My pervious post was about business scalability, a term used by Rakesh jhunjhunwala frequently. I attempted to lay out my understanding of the term in that post.

Business scalability is a critical factor in valuation. As I detailed on my post on intrinsic value, the DCF formulae can be used to calculate this number. There are two key variables in the formuale – Free cash flow and the duration of the same before the terminal value is applied. This duration also referred to as CAP (competitive advantage period) is the time period during which the company is able to earn above its cost of capital. Beyond this period the company earns its cost of capital and hence is valued at its terminal value.

A company with a scalable business will be able to grow its free cash flow faster (higher growth) and also have a higher CAP at the same time. Now higher the growth and CAP, higher is the intrinsic value. If you can identify such a company much before the market does, as Rakesh jhunjhunwala and other top investors are able to, then the returns are very very high.

However identifying such companies is not easy. The most common error I have seen with analysts is that they identify the market opportunity, pick a company most likely to do well and stop at that. The analysis should also involve analysing the business model in detail, identifying the key drivers of performance and doing an assessment of these drivers. If this sounds complicated, then it is. The value is not easily apparent and requires quite a bit of analysis and digging around. All this has to be done before the market recognizes the company and bids up the price.

I think this approach to investing is a very advanced form of investing. It is not easy for a novice investor to practise this form of investing easily. One should have a keen understanding of business models, valuations, economics and other aspects of investing. Graham or deep value investing requires much lesser expertise and also has more diversification of risk. However this form of investing, where an investor can correctly identify a scalable business, is the key to long term riches.

I received the following question from rathin and thought that this a good question which cannot be answered in a short comment.

Hi Rohit,Can you elaborate more on “Business scability”…Rakesh JhunJhunwala emphasises on that…Can you also give one practical example of a company??

Rakesh Jhunjhunwala empahsizes the term ‘business scalability’ a lot in his interviews and presentations. Let me try to give my understanding of of the term

I think business scalability should be analysed based on two key factors

1. Market opportunity – How big is the addressable market, the company is trying to target
2. Business model – How scalable is the business model in its ability to tap the above opportunity profitably

Let me expand further on the above two points via some examples

Lets take the example of Bharti or any other similar telecom company.

Market opportunity – The market opportunity is case of telecom is huge. Telecom services are still far below international level and even after years of hyper growth, there is still a large untapped market. Market opportunity is easier to identify and one can compare the indian market with other markets to get a sense of it. However the fallacy by most analysts is to take a direct linear estimation. For ex: for argument sake US consumes 20 Kg of choclate per capita per annum. India’s per capita consumption is say 100 gm. so the market opportunity is 200 times that of US.

This is a very simplistic approach and should be taken with a pinch of salt. There are far more variables involved in evaluating market opportunity and a range of values for most products and services should be considered.

Business model – This is far more complex to analyse. This is where the genius of investors such as Rakesh jhunjhunwala is apparent. They are able to evaluate the business model far in advance and are able to judge if the business model of the company can scale profitably.

For ex: In case of telecom, there is a huge upfront investment in the infrastructure, license, setting up the marketing infrastructure etc. However once these investments are done, incremental cost of gaining a Rupee of revenue is low. Such business models are far more scalable

To get technical – The marginal cost remains steady or reduces in scalable models. Such companies get more profitable as they grow.

In contrast lets look at IT companies. It is apparent that the market opportunity is large. However the business model is not as scalable as Telecom. Here the relationship of revenue and cost is at best linear. In some case there may be a disadvantage to the scale. As the company grows larger, you need to manage more employees, have more layers and there are other costs involved in managing such large organizations. The top tier IT companies now have 100000 employees . A 10% CAGR growth for next 10 years , which is not a high assumption , would take the employee strength to 1 million plus. So you are talking of model which is not as scalable as Telecom

Lets take an extreme example of a roadside eatry. The addressable market is big. However the business model is not scalable as the eatry can only serve limited geography and may be limited by the competency of its owner and the employees running it. However if the owner can develop a franchise and start licensing it, then the model is scalable. Alternatively if the owner can brand its product then it is scalable to a certain extent

Among the two factors discussed above, I think the more crucial aspect is the scalability of the business model and how competent would the management be in tapping the external opportunity.

Next post: How does scalability impact valuations ?