The mistake a lot of investors make is not conducting their investment work on the right “level”of analysis. Focusing on the right level of analysis is important to properly frame the investment decision and help to determine what information is actually relevant.  Many investors either focus on things that are far too “big” or they misplace their attention on the incredibly “small.”

The primary unit of analysis should be the business with some additional analysis given to the industry in which it operates. By focusing on the business as the unit of analysis, investors help narrow their focus to a manageable set of information that is most closely linked to the long term success of the stocks they own.

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Appreciating the effects of compound returns is one of the basic building blocks of becoming a great investor. Our ability to create wealth over a lifetime is the direct result of the amazing power of compound interest. For instance if we were to put $1000 in an account for a child born today, and that person lived a normal lifespan of around 80 years, while earning a 10% return, that simple $1,000 would grow to over $2,000,000.

Compound interest is an incredible concept to have working on your side. Albert Einstein is even said to have called compound interest the 8th wonder of the world. As investors we should try to understand compound returns to make sure we are doing everything we can to enjoy its benefits. If we are able to develop the correct tools as investors to achieve strong returns and have the willpower to stick with it over the long term, the mathematics of compounding take care of the rest.

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In this article I will explore the interconnected relationship between investment multiples, the yield on that investment, and the rate of return investors should expect. My overarching view is that even though investment multiples are much more commonly used in the financial world, I would urge investors to instead do their thinking in terms of yield. Yields are more simple and explicit than using multiples, and using yields allows easier comparison across investments. I end the article by recommending investors use free cash flow yield in their decision making.

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In this report I provide a framework for categorizing businesses into 1 of 4 types. To determine what type of business a potential investment is, I suggest analyzing a business on 3 primary characteristics: 1) the return on invested capital of the business; 2) the potential for reinvestment in the business; 3) the capital intensity of the business.

Four Types of Businesses