How to do due diligence on a junior resource company

How can investors value a junior resource company so that they know whether or not they should invest in it?

While mowing the lawn, you see your neighbor so you walk over to him, lean on the fence, and chat for a while. He asks you, “So have you heard about ABC Gold Exploration Inc? They trade on the TSX and I hear they have just discovered the world’s greatest deposit of gold… EVER.

What do you do?

Some investors (too many, in fact) will run to their online self-directed brokerage account, check the symbol, and then stick some money into the stock. After all, their neighbor seemed pretty sure of himself.

Sure, we might SAY that we never do this… but it happens. MANY investors do exactly this.

In my experience, people love the idea of risky stocks but they hate risk, and they want to be cautious investors but rarely examine stocks closely before buying them (and instead are guided by emotion and the momentum of a stock’s popularity or unpopularity). Yes, that last sentence seems full of contradiction but it seems to be how people tend to trade.

So let’s say you hear about a junior resource stock. What should you do?

Regardless of the source (whether it’s an completely uninformed source, like your neighbor, or the most trusted source like an industry expert), you need to do the following 3 types of due diligence investigation BEFORE you a penny into that stock.

STEP 1: AM I READY TO INVEST?

Before you ever invest in anything, you need to do some due diligence and the first part of your due diligence is to take a close look at yourself. What kind of investor are you? How much risk can you handle? How much volatility can you handle? Will you lose sleep if your stock goes up by 25% one day but drops by 50% the next day? What happens if your stock drops by 75% and then stays that way for a long time? How much do you want to gain and how much are you willing to lose? What is the timeline that you want to make your money back?

So, before you jump into a stock just because your neighbor’s friend’s cousin knows a guy who heard something good about the stock, here’s what you need to do:

  • General due diligence action: Start by performing a personal assessment about your financial portfolio. The first 28 questions on my How to do your own due diligence blog post will help you with this.

It’s a good idea to revisit these questions periodically (schedule time to think about them once a month or once a quarter. It will go quickly because most of the answers will stay the same but it’s worth figuring out if anything has changed and how that impacts your investing).

If your due diligence reveals that you are okay with the risks and rewards that junior mining companies present, then you can move on to the next step…

STEP 2: WHAT IS THE MARKET LIKE?

Next, you look at the two elements that drive the stock market in general (and the prices of the specific commodity you’re looking at). Those two factors are: The supply/demand ratio and emotion. Examining the supply/demand ratio helps you understand the underlying fundamentals of the company while examining the emotion in the market helps you understand how excitement or fear can impact the price of a company.

You will gain a large advantage over other traders when you examine these two factors at the stock market level and at the more specific resource market level (because they are not always the same but they can influence each other).

The supply and demand ratio: Current metal prices (“commodity prices”) have an impact on the progress of a junior resource company, and metal prices are determined by supply and demand. If a company is operating in a market that has no demand or too much supply, commodity prices are low and it doesn’t make sense to explore, build, and operate a mine. However, if demand is high or supply is low, commodity prices might make it worthwhile to explore, build, and operate a mine. So it’s critical to understand supply and demand, and commodity prices.

Commodity prices are easy to identify – there are many sites and resources that provide that information, and this commodity returns table is a really good at-a-glance way to view commodity returns for the past decade. But for a great site that lists plenty of historical commodity prices and other information, IndexMundi is a good source to bookmark.

Slightly more difficult to identify are the underlying factors that drive supply and demand. Understanding what those factors are doing, and will do in the future, can help you know what the supply and demand is going to be like. For example, copper and molybdenum are driven by industrial growth and infrastructure growth. Graphite is driven by growth in the automotive industry, tech industry, and in the growth of Lithium-ion batteries. (Learn more about the underlying factors driving graphite’s supply and demand at GraphiteInvesting.com). Gold is driven by a sense of unease in the market (so people buy gold as a hedge). And so on.

  • Junior resource due diligence question: What are the underlying factors that drive the commodity price?
  • Junior resource due diligence questions: What has the commodity price done in the past? (See IndexMundi for the answer) And, does it confirm what I’ve just discovered about the underlying factors that drive the commodity price?
  • Junior resource due diligence question: What are those underlying factors doing right now? (Further research might be necessary to determine the answer to this question).
  • Junior resource due diligence question: What do I think those underlying factors will do in the future? (Further research might be necessary to determine the answer to this question).

Emotion: Although individual stock prices might reflect a lot of the information available to investors, the stock market is largely driven by sentiment. Happy investors who feel like there is plenty of money to be made will invest. Scared investors who are afraid of losing their shirt will keep their money out of the stock market. This supply of money in the market (high during good times and low during bad times) drives prices up and down. And contrarian investors who understand the concept of buying when prices are low and selling when prices are high can benefit. This excellent article explains the cycle of market emotions.

  • Junior resource due diligence question: Using the cycle of market emotions, where is the overall stock market currently?
  • Junior resource due diligence question: Using the cycle of market emotions, where is the underlying metal of the junior resource you are examining?
  • Junior resource due diligence question: Using the cycle of market emotions, where is the junior resource company you are examining?

So, we’ve looked at supply/demand and emotion in the market. Here’s how I like to use the information when I invest: In general, I like it when there is a lot of ongoing demand but little supply, and I like it when there is a lot of fear in the market. The reason is: The fear drives the price of the stocks down, which makes it perfect to buy low, but then the ongoing demand brings prices up. Then, as the emotion in the markets becomes less fearful, the prices go even higher.

Just because I invest like that doesn’t mean you have to invest like that. There are other equations of supply/demand and emotion that might influence your trading. But it’s what I like to do (and it’s why I’m investing in specific parts of the junior resource industry right now when I can find good demand, low supply, and a lot of fear.

This step gives you the “context” or the “climate” in which you are investing, and it helps you understand some of the factors that will affect your price that are larger than the company you are investing in. Now it’s time for the last step…

STEP 3: WHAT IS THIS JUNIOR RESOURCE COMPANY LIKE?

Now that you’ve spent time figuring out how comfortable you are with risk, and what the larger investing context is like, now you are finally ready to take a closer look at the junior resource company itself.

Some investors want one single number to determine the value of the company but there are many factors that will influence that number and that might work for Warren Buffett but he doesn’t deal in junior resource stocks. It is possible to find undervalued stocks but you can’t always easily compare one company to the next because there are political and commodity considerations to take into account.

For us junior resource investors, it’s not easy to compare one company with another. A gold company in Bolivia needs to be valued very differently than uranium company in Saskatchewan Canada. Instead, investors need to examine the following factors to determine whether they feel those factors are acceptable to them.

Business model of a junior resource company: A business model is the way a business is structured to use its competitive advantages to operate and make money. Different companies will bring different strengths (and weaknesses) to a business model. You can start answering these questions now but you might refine them as you continue through this part of the junior resource due diligence.

Junior resource companies have business models like “Prospector” (where a company searches for resources), “Explorer” (where a company acquires a claim from a prospector and explorers it further, perhaps bringing the mine through the feasibility stage), “Developer” (where a company takes an explored resource and builds a mine), and “Producer” (where a company mines the resource and brings the product to market). Many junior resource companies do more than one of these roles (some are prospectors and explorers, some will prospect, explore, and develop, others will take a mine from discovery all the way to production). There are also hybrids of this model. A “Project Generator” business model is a good example – where a company will explore a resource and then partner with a senior company to develop the mine and extract the resource. And some mines don’t just take stuff out of the ground, they have a “mine-to-market” business model where they hope to extra minerals and then mill them into sellable metal.

I haven’t found a lot of information written on junior resource business models (and different companies might use different language to describe what they do) but each model has its own opportunities and challenges. For example, an explorer might not have a lot of cash flow so it might have to go back to the market frequently for money (until it sells its deposit or partners with a larger company). And a developer/producer might make some good cash flow but it is expensive to build a mine, so they need a lot of money up-front. Knowing what the model is gives you a point to start thinking about the opportunities and challenges that the company faces.

  • Junior resource due diligence question: What is the business model of that junior resource company?
  • Junior resource due diligence question: what strengths and weaknesses does this business model represent (and how will these strengths and weaknesses impact the company and the price of its stock)?

Life cycle of a mine: All mines go through a pre-defined lifecycle – from the point where a prospector takes a closer look at a big piece of empty ground, all the way through to the point where a giant mine is in operation. (This is related to the business model, above – often, companies derive their business model by specializing at a point in the life cycle of a mine).

There are several stages in between the prospecting and the finishing mine, and each stage has its own risks and rewards and opportunities and challenges. (Note: Some companies have several mines in one stage of the life cycle while other companies might have several mines that are each in different stages.) To familiarize yourself with these risks and rewards, a good place to start by taking a look this video below…

And be sure to check out this simple interactive mining lifecycle page from The Global Speculator.

Then, for more detail, check out what Brent Cook wrote: Life Cycle of a Junior Explorer and then to go read the five-part series about mine life cycle at GoldInvestingNews.com: 1. Staking a Claim; 2. Regional Exploration; 3. Resource Definition and Feasibility Study; 4. Assessment and Approval; 5. Mine construction; 6. Operating the mine.

  • Junior resource due diligence actions: Using the above information, figure out what the company is doing now and will need to do in the future to move forward in the process. Then determine the impact on the company and the impact on the stock price. You’ll also need to think about the level of risk at each stage – what the risks are and how the company is handling those risks.

Resource: Now it’s time to do some due diligence around the actual resource of the mine. You’ll want to pay attention to the following three factors (assuming that you have already done the other due diligence listed above):

  • The amount of the resource (how much is there?)
  • The extraction plan (how easy or hard it is to get the resource out of the ground?)
  • The purity of the resource (how much work is required to make the resource ready to turn it into a product?)

Each type of metal measures the resource differently – some by tons, some by ounces; some use open pit mining; some have very pure minerals that require little separation from the impurities while others need to be separated out of the ore. So don’t be dazzled by the individual numbers without getting some comparisons.

A really helpful resource that is written about gold (but is useful even if you invest in more than gold explorers) is this PDF entitled Models and Exploration Methods for Major Gold Deposit Types. It gets pretty detailed and scholarly (you WILL scan some of it instead of reading it because it’s not very exciting) but it’s about as close as you’re going to get to digging in dirt without getting dirty.

  • Junior resource due diligence question: What is the geology of the area of the world where the junior company is working?
  • Junior resource due diligence question: How much resource is claimed to be there?
  • Junior resource due diligence questions: How does this amount of resource compare to other companies in the same area? (How much resource do those other companies have? Are they finding more? What is the purity? How hard is it to get out of the ground?)
  • Junior resource due diligence questions: What is the company’s plan for making money from that deposit? How far away are they from achieving their goal?

Politics and Location: Junior companies operate in different jurisdictions – both politically and geographically. Each one will have an impact on how successfully a mine operates.

Political jurisdictions might be mining friendly, mining unfriendly, or unstable (politically unstable examples include: A country might unexpectedly nationalize a mine that has just been discovered, or a government might collapse during a coup). So investors need to determine what the political landscape is of the area that the junior resource company is operating in.

  • Junior resource due diligence question: Is the political landscape stable or unstable?
  • Junior resource due diligence question: Is the political landscape pro-mining or anti-mining? (Along with political leaders, consider different interest groups that might have a strong say in whether or not mining work is completed in a particular area).

Part of the location question is the question of infrastructure. If there is water, power, roads, and a potential workforce nearby then it is much easier and cheaper to set up a mine, compared to those situations where a mineral deposit is discovered far from civilization and diesel generators have to be barged in only when the water isn’t frozen.

  • Junior resource due diligence question: What is the infrastructure like? (No infrastructure can mean higher costs to develop a mine).

Management: Next, investors need to look at management. Since just about anyone can start a junior resource company (no experience necessary!), it’s important to know what the background of the management is and whether they are experienced and skilled at operating the company with the business model, life cycle, and location that they are working in.

Look at the website to get a list of management and the directors. Then look at the following:

  • Junior resource due diligence questions: What is the experience that each person had? Although longevity in the industry is one helpful indicator, it’s certainly not the only one. Also ask: How much experience has this person had with this particular type of business model?
  • Junior resource due diligence question: What connections do management and the board of directors have with larger companies? Is there a potential joint venture relationship possible?

Financials: The financials of a company will also help you to value the company and they are essential for you to review. I’ll go into detail in a moment, but here is a bird’s-eye-view of the numbers you want to pay attention to:

  • Are there ways that the company is making money right now? Do these support exploration?
  • How much cash does the company have right now?
  • How much is the company spending right now?
  • If the company doesn’t get any more money, how long will it last until it needs to find more?
  • How will the company get more money if it needs the money?

Below, I’ve provided a number of really helpful resources. Each one gives you a slightly different perspective or way to value a company. I don’t think there is any one single right way. I prefer to do several of these methods and decide how I feel about the company based on a collection of numbers.

So, to get started, go to the company’s website or to a site like Yahoo Finance to get their latest financials. Then go through the list of videos, websites, and PDFs I’ve provided below to piece together a picture of the financial health of the company.

InformedTrades.com provides the following 3 excellent videos about how to understand financial statements of mining companies. Watch these! They are very good.

Roger Montgomery shows us how long the mine will survive at the current amount of money it spends:


The really good stuff is between 1:20 and 1:45

His advice is to look at a company’s expenses over the year, divide the number by 12 to determine the cash burn rate. Then look at the how much money the company has in the bank.

This PDF from Mining.com helps investors use financials to find the real value of junior mining companies.

Although the content of this site has nothing to do with mining, they have devoted a page to this really helpful mining calculation: Enterprise Value Per Ounce and Cost Per Ounce.

Check out Paul van Eeden’s articles How to value a mining stock and How to value an exploration company.

If you want to get really advanced, this 81-page PDF from basinvest.com gives a lot of detail about using financials to value a mining company.

Each company will need to be weighed on its own financial strengths and weaknesses. You are looking for the answer to this question:

  • Junior resource due diligence question: When will this company become profitable and will it need to dilute its share price or borrow more money to get to that point?

Answer that question and you will have a fairly good idea of what to expect. Ideally, you want a company that has cash flow coming in from operations (perhaps selling or JVing properties or selling ore). If you don’t have that, then you want a company that has money in the bank that can afford to explore or extract the deposit for a while before it needs more money.

ADDITIONAL MUST-USE RESOURCES

8 Page Guide: Resource World Magazine put out a great 8-page guide to valuing a mining stock. This guide gives a good introduction to various aspects of a junior company – including geology, mine life, and financial calculations.
Excellent video from BuchanBullBullion: This guy does an amazing job of outlining great tips, ideas, and websites that investors should look at when they are doing junior resource due diligence:

Some highlights from the above video:
1:35 – 2:03: How to research management
3:10 – 3:54: How a little knowledge can help you profit from volatility
3:57 – 7:05: Fundamentals to look for in a junior company
7:05 – 14:00: Understanding the lifecycle of a mine

ResourceInvestor.com: This article from ResourceInvestor.com called How to value a mining share goes into greater detail and lists 8 factors that investors need to be aware of when they are valuing a mining company.

WHAT YOU END UP WITH

After doing all of this research, what do you end up with? Unlike some stock research, you don’t end up with a single, simple number that indicates whether or not you should buy the stock. Instead, you end up with a sense of the company’s short-term and long-term health, and short-term and long-term opportunities. You end up with enough information to either feel comfortable about owning the stock because you reasonably expect the price to go up, or uncomfortable about owning the stock because you reasonably expect the price to go down.

Of course there will always be things you didn’t consider — a CEO who goes rogue, a crazy investor who gets the jitters and sells their holdings and drives the price down, etc. But in general, you gather enough information to feel overall bullish or overall bearish… for good reason.

If and when you decide to invest, the next step is to “screw your courage to the sticking place”, as they say in Shakespeare, and be confident in your purchase. If a stock price falls but nothing has changed in the information you gathered then there is no need to sell. To help with this, I suggest you develop an exit strategy for each stock.

An exit strategy consists of the following elements:

  • A profit thesis (the reason why you own the stock and expect it to go higher
  • A best-case-scenario exit strategy (the point at which you will exit the stock or at least re-evaluate whether you should continue to hold the stock). I like to include a share price and a date.
  • A worst-case-scenario exit strategy (the point at which you want to jump off of the sinking ship).

Here are a couple of examples of my profit thesis: I hold one company because it has an amazing gold resource that is increasing in size, is run by management with plenty of experience, and is in a politically stable area. My profit thesis is that as long as gold is in demand, and as long as this company can find more and then extract it, they are going to do okay. But I’ve also set a price and a date in the future. If either of those become true (the price rises to the price I’ve identified, or the date arrives that I’ve identified) then I will re-evaluate.

Another example: I hold a company that owns a past-producing mine and on-site mill. They have all of the infrastructure and they have a new deposit. My profit thesis is that I believe the stock price is going up as soon as they can get their new deposit out of the ground and into their on-site mill. Again, I have a price and a date and I’m just waiting for either of those to be true before I do anything. The stock has gone down — (it dropped by 30% this spring!) — and there were many days when I had to go back to my profit thesis to remind myself why I bought the stock. Nothing had changed except for market emotion so I stayed the course.

CLOSING THOUGHTS

As you can see, there are many things to consider when doing your due diligence in in a junior resource company. Look at as many facts as you can and decide whether you believe the stock’s potential risks and potential rewards are right for you. If they are, buy with confidence and courageously hold your stock until the facts change.

What I’m working on this week (Aug 20 – 24)

I can’t believe this is the third week of the month. Yikes! Time flies when you’re having fun.

These 10000 word-count days (which I try to do on Monday, Wednesday, and Friday) are a lot of fun. I love them and I haven’t looked forward to work this much in a long time. They really re-energized me. (Plus, I’m getting a ridiculous amount of work done and who doesn’t love that?)

I’m also really happy to have seen some success in a few other productivity elements I’ve incorporated into my business. After a couple of false-starts, I’ve finally found the right balance by incorporating elements of GTD into my business. (The false starts were because I struggled with figuring out how to make GTD work for my specific business… but I think I’ve got it figured out).

So here is what I’m working on this week:

  • Writing blogs and press releases for a real estate investing client who has just published a book (which I wrote in the spring) and is now getting ready to host a real estate investing bus tour.
  • Writing articles for a credit repair specialist. Her business has really blossomed in the year and a half we’ve been working together. It’s quite exciting to see!
  • Writing newspaper articles for a mortgage broker.
  • I also have a short-term project for someone who works on 401(k)s. They are taking their business to the next level by offering some tools and new information to attract and retain a new type of client, so I’m helping them put that information together.
  • Writing my book. You know, the book I start and stop and start and stop and then shelve for months while I work on client work? That one.
  • I was contacted a couple of weeks ago by a training company who needs help putting together a workshop or training course and delivering it. Since the speaking side of my business is something I’d like to grow, this was an opportunity I couldn’t pass up! So although it’s not confirmed yet, it’s something I’ve been working on… we’re still in talks to make it happen.
  • As you know, I have a few brands that I own (and write for). Some of them are in good shape and others I have struggled to keep up with. So I’m writing a couple of them to maintain them, and I’m writing a couple of them to catch up. But I’m also exploring some ideas about how to make some of them a little easier to run. For example, one of them was developed without a content management system, so uploading new html is somewhat time-consuming. So I want to get a CMS system going on it to make it a bit faster and easier to manage.
  • Plus, I’ve got some really cool blogs coming up that I’m excited about. I hope you like them.

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What 1001 blog posts taught me about blogging

The last blog post (posted a couple of days ago entitled: “Small business strategy question: What does your business do? And what does your business sell?“) was blog post #1001. Technically I’ve written more blog posts than this but I lost a bunch when I switched from Blogger to WordPress a few years ago.

WHAT I LEARNED FROM 1001 BLOG POSTS

Blogging is demanding. Even if you pre-write some blogs (which I like to do but am not always able to do it), you will always struggle to keep up with the “deadlines”. The farther in advance you schedule blogs for, the harder it will become: Life’s commitments get in the way and I like being timely and relevant on my blog, which is harder to do when you don’t know what’s going to happen a few months down the road. My solution has been to pre-write and schedule a week or two in advance, and then pre-write (but not schedule) another handful of blog posts. That way, I’m staying ahead of the curve but not pre-writing so far in advance that I’m irrelevant.

Blogging is personal. When I first started my blog (well, when I first started this most recent WordPress iteration of my blog), I wrote shorter posts that were pretty wooden. In spite of the fact that I’ve been writing professionally for 18+ years, it took me a while to find my voice for this blog. How “corporate” did I want to be? I started blogging for business purposes and though that I should keep it professional (and in my mind, professional = cold and formal) but then I realized a few years ago that even if I wasn’t blogging for business, I would still blog. That was a watershed moment for me and I took the stick out of my ass and started share a little bit more about me. Although I’m still a pretty private person, I’ve enjoyed opening up a little. I can’t speak to whether or not it directly helped my business but it definitely helped me as a writer and business owner.

Blogging goals are important (but you can’t do everything): When I first started this blog, I dreamed of a busy, highly active blog with hundreds of visitors, each leaving massive numbers of comments on my highly engaging blog posts. That hasn’t happened and I’m okay with that. My blogging goals have shifted over the years so I’m not as concerned about traffic or comments or social shares. When those things used to concern me, it impacted my blogging and I didn’t enjoy it as much. Today, I write about what I want, I’m thankful for the traffic I get, and I don’t lose a wink of sleep over comments or social shares. That’s not to say I don’t pay attention to that stuff, but I mean: I’m not going to stuff keywords into my blog posts to get more clicks. I’m going to focus on good content that reflects the things I’m thinking about right now. If someone finds that stuff useful, I’m happy.

Someone else’s blog is always going to be better than yours… and that’s okay. Some bloggers are insanely practical or insightful in every blog post (Seth Godin, Chris Brogan). Some bloggers have a very clearly laid-out blog that looks crisp and attractive and makes me want to read more (Tim Ferriss). Some bloggers build up a massive amount of traffic even though they write crap (Names withheld to protect the guilty!). Then I go over to my blog and I think “Bleh. My writing is mediocre and my site is a mess”. On a sunnier day, I might not think that but it’s easy to compare myself to others. That’s still something I struggle with but I’m learning to stop and consider what I do have before I make drastic changes. I’ve built something I’m proud of and it works for me. Those should be my only measures of success.

Blog posts don’t have to be perfect. As a writer, I initially thought that I needed to have perfect blog posts. But that’s impossible so I’ve revised that idea. My blog posts have spelling mistakes and grammatical mistakes and flawed logic and rambling sentences and I’m okay with that. When it comes to client work, I try to be flawless but my blog is me and I’m far from perfect. (My wife disagrees but she is wrong). I don’t think those errors position me as unprofessional. (Well, maybe they do but I’m fully booked until 2015 so I have enough clients who like that I’m unprofessional). Just write your blogs, get your ideas out there (even if they are half-formed). A blog is a work in progress and each blog post is only part of the mosaic.

Blogging should be fun. Blogging should be fun. If you don’t like it, don’t do it. If you absolutely have to have a blog for your business, outsource it to someone who will have fun with it. As soon as blogging stops being fun, your blog posts will no longer be readable.

LOOKING FORWARD TO THE NEXT 1001 POSTS

Where will I go for next 1001 blog posts? That’s hard to say. I’d like to blog more frequently. And as my business changes (it’s ALWAYS changing because I won’t let it stand still), my topics will continue to reflect those changes. I’d like to do more video and share a little more of my life with my readers. As I get closer to publishing my book or jumpstarting the speaking side of my career, you’ll see me blog about that a little more too. I’m looking forward to it. Here’s to the next 1001 blog posts!

Small business strategy questions: What does your business do? And, What does your business sell?

Recently, I posted a list of 100 Small Business Strategy questions that every entrepreneur should ask themselves from time to time. The very first two questions of the list are…

  1. What does your business do?
  2. What does your business sell?

Those questions are related yet different, and you need to answer them at the same time.

Answering the question “What does your business do?” is describing why people buy from you.

Answering the question “What does your business sell?” is describing what they’re actually getting when they hand over your money.

The product or service they get (which answers your second question) should deliver the benefits they expect (which answers your first question).

The key is being able to articulate who you serve and what problems you solve or needs you fulfill and then how you deliver that solution to your customers.

Create a list to answer each of the questions. In general, your answers to the first question should be different than your answers to the second question, and your list of answers to the first question should be longer than your list of answers to the second question.

Not all of your products or services will necessarily achieve all of the things in the list of your first answer, but collectively they will all provide those things.

EXAMPLES OF THE DIFFERENCE BETWEEN THESE TWO QUESTIONS

Here are some examples. I’m going to show you first what the business sells (the answer to the second question) and then I’m going to show you what the business does (the answer to the first question).

A financial advisor sells portfolio management services. But what they do is provide advice, and a filter for crazy investing ideas, and access to the stock market.

A house painting company sells a paint-your-house service. But what they do is provide convenience, professional experience, time-saving and effort-saving value, high quality paint, and fast application to busy homeowners who don’t want to paint their house themselves.

A bookstore sells books. But what they do is provide an escape, a place to curate all the best books that a book-lover should read, advice and suggestions on reading, and a few minutes of peace and quiet in a fast-paced world.

WHAT HAPPENS IF YOU STRUGGLE WITH FINDING AN ANSWER

The answer to the second question is easy. We all know what we sell. The answer to the first question is much harder because we don’t always know what our business does (or how it’s different from what we sell). This is especially true if you sort of “fell” into your business or inherited from someone else or bought a franchise.
So if you are struggling to answer the question “What does my business do?”, try doing the following:

  • Try listing the benefits of your product or service. It doesn’t always give you a complete answer but it’s a good start.
  • Think about when people buy from you. What was the situation that inspired them to come looking for you?
  • Ask the question “Why do people buy from me?” and “What value do I offer?”
  • Ask your previous customers to tell you why they bought from you. Look at testimonials for hints, as well.
  • Examine your most successful marketing campaigns (or, if you’ve just started your business, examine your competitor’s marketing campaigns) to see what kind of language drove people to buy. What was promised?
  • Use a search engine keyword tool to find what your target market is searching for. (People will sometimes search for the name of the product or service they want, but many people will also search for the solution to their problem… and THAT is the answer you’re looking for.

WHAT TO DO WITH THE ANSWERS

Figuring out what your business does is essential to growing your business.

You’ll write a clearer business plan and increase the likelihood of finding investors because your business will be clearly articulated.

You’ll create more effective marketing campaigns because you’ll be focused on the reason your customers are likely to buy from you.

You’ll even discover new ways to make more money. For example, you can look at the answers to your first questions and figure out ways that you can provide the same benefits with new products or services. That’s why financial advisors often also sell other things besides strictly buying and selling investments for their clients – they also sell insurance or mortgage products, too.

Answering the questions “What does your business do?” and “What does your business sell?” are the first and most important questions any business owner should be able to answer.

Value: The whole versus the sum of the parts

It’s a weird fact that the value of a car is actually less than the sum of its parts.

In other words, if you were to go to a car dealership, you would actually spend less on the car you drive away with than if you were to buy the individual parts from the manufacturer and assemble it myself.

Don’t believe me? Go to an autobody shop and ask how much a single panel costs then do the math yourself. Your car costs less if you drive it off the dealer’s lot (versus if you were to buy the parts individually and build the car yourself).

I use this example to illustrate something you notice in business valuations, equity investing, and even in real estate investing: We can place a value on something (a business, a stock, or a property) but that value is one number for the whole thing. There is also a “sum-of-its-parts” value as well.

Here’s a business example:

If I were looking to buy a business, I might identify the value of the business by looking at its balance sheet to examine its assets and liabilities, but I would also look at its cash flow and profitability to help me identify the business’ earning potential in the future.

But what if I wanted to buy the business but didn’t care about its earning potential in the future. Maybe I like the property it’s sitting on and the computer system they have and their list of customers. In that case, I might value the company different because I only care about the sum of its parts rather than the whole.

Here’s a stock market example:

If I were looking to buy a stock, I might value the stock by looking at the market capitalization (which is calculated by multiplying the outstanding shares by the stock price). This is the full value of the company if I were to ask every partial owner to sell me their shares right now.

But I might also consider the sum of the company’s parts by looking at the Enterprise Value (which is calculated as market capitalization plus debt plus minority interest and preferred shares minus cash). This takes into account not only the cost of buying every share but also the impact of other aspects of the company’s balance sheet.
(Note: There are other measures to value a company besides market cap and EV; I’m just presenting them here as two alternatives that each represent value in a different way).

Here’s a real estate example:

If I were looking to invest in a property, I might look at how much it cost to buy the property from the seller, which could be acquired via a real estate agent who gives me a “market comp” (which is an estimated selling price based on what similar houses have sold for recently).

But maybe I don’t want to buy the house because I want to fix up that house and rent it out. Maybe I love the property but think that I make more money in other ways – perhaps I can pull the brand new furnace out of the property to put into another property, and then I can turn around and sell the house without doing any more work on it because I know that a developer is going to pay top dollar for the land very shortly. So my value of the property is defined by its parts – the furnace and the land.

TWO VALUES

My point here is that I talk a lot about value but value is perceived in different ways. You might think of it as the difference between the value of the whole and the value of the sum of its parts (or, at least the value of the sum of its important parts). (I also wrote recently about value being the amount someone would pay and the amount of benefit it provided to them… but now I’m talking about two different kinds of value!)

Think of it like this. The value of the whole business (which I’ve represented in green) and the value of the sum of its parts (which I’ve represented in blue). In many cases, the value of the whole business is often more than the value of the sum of its parts.

But the graphic above doesn’t give the whole picture because those two values are never static. Each type of value rises and falls, sometimes together and sometimes independent of each other. There are times when the value of the whole is worth less than the value of the sum of the parts. It looks more like this…

WHY DOES THIS MATTER?

It matters because when we understand that there are two different values, we can make money.

As an entrepreneur, you might find businesses that you can buy at a lower price but whose sum-of-its-parts value is much higher. In this way, you can easily add assets (like equipment or a customer list) affordably. Take the example of a hair salon. If there is another hair salon nearby that is going out of business, you might be able to buy it quite cheaply, and easily make your money back by selling off the equipment, keeping the customer list for yourself, and by renting out the space to a different business.

As an equity investor, you might find undervalued stocks whose whole price is worth less than the sum of its parts. As the company improves and its stock price improves, your position improves. (This is a classic Warren Buffett play, by the way). If I were to give you an example, I’d suggest that Research In Motion fits the bill. The value of the company as a whole is very low (and getting battered down every single day) but there is a point at which the value of the company as a whole crosses under the value of the company’s sum-of-its-parts. In other words, someone could come in and buy the stock from its shareholders and then part out the company – selling its patents and its enterprise software and its customer database – and potentially make more than what they paid for all of its share prices. (Disclosure: I’m not sure what that price would be, but I suspect that we’re pretty close as of this writing!)

As a real estate investor, you might find a piece of land that you can buy and then subdivide into smaller lots to build and sell as a community. (In fact, you don’t even have to build the subdivision yourself; you just need to subdivide it and find a builder who will buy it from you and build). This is a very common way that real estate investors play the difference between whole value and sum-of-its-parts value.

Every business has a value as a whole and a value as the sum of its parts, and those two values move up and down. Scrappy capitalists are the ones who know those two values and pounce when the time is right.