How to Spot a Great Company

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To become a savvy stock evaluator, you must master a multitude of skills. It's undeniably important to hone your quantitative kung fu by familiarizing yourself with financial statements such as the balance sheet, the income statement, and the statement of cash flows. But the qualitative side of the business -- the strengths and weaknesses that lie beyond the numbers it reports -- are no less crucial.

So what should I look for?
Good management is the first virtue Fools should seek in a business. How up-front and honest are a company's leaders? How much faith do you have in them? In good times and bad, look for a company whose earnings reports are free from hype or excuses, and whose managers are equally candid about their business's strengths and weaknesses.

Competitive advantages are also critical; some of the best companies have a sustainable edge over their competition. eBay (Nasdaq: EBAY  ) , for example, has such a huge base of users that it would be incredibly difficult for an upstart rival to attract eBay-sized amounts of traffic. If you want to buy or sell something in an online auction, why go to smaller sites when you can use eBay or other huge, established venues? Thanks to their size, they're likely to have the most buyers if you want to sell, and the widest selection if you want to buy.

A model business's business model
Lastly, and no less importantly, investors should examine a company's business model -- how it goes about making money. (Nasdaq: AMZN  ) , for example, bases its business model on its ability to sell books, music, and other goods online, without the costly inventory, property, payroll, and other expenses of bricks-and-mortar rivals Barnes & Noble (NYSE: BKS  ) and Borders (NYSE: BGP  ) . eBay's business model is lighter still; while even Amazon must maintain warehouses of goods, eBay has no inventory at all, merely taking a cut of every transaction between the buyers and sellers it brings together.

The lighter the business model, the more profitable the business generally is. Bricks-and-mortar stores can dominate rivals and make gobs of money, as Wal-Mart (NYSE: WMT  ) amply demonstrates, but they generally must sell vast volumes of goods to do so.

The razor-and-blade model
King Gillette, inventor of the disposable safety razor, pioneered one of the most profitable business models around. A safety razor might just seem like a convenience to you, but savvy business observers see dollar signs.

Gillette shrewdly realized that once a consumer bought a razor, he would keep buying blades for it, generating lots of regular repeat sales. Therefore, the razor's pricing became far less important than that of the blades. Indeed, in World War I, many soldiers received free razors from Gillette -- an altruistic gesture, yes, but also a canny and profitable one. Procter & Gamble (NYSE: PG  ) clearly appreciated the beauty of this model, since it bought Gillette's self-named company in 2005.

Today's inkjet printers owe a clear debt to Gillette's clever model. You can buy a printer for your computer from Hewlett-Packard (NYSE: HPQ  ) for a pittance -- less than $100 in many cases, and sometimes as little as $50. But to refill its ink cartridges, you'll need to shell out $15 apiece, again and again, with multiple cartridges needed for proper printing. Over the life of the printer, you'll spend more on the ink than you paid for the printer itself. And which do you think carries a plumper profit margin -- the high-tech printer, with all its parts and circuitry, or the little plastic box of ink?

Know another company with a compelling business model? Share your keen observation with your fellow readers in the comments box below -- or drop in on our free CAPS stock-rating community to swap opinions and analysis with more than 125,000 of your fellow Foolish investors.

Fool co-founders David and Tom Gardner are always on the lookout for compelling business models in their Motley Fool Stock Advisor newsletter service. See all their promising investment ideas with a free 30-day trial.

Longtime Fool contributor Selena Maranjian owns shares of eBay and Wal-Mart. Wal-Mart and eBay are Inside Value recommendations. eBay and are Stock Advisor picks. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.

Read/Post Comments (3) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 25, 2008, at 3:57 AM, Alwaysgolong wrote:

    A very good article for a new investor friend of mine. I'll forward the link to him.


  • Report this Comment On December 26, 2008, at 12:26 AM, onlineseller wrote:

    I think ebay is open to other companies taking there business. why go to smaller sites when you can use eBay or other huge, established venues? Thanks to their size, they're likely to have the most buyers if you want to sell, and the widest selection if you want to buy. They dont have a chance against smaller companies. There fees are way to high for there service and they cant come down to a price to compete. I think many small companies have and

    are going to take away lots of there future business.

    Look at if you sell antiques and collectibles. How will they go up against them in the future. There will be many more to come and a lot of these new companies are going to build a large customer base. The fools Rules

  • Report this Comment On February 18, 2012, at 2:33 AM, ArieAvnur wrote:

    The razor and blade model has also some unintended consequence: reduced loyalty incentive. Pittance price for a printer means there is no real investment in it, no barrier to replace it. When a competitor releases a printer that is even just a bit better, there is no real reason not to replace; disposal is the main difficulty. This is demonstrated in some real capital equipment markets, like e.g. clinical laboratory analyzer test equipment that may cost millions a piece, and is given almost for free like the printer. Reagent consumption is the revenue driver. Lab managers and owners have no real issue to move this large equipment out and bring a new one in for any advantage. Bad news to the vendor that lags behind even a bit, to its investors, but good news to the public that will get the latest and best in diagnostics faster, thanks to less impeded market competition. Gillette managed to stay on top by keeping its place on the “leading edge” (literally and figuratively), but others (like Xerox I believe) suffer.

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