In a previous article, I looked what trends and fundamentals to look at before buying a companies stock. This article will focus on five ratios you need to look at before buying into any business/stock. As we are looking at ratios, this article involve some math. It als involves thinking hard about rather abstract ideas.
The ratios found below are a nearly foolproof way to evaluate the quality and the value of any business. This ‘five-part test’ will allow you to quantify, with reasonable accuracy, exactly what makes a given business great, average, or poor. This knowledge will allow you to make vastly better and more-informed decisions about what any business is worth and what you should be willing to pay for it on a per-share basis.
But the best part about this four-part test is that it will teach you discipline to always do this work before you buy any stock and thus you’ll never make a quick decision to buy a stock ever again. You are also going to radically improve the quality of the stocks you are willing to invest in because you’ll have the skills to do so. And this will hopefully eliminate more than 90% of your investment mistakes.
The 5 ratios for Investing success:
- Cash operating profit margin: cash from operations / revenue (should be greater than 20%).
- Shareholder payout ratio: capital returned to shareholders / capital expenditures (should be greater than 1).
- Return on invested capital: net income / long-term debt + shareholder equity (should be greater than 20%).
- Returns on net tangible assets: net income / net tangible assets (should be greater than 20%).
- Share price multiple: enterprise value / EBITDA (ideally less than 10).
Lets Look at the above in more detail.
High profit margins
The most obvious characteristic of a great business is high profit margins. High profit margins are proof of a superior product, great brand, some form of regulatory capture that permits greater-than-normal profitability or a company that has an economic moat PUT LINK (competitive advantage).
You want to know how much cash the company brings in for every dollar of revenue.
To work this out do the following calculation
Total cash flow from operating activities / Total revenue of company
You can find both these figures in the company’s account. Revenue is found in the profit and loss account and cash flow from operating activities is found in the cash flow statement under the line : “total cash flow from operating activities”
Working out the above formula will give you a fraction that is commonly expressed in percentage form.
A great business should have cash operating profit margins greater than 20%.
How much capital the company requires to maintain its facilities and grow its revenues.
You basically need to figure out whether the company in question distributes more capital back to shareholders… or spends more money “on itself” via capital-spending programs.
Does the business produce substantial amounts of excess capital, and does management treat shareholders well?
A great business is able to distribute more profits to its shareholders than it consumes via capital investments
The formula is :
Shareholder payout ratio: capital returned to shareholders / capital expenditures
The result of this should be greater than 1 for it to be a good business.
Investing in capital-efficient companies with dominant brands is one of the simplest paths to great wealth .This strategy has made Buffett one of the richest people on the planet. See my article on Warren Buffets Economic Moat.
Return on Invested Capital
We use this metric because there’s no purer way of determining the value and the power of a company’s “moat” – the degree to which the company is sheltered from profit-eliminating competition
The formula is
Return on invested capital: net income / long-term debt + shareholder equity
For it to be a wonderful business, the Return on invested capital should be greater than 20%
Again, long term debt and shareholders equity can be found in the balance sheet or you can scour these figures from either yahoo finance or msn money under the heading balance sheet statistics.
Return on Net tangible assets
This number gives you the best overall measure of the quality of any business. It’s similar to the more commonly used return on equity (ROE) with two important differences.
measuring returns against net tangible assets takes goodwill out of the calculation. So companies with large amounts of goodwill (like companies with great brands) will typically show a much higher return.
Second, this measure of quality rewards companies that can borrow most of the capital they need because their results aren’t cyclical.
Formula is :
Returns on net tangible assets: net income / net tangible assets
This figure should be greater than 20% for a wonderful business.
The net tangible assets figure can be found in the balance sheet or alternatively Yahoo Finance lists “net tangible assets” among its balance sheet statistics.
The return on net tangible asset is a true measure of great companies – it is the single best overall measure of the quality of a business. It combines brand value, capital efficiency, the quality of earnings, etc.
Share price multiple
Business quality is extremely important, but the stock price is equally important for investment outcomes. The best advice is to value high-quality businesses by the amount of cash they earn before interest, taxes, depreciation, and amortization. In finance jargon, this measure of profits is called “EBITDA.”
The formula is
Share price multiple: enterprise value / EBITDA
Try to avoid paying more than 10 years’ worth of EBITDA per share when we buy a business. We measure the cash earnings against the enterprise value of the business (the value of all of the shares and all of the debt, minus the cash in the business). But you don’t need to do all of this work yourself. You can find this multiple on Yahoo Finance on the key statistics page for any given stock
You can use the stock screener found here http://finviz.com/screener.ashx . Under the financials tab, many of these ratios are given so this takes out the hassle from calculating it yourself.