One of the things that is important to any Value Investor is the 'understanding of the business' of the potential investment. If you look at any annual reports or any writings of Warren Buffett, he clearly focuses on understanding the business.

Why does it matter? A clear understanding of the business is about knowing the underlying economics of its business model and ultimately, valuing it. The valuation, to a great extent, depends on the investor’s understanding of the business. As the late Mr. Rakesh Jhunjhunwala said, “Like the beauty of a girl, the value of a stock lies in the eyes of the beholder.”

The economics of any business is defined as its ability to generate a return on the capital that is being used by it. This economics is dependent on its competitive positioning related to other competitors within the industry.

Mr. Buffett has categorized businesses into three groups based on their economics prowess:

The Great Business

Buffett writes,
"A truly great business must have an enduring ‘moat’ that protects excellent return on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore, a formidable barrier such as a company being a low-cost producer or possessing a powerful world-wide brand is essential for sustained success."

Great businesses generate very high returns on invested capital due to the presence of a certain type of competitive advantage. This competitive advantage can come from either being a low-cost producer which restricts competition or by being a producer of a differentiated product with a certain degree of customer captivity in terms of habit and switching costs.

Great businesses do not require continuous reinvestment of their earnings to grow. They are not capital-intensive in nature. Though these businesses can't grow for any extended period reinvesting a large portion of their earnings internally, these earnings can be taken out to distribute to the owners of the business.

The Good Business

While the great business generates great returns, a good business generates satisfactory returns. This business also possesses a competitive advantage but also needs capital investment to finance its growth. That is because growing businesses have both working capital needs and a requirement for fixed asset investment. Therefore, some earnings are reinvested into the business and the rest are distributed to the owners.

A good business generates good returns by operating at high margins and high capacity utilization. Therefore, management skills are also important for better allocation of capital.

The Gruesome Business

Buffett writes,
"The worst sort of business is one that grows rapidly, requires significant capital to engender growth, and then earns little or no money. These are the businesses with no competitive advantage, generating depressed returns on invested capital. On top of that, the money generated is insufficient or barely sufficient to fund further growth, with nothing leftover to distribute to the owners of the business."

This typically happens in industries with oversupply and commodity types where the products are undifferentiated. The oversupply situation is a drag on the return that a business can generate. It makes the business the price takers on their products and leaves them with ample unutilized capacity.

To conclude, Buffett writes, “Think of three types of savings accounts. The great one pays an extraordinarily high-interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”

For the long-term investor who holds onto the businesses for the long period, the potential investments are “Great” and the “Good” businesses. With a clear understanding of these businesses, investors can come up with satisfactory valuations. When purchased at the price below that valuation, it can generate a very good and satisfactory return for the owners of the business.

Disclaimer: The above are our personal thoughts. We try to apply these thoughts to our investment operation. We can be wrong in our thinking or that our thinking can change in the future as we learn more. So. Let's move forward with a sense of skepticism.