In case you’ve been living in Tibet for the last 13 years, or you’re simply fed up with the drivel served up on television these days and stopped watching altogether (in which case I salute you), Dragons’ Den is always an option. It’s a BBC TV series that allows budding entrepreneurs to pitch their business ideas to five multi-millionaires, or ‘Dragons’, in the hope of securing an investment.
These shrewd tycoons didn’t get where they are today by throwing their cash around willy-nilly, and I truly believe ordinary investors like you and I can learn a lot from their approach when pondering which businesses to back with their own money.
1. The business model
One of the first things I’ve noticed as a viewer over the years is that the millionaire Dragons never invest in businesses they don’t understand. Investors need to know in simple terms how a business will make money. If the Dragons don’t understand the business model, it’s highly likely they’ll soon be uttering those fateful words “I’m out” to the nervous entrepreneur(s) standing in front of them.
Likewise, it’s important for us to try and understand, at least at a basic level, what a company does and how it generates profit, before we can even contemplate parting with our hard-earned cash. Warren Buffett, perhaps the greatest investor of all time, famously said that he doesn’t invest in businesses he doesn’t understand. It’s almost impossible to make an informed investment decision without understanding what a business actually does, and how it generates profits.
2. The economic moat
Oftentimes, entrepreneurs pitch great business ideas or products in the Den, without securing an investment. The reason? The individuals have failed to convince the Dragons that the business has a competitive advantage, or what Mr Buffett refers to as an economic moat. In other words, does the business have a competitive advantage that will help protect long-term profits and market share from its rivals?
Economic moats can come in a variety of forms such as intellectual property, patents, economies of scale, or even just a strong brand. Without an economic moat, it can be easy for larger rivals to produce your goods at a lower cost, and take over market share. When was the last time you bought a cola that wasn’t branded Coca-Cola or Pepsi? Quality companies with a wide economic moat are worth their weight in gold.
3. The valuation
Many entrepreneurs coming to the Den fall flat right at the last hurdle. One or more Dragons may have spotted a promising business with a wide economic moat and great prospects, but if the valuation is too demanding, the entrepreneur will almost always leave the Den empty handed.
Warren Buffett may have missed out on the dotcom bubble in the late 1990s when company valuations hit the stratosphere, but he was also one of the few left relatively unscathed when the markets came crashing back down to earth in 2000. The lesson here is that like the shrewd multi-millionaire Dragons, we too should be prepared to walk away from the latest hot growth stocks if the valuation looks too excessive.