Block 12: Business
As stock market investors, we are buyers of tiny portions (or big portions, you never know) of businesses. Therefore, we should have a pretty good understanding of business.
If you’ve ever started a lemonade stand, that’s just about as good as getting your MBA (ouch, I just disqualified myself from ever having an MBA (Masters in Business Administration) read past this section)). Joking aside, businesses sell goods that consumers or other businesses or governments buy. Essentially, businesses solve problems, make life better for consumers, and provide crucial products and services.
Back to that lemonade stand. If the goal is to make money you need to be intentional about your decisions. If, however, your goal is to make your neighborhood a happier place, you don’t have to worry too much about these next things.
So before you start selling the lemonade you need to go to the store to get cups, maybe straws, some lemons, possibly a cooler, and a pitcher. Let’s say all those items cost you $50 and you think you can make 100 cups of lemonade from the supplies. So how much should you sell a cup of lemonade for?
Well, to break even, you can sell a cup for 50 cents. Because:
(# of cups of lemonade* price of lemonade = revenue or sales)
100 cups * 50 cents = $50
(revenue – expenses (or costs) = profit))
$50 in sales – $50 in costs = $0 in profit
So you should probably charge more than 50 cents. But if you charge too much, say $20, the mailman will probably turn the corner and continue on his way.
If, however, your lemonade has the potential to make people better looking, then you might be able to sell it for $20. That is called pricing power. It is when a business can demand a higher price because of something special. For instance, a Ferrari costs more than a Honda Civic because there are additional benefits like social signaling, the ability to drive faster, or comfier seats (doubtful that this is a big factor in the Ferrari-buying process though).
Businesses with strong brands can demand higher prices. iPhones cost $1,000. Tiffany’s jewelry is not cheap. Whole Foods can sell $5 mangoes. But a high price is not always indicative of a strong brand. Amazon and Netflix provide their services for low prices compared to alternatives. Compared to most on-line retailers Amazon is inexpensive and compared to most cable subscriptions Netflix is also affordable. However, the same principle remains; strong brands can demand higher prices. People would probably be willing to pay $15/month for Netflix. By the time some of you are reading this, Netflix is probably charging that. So why would Amazon and Netflix sell their goods and services at a lower price than people would pay?
For one, both of these companies service big markets so it is a good idea gain market share. Market share, surprisingly, is just share of the market (revenue divided by the total market revenue). These companies can grab more market share and then eventually raise prices to make themselves more profitable.
Back to the lemonade stand. Let’s say you start doing scientific research to make your concoction tastier. And you also want to start lemonade stands in other towns. And you want to advertise on a local television station. And you want to hire your friend to be “Head Lemon Squeezer.” All of those operations take money. But that is business. In a nutshell, how can you sell more lemonade or how can you charge more for it? While at the same time, limiting the costs that those strategies and operations require.
Understanding business at a fundamental level is crucial to becoming a market-beating investor. Next, we are going to go over the language of business and how you can figure it out…