Have you ever thought about why a company or a business actually exists?
Most businesses exist to convert stuff into other stuff, that is useful for customers, ideally for a profit that goes to their owners.
- A well-known pizzeria takes 100 grams of flour, 50 grams of vegetables and 50 grams of cheese, all of which cost Rs. 25 in total, pays a chef and the electricity bill for an oven, in order to transform these ingredients into a Rs. 500 pizza.
You and I are happy to pay Rs. 500 for this pizza, even when we know the ingredients cost much less put together, because we got a chance to catch-up with friends, in a fancy ambience, in-between chewing on that Margarita.
- An IT services company buys laptops, trains humans, and pays them to travel to a foreign client location to gather requirements, code software, test it, deploy it and maintain it. The employees are paid in a weaker currency. It then bills the client 2-10X of what it cost them to deliver this service, in a stronger currency. The client, say, an insurance company, is happy to pay since they believe the IT services company is competent, will deliver on-time and at a reasonable cost. The new system is in-turn expected to enable them to serve their insurance customers better and faster and increase their foothold in the industry.
- An app connects you to someone who happens to be driving a car on a road nearby. You want to get from A to B and by booking a ride. The driver pulls up and confirms it’s you who asked for a ride. At the end of the drive, you pay the app, the app takes its generous cut (without telling you how much) and pays the driver for the car, fuel and his effort in navigating chaos on the road. You arrive for your meeting relaxed and not sweating. The owners of the app company are trying to make this a habit for you and me, The driver seems upset because the app has been gradually reducing the share he gets. The owners believe that they will make tons of money in the near future since they just run a technology platform consisting of servers, storage, database, networking and a few thousand specially-trained humans who can be fired at will.
- A barista calls out your name and you collect a drink with decoction, sugar, and milk. You love the ambience and the free wi-fi so much that you’re more than happy to pay 4X the cost of all these items, and a part of the barista’s salary. Instead, you could make this drink at home and carry it in a flask. But, it’s so much cooler to be seen here!
- In the good old days, whenever we went out in our Ambassador cars we used to carry cold water in a Milton Cool Jug, but we’re much smarter now that we just buy a bottle anywhere we go. A bottled-water maker is happy for us to indulge in this new-found habit. What a no-brainer business eh! So convenient!
- A bank pays you 3.5% for your savings deposit. It lends the money at 10.4% to your colleague who wants a home loan. The bank earns the difference. Your other colleague who owns shares in the bank is thrilled that it’s been expanding its loan business consistently every year. In fact, the bank did this with 10,000 fewer people than last year and has no plans to spend money on more branches. It’s going to automate everything with neural networks, AI, and chat-bots, which should mean even more profits in the future!
Every minute of every day, materials are being transformed into products by entities all around you. You’re doing so too, right now in your own company, before you took the break to read this.
When a company profitably transforms inputs at one cost into outputs a higher cost, its called “adding economic value”. (It’s a fancy economics term for ‘useful work’).
The value addition you do through your actions is a small part of the value addition all the employees of your company do for your customers (including your CEO). This cumulative value addition is reflected in the value of the company and thereby its share price over time.
Just like a performance appraisal of your work, shareholders appraise the earnings reports of companies each quarter and decide what they’d like to do with it (hold the share, invest more, sell some, sell it all, whatever). This value cannot be assessed in one day or even one quarter or one year. Just like you might have a bad day, week or year, every company might have one bad quarter. Over time, the consistent performers reveal themselves and people are usually willing to pay a premium for consistency (just like consistently performing co-workers get consistent salary hikes). People are also willing to pay for the future potential of a company, just like a new employer might give you a salary hike when you join, in the hopes that you’ll more than makeup for that cost with your actual performance.
Watch out for value addition in your life! As you observe it, you’ll marvel at it. And you’ll want to own every business that you see. I for one, want to own that unisex salon that insidiously up-sold me on a Rs. 5,000 “hair-spa” and “top-class facial” last Sunday! And an ice-cream parlour that sells “Death” (!!!) but “by chocolate”. Now that’s a winner!