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Decision Frameworks

Business Evaluation (Six-Filter Framework)

intermediate3 min readbusiness · economics · psychology

A structured decision framework from value investing that applies six sequential filters to evaluate a business: understandability, competitive advantage, management quality, price, disconfirmation, and downside consequences.

THE IDEA

BUSINESS EVALUATION

Filter 1 - Can I understand the business - predictability?

  • Reasons for demand - How confident am I that people will continue to buy this type of product or service, and can I explain why? What has happened in the past and what is likely to happen in the future? Cyclicality in demand? Capacity versus demand?

  • Return characteristics - Industry and company return characteristics and change over the last ten years?

  • Industry structure - How many competitors are there, and how large are they? Who dictates the terms in this industry? What is needed to make money in this industry? Position within the industry? Do I know who is going to make the money in this market and why?

  • Real Customer - Who decides what to buy, and what criteria do they use?

Filter 2 - Does it look like the business has some kind of sustainable competitive advantage?

  • Competitive Advantage - How confident am I that customers will buy from this company rather than a competitor, and can I explain why? Are the reasons virtually unchanged from what they were ten years ago? Are these motivations likely to be unchanged over the next ten years?

  • Value - How strong and sustainable is this advantage? Have the advantages become stronger and more durable over the years? What can destroy or reduce them? Barriers to entry? Brand loyalty? Vulnerable to change in demand or prices? Easy to copy? Short product life cycle? Customer cost and incentive to switch supplier? Annual cost differential against competition? Capital investments needed? Bargaining power? Obsolescence risk? New customer alternatives? Change in buying habits or power? Competitor potential to undercut prices assuming same cost structure? What is needed to make sure the advantages stay sustainable? Growth opportunities left? Is demand for the product likely to grow? Untapped unit volume demand? Pricing power?

  • Profitability - Can the advantage be translated into profitability and why? How does the company make money? How much capital is needed to produce incremental revenues? Financial characteristics: return on capital (operating margins and capital turnover), gross margins, sales growth, cost and capital structure and efficiency? Normalized free cash flow? Advantages of scale? Critical variable?

Filter 3 - Able and honest management?

  • Are the managers competent and honest, and do they understand and focus on creating value?

Filter 4 - Is the price right?

  • Can I buy at a price that provides a good return with a huge margin of safety measured against other available alternatives and with evidence from facts and figures?

Filter 5 - Disprove

  • How can the business get killed? If the company could kill one of its competitors, who would it be and why? If the company disappeared for 5 years, which competitor would its managers bet on, and why? How resistant is the business to adversity? Assume the company paid out all its equity capital, would it still have any value? Could someone with the access to billions of dollars and talent, successfully compete with the company? How much damage could a competitor do if he doesn't care about returns? Recession sensitivity? Execution risk? Will new technology help or hurt?

Filter 6 - What are the consequences if I'm wrong?

When to use it

  • Use this framework to screen potential stock investments before committing capital.

  • Apply the filters to analyze a company you already own to identify blind spots or new risks.

  • Use Filter 5 (Disprove) proactively in a business strategy session to stress-test assumptions about a product launch or expansion.

  • Leverage Filter 3 (Able and honest management) during due diligence for a merger or acquisition to evaluate leadership quality.

FROM THEORY TO EVERYDAY LIFE

In practice

01

Applying Filter 2: Sustainable Competitive Advantage

An investor evaluating Coca-Cola would examine brand loyalty, distribution network, and cost advantages. The filter prompts asking whether the reasons customers buy Coke are unchanged from a decade ago and likely to persist for another decade.

02

Applying Filter 5: Disprove

For a technology company, the disprove filter might ask: 'Could a well-funded startup replicate the product with better features? Could technological change render the company obsolete within five years?'

✳

A MOMENT TO REFLECT

Put it to work.

  1. Think of a business you considered investing in. How would you rate it on each of the six filters? Which filter revealed the most uncertainty?

  2. What assumptions are you making about the sustainability of a company's competitive advantage? How would you test those assumptions with evidence?

  3. If you were forced to invest in a business that fails Filter 1 (unpredictable), what additional safeguards would you need?

Connected ideas

Another lens can bring the same problem into focus.

Margin of Safety↗

CONTINUE THE CONVERSATION

Source texts

  • Seeking Wisdom From Darwin to Munger (Peter Bevelin)
EXPLORE FURTHER
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