Understanding the quality of a business is critical to being a successful investor, as it is a major determinant of what one should be willing to pay for a stock. Commodity cyclical businesses with poor economic characteristics might be worth at most 10 times normalized after-tax earnings -- meaning a savvy investor would never pay more than five times earnings -- while insanely great businesses such as eBay (NASDAQ:EBAY) might actually be worth a very high multiple of today's earnings (though at 92 times this year's consensus estimate, eBay is significantly overvalued today in my opinion).

To determine how good a company is, it helps to think about what the perfect business looks like. Since the value of anything -- companies, bonds, real estate, etc. -- is the future free cash flows discounted back to the present, obviously the perfect business has huge free cash flows that will grow for a very long time. With this in mind, let's examine the characteristics of the perfect business:

  1. High profitability. If customers want or need a product or service very much, and only one company can provide it, then that company can charge prices far above its costs. Good examples are Microsoft (NASDAQ:MSFT) -- try using a computer without Windows or Word -- and pharmaceutical companies such as Pfizer (NYSE:PFE) because many of its drugs save or vastly improve lives (so people really need them) and also are unique and patent-protected (so there are few, if any, substitutes). (Incidentally, I think margins across the pharma sector are likely to shrink for reasons I discussed in a column last month.)

  2. High returns on capital. A company can have high margins but not be particularly attractive if it requires massive amounts of capital to launch or maintain its business. For example, Union Pacific (NYSE:UNP) has above-average net margins of 7.2% but only 7.0% returns on equity because railroads are so capital-intensive. The greatest businesses require little or no money to start, can grow without major additions of capital, and do not require much maintenance cap ex. Think eBay.

  3. An enormous moat. Far more important than high margins and return on capital today is whether such characteristics can be maintained long into the future. Thus, it's critical for a company to have major competitive advantages that are unlikely to be dissipated over time. The key here is lack of change -- it's amazing how few investors understand that rapid change (think most of the tech sector), while fun to watch and benefit from as consumers, is very bad for investors. Warren Buffett has said, "We see change as the enemy of investments... so we look for absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.... I guarantee that Coke (NYSE:KO), Wrigley (NYSE:WWY), and Gillette (NYSE:G) will dominate. The Internet won't change what brands people like."

  4. Profitable reinvestment opportunities. The greatest businesses -- a good example is Coca-Cola during its first 100 years -- can reinvest their robust free cash flows back into the business at equally high rates of return on capital. For example, Warren Buffett has often lamented the fact that See's Candies has never been able to expand much beyond its historical West Coast markets. It's a fabulous company and was one of his best acquisitions ever, but the inability to reinvest its free cash flows back into growing its operations makes it an inferior business to, say, Wrigley, which has been able to grow globally over the years.

  5. Future growth. I deliberately did not put this at the top of the list because, despite investors' fixation with growth, I don't believe it's of paramount importance. Of course, all other things being equal, it's better to have a company that can sell to vast worldwide markets (see the many examples above), but how many companies have crashed and burned mindlessly pursuing growth? It's especially common among multiunit retailers that saturate their markets, yet keep building more units -- look at what happened a few years back to the Gap (NYSE:GPS) and McDonald's (NYSE:MCD). Growth benefits shareholders only if a company can continue to earn good returns on incremental invested capital.

  6. Good cash flow dynamics. Some companies tie up huge amounts of money in working capital, while the best companies actually receive cash from customers before they have to pay their vendors. This is measured by the cash conversion cycle (CCC), which is simply days of inventory plus days of accounts receivable, minus days of accounts payable. Dell (NASDAQ:DELL), for example, has a CCC of negative 34 days, far better than its competitors -- a major differentiating factor in a commodity business (especially one in which inventory is declining in value by the day). Or consider Wal-Mart, which over the past four years has reduced its CCC from 22 days to 15 days, thereby freeing up $4 billion of extra cash.

Case study of the money management business
As I wrote in one of my all-time favorite columns, Traits of Successful Money Managers, the best investors love what they do. Buffett has said at various times, "I'm the luckiest guy in the world in terms of what I do for a living"; "I wouldn't trade my job for any job"; and "I feel like tap dancing all the time." This is certainly true for me as well: I truly enjoy evaluating companies and industries and trying to outfox the market -- no easy task, but a fun and challenging one.

While I chose this profession because I enjoy it and think I'm good at it, I'm certainly not complaining that it's as close to the perfect business as any I can think of. Let's go through the criteria above:

  1. High profitability. Costs are low -- in fact, I operated my business out of my home and had no employees for the first few years -- and fees are (let's be honest) high, especially if one is running a hedge fund (as I do).

  2. High returns on capital. It costs almost nothing to get into the hedge fund business (it costs somewhat -- but not much -- more to open a mutual fund), growth requires little capital, and there's virtually no cap ex.

  3. An enormous moat. In this area, money management businesses don't look so attractive, as there are almost no barriers to entry. On the other hand, a talented money manager is very rare.

  4. Profitable reinvestment opportunities. While money management businesses don't require much capital to grow, the lack of reinvestment opportunities is hardly a disadvantage. The owners can simply take their profits and reinvest them in other attractive opportunities -- that's their business after all.

  5. Future growth. The money management business is almost infinitely large worldwide and is growing at a healthy rate, so the sky's the limit for a successful firm. In fact, the most successful ones tend to stop growing not because of lack of opportunities but because they choose to stop taking in new money.

  6. Good cash flow dynamics. Investment firms have no inventories, and management fees are generally paid in cash, in advance. And for hedge funds, the promote is paid the instant that it's earned, with zero risk of not getting paid. (The promote is the percentage of the profits -- typically 20% -- that is earned at the end of each year.)

It's little wonder that Buffett has said, "Investing is the world's best game. I was in the department store business where you have to match your competitors -- it's a business that throws defensive decisions at you all the time. We want a business where we don't have to make defensive decisions. Investing is a perfect example. You can just watch ball after ball come through and sit and wait for just the right pitch."

Hedge fund bubble?
As money continues to pour into hedge funds -- they attracted $46.6 billion during the first nine months of this year and now have $890 billion under management -- there's been a lot of talk about a hedge fund bubble. I don't buy it. Given the economic characteristics detailed above, the only thing that surprises me is that it's taken so long for so many smart people to get into the business. The fact that a large amount of capital is following such people is simply logical, not the sign of a bubble.

That being said, there's a lot of leverage building up in every layer of the system, and many inexperienced people are starting funds. But this is a recipe not for a bubble bursting, in my opinion, but rather reduced returns industrywide (especially net of such high fees), as the happy hunting grounds in which hedge funds have typically made their profits become more and more competitive and picked over.

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Fool contributor Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned McDonald's, Berkshire Hathaway, and Microsoft calls at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security.To read his previous columns for The Motley Fool and other writings, visithttp://www.tilsonfunds.com. The Motley Fool isinvestors writing for investors.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.