example, a $300,000 property that you can lease for $2,000 a month, or $24,000 annually, will take 12.5 years for it to pay for itself.
3. Cash Flow
This might go without saying, but I want a business that’s cash flowing and growing that cash flow. With private companies, this can be a bit harder to figure out. A small mom-and-pop businesses isn’t going to have nice financials like what we get with publicly traded companies.
Most of the time we’ll be going off earnings before interest, taxes, depreciation, and amortization, or “EBITDA.” This gives us a good idea of the company’s operating profitability.
This figure is also where the value of the company will be derived from. You’ll typically pay some multiple of EBITDA based on the industry.
In the public market, we see businesses all the time that trade for rich valuations that aren’t actually profitable. Sometimes, this is okay if it’s in a hyper-growth market — as long as you know what you’re getting into. But you want to make sure you have clear visibility to profits in the future (that’s hopefully not too far out).
I bring all this up because a lot of this can be translated to the stock market, too. For example, when thinking about your exit plan, you can decide on a stop-loss. Ideally, you should do this before you even press the “buy” button… because you’re far more likely to be in a rational state of mind before you’re committed to the investment.
Here’s another example… When thinking about a firm’s liquidation value, you can look up a stock’s book value. This is essentially what you would get if the firm sold off all of its assets… property, plants, equipment… the works. Granted, this metric works better for sectors that are asset-heavy – it doesn’t work as well for knowledge or service-based industries.
The point is that you should treat each investing decision you make like you’re going into business. That’s why Warren Buffett calls Berkshire Hathaway shareholders his “partners”.
We have a lot of readers that are successful business owners. Very successful. But for some reason, when it comes to the markets, all that good sense that led to their success starts flying out the window.
It happens to most of us at some point or another.
If you want to speculate on an investment with a lot of potential, that’s fine. But know what you’re getting into, and know when to say “no”. And if you do pull the trigger in mind, keep these points in mind so what you’ll be aware of the risks and know when it’s time to get out and move on.
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