Part II:
Now, back to the $30K that your dad spent on the espresso machine. Although he is mustachian, most of the neighbourhood is not so he sells 200 coffees a day at a $2/cup profit margin. This adds $400/day = $100K per year (give or take) added to EBITDA. Let's say this ends up being $60K additional net earnings.
Net earnings has grown from $60K to $120K - 100% growth.
Furthermore, the return on the capital spent ($30K) is 200% - Totally awesome. If you could buy shares in a growth business like this you are home and hosed, but very very hard to find at a decent scale and publicly traded. This is what offices full of analysts spend their days trying to find.
Now there are a few comments above about getting yourself into trouble through not understanding how to pull apart the finances of a business and how that can end in trouble. Here are a couple of scenarios with this example business to illustrate what can go wrong:
1. Instead of buying an espresso machine your dad gets the business to spend $30K on a fancy new car. This adds nothing to the revenue of the business. $30K down the drain which could have been paid to shareholders. You see this every day with corporations. Big fancy new offices, sponsoring yacht races etc. Warren Buffet talks about corporate waste in the Berkshire Hathaway annual reports. You could get a lot worse education than reading through those.
2. You dad misreads the market and it turns out he's in Vegas where, apparently, no-one knows what a decent espresso tastes like. Especially at the convention centre. Rather than selling 100 a day he only sells 5 on average to a few pretentious yuppies sneaking across the state border in their Foresters for a session at the tables. $30K invested yields $2500. Not bad, but not really worth getting out of bed for.
3. Your dad doesn't invest in staff training so the barista doesn't know how to tamp the grounds properly, uses stale coffee etc. Consequently a bad product is shipped to the customer. Word gets around. Same effect - 5 coffees per day sold to folks with no taste buds.
4. Your dad (with a vote from your mum - the other board member) awards himself a $30K bonus for great performance. Together with the $30K spent on the espresso machine there is nothing left as a dividend to the other shareholders. Brother-in-law is not happy. This happens very frequently too - the executive management, in cahoots with the board, create remuneration plans which strip the profits before they are even reported.
5. The majority owners of the business decide they want a fat dividend. They pull the whole $60K profit out leaving nothing to invest in growth. The $100K
per year of additional earnings possible through the espresso machine is lost for the sake of an extra $30K of dividend distributed
once. This typically happens when major institutional investors demand a certain dividend rate. Again, you can read Warren Buffet's thoughts on this. He has consistently reinvested internally generated profits and over 40 years made staggering buckets of cash for Berkshire Hathaway.
6. Possibly the worst crime of all. The business made $60K profit, the owners demand a $100K dividend. The business borrows money or raises additional capital through creating and selling more shares to pay for the shortfall between profits and dividend payout. Although this is blatant stupidity on a huge scale it does happen. Not only has the business not reinvested into growth, it has taken on debt and the ongoing servicing costs which will eat away at future profits and eventually cripple the business.
7. $20K of the profit is booked because Mrs Meggs comes in and orders 16 tonnes of cabbages for the next 12 months. She will pay after they are delivered. That $20K is paid out as dividend because it is reportable as profit even though the cash hasn't hit the bank yet. As a result the bank account is stripped clean and your dad can't pay his suppliers. The company is now insolvent due to timing of when profit is reported and when cash is received. This is a silly example, but things like this happen all the time. Services companies, particularly ones which are growing aggressively, often have a big lag between work in progress being recognised as revenue and when the cash arrives. They can't delay their expenditure because it is payroll and high paid consultants tend to quit if they don't get paid on time. Net result is a cash-flow hole which leads to big trouble. Just ask anyone who hasn't kept up with their mortgage payments - same story for business.
That is an example of some of the things which can go bad in a business. There are many, many more. You can often see it for publicly traded companies. For example, you can see on MMM forum the love for Hondas etc - nice panel fit, last for ever, nice to drive etc, etc. You don't hear much love for Ford or GMC. Guess what, that's the same story as the untrained barista churning out crappy espresso coffee. They haven't kept up with what world-class looks like, ship an inferior product at higher cost and sales die off resulting in huge financial losses, resulting job losses and a very sad and sorry picture in Detroit. You could see it years out based on what people are talking about on the street so you would want to steer clear of those businesses.
Also be aware of people's motivations which can drive how they report data to the public. Although the financial reporting rules for public companies are quite stringent (following Enron etc) there are always plenty of way to manipulate raw data into something which looks a whole lot better. This behaviour is often driven by short term incentive plans for senior management. The manipulated data can hide the true state of affairs.
If you are going to invest in individual shares you need to learn to read balance sheets, profit and loss statements, cash flow statements and all the boring notes which clarify how the numbers were derived. You can see most of these problems from the financial statements. However, it is hard to judge long term viability and growth potential from the financial statements - for that you need a lot of qualitative data. Phil Fisher had a lot to say about that:
http://en.wikipedia.org/wiki/Philip_Arthur_Fisher. If you are seriously going to attempt share-picking you should get your hands on his books and read them carefully.
For me, personally, it is less of a headache to start your own business than invest into just one or two publicly traded ones. At least you have an idea what the management is up to. ;). And by the way, if you do run your own business for a bit you will start to read company annual reports in a totally different way.
Hope that helps...