April 05, 2016

The Importance of Capital Decisions

You may have heard of someone who, after purchasing a business for a small fortune in the hope of raising their income, soon discovered that the business was worthless. Despite their best intentions, in the process of making a single decision they may have lost decades’ worth of income. At times, a less important goal can actually distract from what matters most in financial decision making.

Investing corresponds with this analogy of buying a business- it requires the right framework and focus. It is not only what we don’t know that can get us into trouble, but also our assumptions, and what we think we know for certain.

The ability to discern between conventional wisdom and what really matters is crucial. Where common thinking directs our focus to certain things, and may uphold potential income and growth, these often form only one part of a larger equation. It is important to deepen our understanding of value- where it lies and how it is measured- in order to form a well-rounded decision.

In the example above, the individual’s interest in raising of income may have distracted from what was actually occurring with capital. Some of the most significant financial decisions are made when we turn our attention to capital.

In any financial decision we must ask, what is happening to capital? It is worth considering the capital structure and what capital represents. A business purchase may be based on profit estimates that are extrapolated into the future in order to determine the value of the firm. However, there may be little intrinsic value in many such appraisals. It is not just a question of the quality of an asset, but whether a price accurately represents its value.

Paying the right price for a business or investment is fundamentally important, and is an outcome of a focus and decision framework that respects capital. In the same way an investment product may offer a particular return, there must be equal if not greater focus on any capital that has the potential to change in value.
For example, whilst growth is considered a positive attribute, it can also represent one of the riskiest periods for a business. Often successful businesses lose significant value during a period of growth, as they acquire assets at more than they are worth.

A broad scope is vital when making investment decisions. It is necessary to ask the right questions whenever investment opportunities become available, are packaged, when private equity deals are re-engineered and floated, as IPOs arise, or other financial products listed. Questions such as, who are the agents and where do their interests lie? Is there adequate focus on capital? Are there liquidity issues? What intrinsic value exists? How accurate are the projections? What is the capital structure? Are the analysts or advisors involved impartial?

Some of the most significant decisions in investing involve capital. Whilst instinctively it may seem essential to be focussed on the effect on income in the short term, a broader scope is needed to properly assess the true value of an investment. Approaching investments with the right focus can reveal opportunities to generate profits that would otherwise seem unlikely in an efficient market.