Don't pay twice for outstanding management

At Intelligent Investor, we spend countless hours debating what makes for a stellar management team. Do they act in the best interest of shareholders? Do they need to own a large stake in the company? Are they honest? Do they understand the key economics of the business? What's their attitude towards debt? These are just some of questions we ask.

But, perhaps, what's most surprising is how the answers effect our valuations. Intuitively you might assume that better quality management should yield higher prices. Yes and no. I'll explain with a simple example.

Imagine two identical companies. One, Company 'A', has the 'All Blacks' of management running the show and the other, Company 'B', is stuck with the 'Namibia's First XV'. Company 'A' unsurprisingly is able to generate much higher profit margins (and profits) (see Table).

But in estimating the value of each business, be aware you might be paying twice for management. Profits from Company 'A' are already higher because of its fantastic management, so even paying the same multiple of 10 means paying something for good management.  Paying a higher multiple of 13 means paying for the excellent management twice.

Also, be wary of using earnings generated by an excellent management team as the basis of valuation. If management changes (and it frequently does, see Beware the new chief executive) any boost to earning caused by excellent management could disappear. This is further compounded if the stock traded on a high multiple on the basis of excellent management.