Aswath Damodaran, professor of finance at the Stern School of Business, New York University, is of the opinion that a good company can often be a bad investment and a bad company can just as easily be a good investment.
Further, not all good companies are well managed and many bad companies have competent management.
Let's look at the various criteria Damodaran lists to determine whether a stock is a good investment.
Profitability
A company that generates more in profits is better than one that generates less. But that statement may not be true if the company is capital intensive (and the profits generated are small relative to the capital invested) and/or a risky business, where you need to make a higher return to just break even.
Growth
However, growth can be good, bad or neutral for value and a company can have high growth, while destroying value.
High excess return
This is return on capital that is vastly higher than its cost of capital. I believe that it is the best measure of corporate quality, though there are caveats about how return on capital is measured.
Good Management
The essence of good management is being realistic about where a company is in the life cycle and adapting decision making to reflect reality.
Its investment decisions (where it invests scarce resources), financing decisions (the amount and type of debt utilized) and dividend decisions (how much cash to return and in what form to the owners of the business), good management will try to optimize these decisions at their company. For a young growth company, this will translate into making investments that deliver growth and not over using debt or paying much in dividends. As the company matures, good management will shift to playing defense, protecting brand name and franchise value from competitive assault, using more debt and returning more cash to stockholders.
At a declining company, the essence of “good” management is to not just avoid taking more investments in a bad business, but to extricate the company from its existing investments and to return cash to the business owners.
Price
For a company to be a good investment, you have to bring price into consideration. After all, the greatest company in the world with superb managers can be a bad investment, if it is priced too high. Conversely, the worst company in the world with inept management may be a good investment is the price is low enough. In investing therefore, the comparison is between the value that you attach to a company, given its fundamentals and the price at which it trades.
Looking at only one side of the price/value divide can lead you astray. Thus, if your investment strategy is to buy low PE stocks, you may end up with stocks that look cheap but are not good investments, if these are companies that deserve to be cheap (because they have made awful investments, borrowed too much money or adopted cash return policies that destroy value). Conversely, if your investment strategy is focused on finding good companies (strong moats, low risk), you can easily end up with bad investments, if the price already more than reflects these good qualities.
In effect, to be a successful investor, you have to find market mismatches, a very good company in terms of business and management that is being priced as a bad company will be your “buy”.
Separating good companies from bad ones is easy, determining whether companies are well or badly managed is slightly more complicated but defining which companies are good investments is the biggest challenge.
Good companies bring strong competitive advantages to a growing market and their results (high margins, high returns on capital) reflect these advantages. In well managed companies, the investing, financing and dividend decisions reflect what will maximize value for the company, thus allowing for the possibility that you can have good companies that are sub-optimally managed and bad companies that are well managed.
Good investments require that you be able to buy at a price that is less than the value of the company, given its business and management.
Thus, you can have good companies become bad investments, if they trade at too high a price, and bad companies become good investments, at a low enough price.
Given a choice...
I would like to buy great companies with great managers at a great price, but greatness on all fronts is hard to find. So. I’ll settle for a more pragmatic end game. At the right price, I will buy a company in a bad business, run by indifferent managers. At the wrong price, I will avoid even superstar companies.
The above is an extract from Aswath Damodaran's blog
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