How to understand potential investments at a deeper level
Asking these simple questions can reveal valuable things about a company’s quality and economics.
Do you ever feel like you are just looking at a companies’ numbers, share charts and valuation ratios without really understanding the essence of the business below? Without having a good idea of what makes the numbers what they are, or what matters for them going forward?
In this article I want to explore ways to go beyond simple facts and numbers – the revenue, the profit margins, the returns on capital – and understand a company at a deeper level. In a moment I will introduce a few questions you can ask to do this. But first I want to ponder what a company is.
What is a company?
You could answer this from a couple of perspectives.
Ask a shareholder, for example, and they might say something like “a company exists to take my capital, generate earnings and continually reinvest those earnings for the best long-term returns”. Today I’m more interested in looking at it from the customer’s view.
What is a business from a customer’s point of view? It is a problem solver. It is a life improver. It is a product or service that takes you from the before to a better after. You buy the fancy $12 croissant because it will elevate your morning. Elevate 100 mornings per day and the baker has a business.
The companies we study in the public sphere are just much bigger versions of the croissant shop. They are solving customer problems or making their lives easier, better or more profitable in return for cash or credit. If they don’t do this, there are no revenues, no profits and no returns on capital. A company is not its latest EPS number or its price to earnings ratio. It is the customers who would truly miss it if it were gone.
Three questions
I chatted recently to one of our analysts about a company that is on the fringes of the industry they cover and that they might be interested in. They hit me back with three questions that I think offer a great starting point to investigate the essence of any business from the customer’s viewpoint.
The three questions were:
- Why do customers use this type of product?
- What are the main deciding criteria?
- How does this company score on those criteria vs alternatives?
To give you an example of this in action, I thought I’d answer these questions in the context of a recent purchase: my replacement iPhone, bought after my old one finally snuffed it after years of abuse.
Why do I use a smartphone? I use a smartphone because it enables modern life. I need it to make plans, stay in touch with friends and family, stay on top of my finances, log into all of my work accounts through two factor authentication, scan tickets to enter concerts or sports games, get from A to Z with Googe Maps, pay for my bus journeys, get on flights, et cetera, et cetera.
What are the main deciding criteria? Over everything else, I wanted as little disruption moving from my old phone to my new phone as possible. And I didn’t want to lose any photos. That mattered far more to me than how many megapixels the camera has or how thin the phone is. Remember megapixels? I had forgotten it was a word.
How does an iPhone score on those criteria vs alternatives? Given what I just said about my main deciding criteria, I didn’t even think of an alternative. I just wanted the best/newest preowned iPhone in my budget range. No other option would let me carry across all of my iCloud photos and have all of my apps, logins and Apple Pay cards ready to go.
Asking just three simple questions made it clear that 1) Apple’s products are essential to the user’s life and 2) many users – I can’t be the only one! – would not even think about changing brand. For many people, the iPhone competes in a category of one.
This hints massively at the potential quality of the business. And it provides a great deal of meaning to numbers that you might come across later in the financial statements. Dive into the accounts straight away – or even worse, go straight for the stock chart – and you have none of this context.
Combining this with financials
With this kind of context, the numbers that you see in a company’s financial reports might make more sense. Here are some questions you might start with:
- How does this company make its money?
- Which products and segments of its business provide the bulk of revenues and profits?
- How is that shifting over time?
- What are its profit margins like and why?
Note: For companies you are less familiar with than Apple, starting with these questions could tell you which products and services to apply the three questions about the customer’s buying decision to.
I remember that my old colleague Steve Clapham from Behind The Balance Sheet used to recommend breaking a segment down to a single unit.
One Uber ride taken. One hotel room booked. What does each transaction look like in terms of revenue, costs and profit margin for the provider?
Combine this with the three earlier questions about a customer’s decision and you can get a pretty cool view of a business from two angles.
A quick look at Apple’s numbers
First let’s look at where Apple’s sales and profits come from.
The 2024 10-K shows that roughly 75% of revenue comes from products like the iPhone, Mac computers, and wearables. The rest comes from services attached to these products, like App Store commissions, iCloud subs, et cetera. The money Google pays to be the iPhone’s default search engine also lives here.
Apple’s management team have previously spoken about gross profit margins of 74% from the services business. This means that for each dollar a customer provides in service revenue, just 26 cents are spent directly on providing this service to users.
When you break this down to one unit sold, this makes sense. Providing the next gigabyte of iCloud storage to users will cost Apple essentially nothing. As would facilitating each download or subscription that generates app store revenue. Or setting Google as the default search option in return for a few billion.
The margins from services are higher than the roughly 40% gross margins that are gleaned from selling iPhones and other products. Again, at the unit level this makes sense. Each of these products requires the purchase of the raw materials and also labour directly related to their assembly.
The result is that services make up an outsized percentage of Apple’s total gross profits: almost 40% versus their 24.5% share of sales. The percentage of sales coming from services has also been growing at an average of 11% per year over the last two years, while product revenues have been roughly flat.
This makes sense through the lens of my device purchase. Even if people, like me, buy a preowned iPhone and somebody else gets the device revenue, we are still in the Apple ecosystem. This means more iCloud fees, more Apple Pay taps, more App Store commission, et cetera.
Could this make the services business, which essentially has a captive customer base, more resilient to economic downturns than the device business, which relies on high ticket sales?
What have we learned?
By combining these two styles of questioning, I think we have given ourselves a far better understanding of what drives Apple’s business than you’d get by looking at past numbers alone. In many cases, the questions we have asked have given a ‘why’ helped explain those numbers.
This context also leaves us better placed to consider something more important than the past: the future. Are the competitive and customer choice dynamics going to persist, strengthen, or weaken? What might this mean for revenue, segment contributions, margins and profits a few years from now?
It also brings in some potential risks that you might consider. What if regulators target Apple’s App Store commissions or the payments from Google? What if Apple is forced to make it easier for people to use iPhone features without handing them more services revenue? What if we move beyond smartphones?
Thinking about questions like this – and questioning other things like how the company is likely to allocate capital and pursue future growth – is surely a more valuable use of your time than simply looking at numbers, P/E ratios and past growth rates in a vacuum.
A Lynchian sidebar
I chose Apple and the iPhone as my example for a couple of reasons.
Number one, the purchase was still reasonably fresh in my mind. Number two, it is a company and a buying decision that I have first-hand experience of. Without that, I wouldn’t have had the insight.
This probably sounds a lot like the idea behind Peter Lynch’s One Up On Wall Street, where Lynch suggests that investors can use their experiences as a consumer to understand companies in a way that professional investors haven’t cottoned onto yet.
That obviously doesn’t apply to Apple. But it could apply to smaller, less discovered companies that you frequent as part of your life and work. Why not try out the three questions and see what it tells you about a company’s business and potential competitive advantages?
This also poses a question about how hard this would be to apply to companies that you do not have first-hand experience or specialised industry knowledge of. This probably explains the rise of ‘expert networks’ in recent years, which offer investors the chance to interview people that do.
That is probably out of reach for everyday investors. So personally, I like to look out for snippets and insights on this from analysts paid to ask these kind of questions – for example by examining the Moat section of our equity research team’s reports on their various companies.
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