I don’t look at a single metric, but rather on a list of metrics that must satisfy my criteria before I even dig deeper.
Insider ownership and salary
This is one of the most important metrics for me. Management should own a meaningful amount of stock, ideally the CEO would hold at least 5–10% in the company. After all, if management doesn’t own stock then why should I? Research and my own experience has shown, that family-owned or owner-operated companies significantly outperform others. And it all comes down to incentives. As Charlie Munger once said: “Never, ever, think about something else when you should be thinking about the power of incentives.” Incentives are a very powerful force for all human beings. If a CEO is compensated based on EPS or total revenue, then he will buy back stock or use accounting tricks to inflate earnings, or make dumb debt-fueled acquisitions to increase the size of the company. On the other hand, if he owns 20% of stock then he derives most of his income through ownership, so he is incentivized to increase the value of the business in the long run. Never, ever underestimate the power of incentives.
I haven’t found a reliable source for insider ownership yet, so I go directly to Proxy statements or Annual reports of individual companies. Here is the ownership summary for one of my favorite companies, Arista Networks (ANET):
Source: SEC Filing Details
As you can see, the founder Andy Bechtolsheim holds around 17% of the stock through a family trust, and CEO Jayshree Ullal has a 5% stake.
On page 35 in the same document, you can find the “Summary compensation table” with salaries and bonuses for all executives:
Jayshree Ullal made $8 million dollars last year, which might sound like a large amount. Arista’s market cap is around $19 billion now, which means her stake is worth $950 million. So a mere 10% move in the stock price increases assets by $95 million. I believe that she and CDO Bechtolsheim are very incentivized to increase the value of the company in the long run.
I have made some exceptions in the past, where I bought stocks with low insider ownership. But that was only when the companies had really exceptional economics, large runways for growth and high returns on capital.
Operating cash flow
I have a personal rule, that I never invest in companies that have negative operating cash flow. Now there is nothing wrong with that, many businesses that are developing new products, services or innovations do not generate enough income yet and need continuous financing. However, I have found through some previous investments, that I’m not very skilled in this area (expensive lesson), and I can’t tell which company will eventually “make it” and which won’t. So I prefer to wait until they generate enough cash on their own and do not rely on external financing. Here is an example of Arista’s operating cash flow over the past 12 months:
Source: Arista Networks, Inc.
3. Debt and net current assets (NCA)
The next metric I check is the debt/equity ratio and net current assets figure. I hate debt (it’s a personal thing), so I always invest in companies that have very little or no debt. It might not be completely “rational” as debt financing can be somtimes cheaper than equity, but that’s the way I like it.
I look primarily at the net current asset value, which is calculated as
Current assets - Total liabilities. That’s right, I want companies that can pay all their liabilities from current assets alone. Arista had $2.38 billion in current assets ($1.7 billion out of that was in cash and ST investments) and only $735 million in total liabilites, giving us an NCA figure of $1.64 billion.
Source: Arista Networks, Inc.
You may call me too conservative or a weirdo or “prudent”, but I simply can’t stand debt. The funny thing is, that this rule automatically moves me into asset-light industries, or into companies that are generating so much cash, that they have no need for external financing at all.
4. Return on equity (ROE) and return on invested capital (ROIC)
ROIC is one of my favorite metrics. If you have 2 businesses that generate $1 million in operating income, but business A needs $5 million of capital to achieve it (20% ROIC), and business B needs $20 million (5% ROIC), then business A is clearly more valuable. The power of ROIC is best illustrated by Warren Buffett :
“That probability exists because
true economic Goodwill tends to rise in nominal value proportionally with inflation . To illustrate how this works, let's contrast a See's kind of business with a more mundane business. When we purchased See's in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See's, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes"---even if both businesses were expected to have flat unit volume---as long as you anticipated, as we did in 1972, a world of continuous inflation.
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.
Remember, however, that See's had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large---a need for $18 million of additional capital.
After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)
See's, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital---over $3 of nominal value gained for each $1 invested.”
Source: The Essays of Warren Buffett: Lessons for Corporate America by Lawrence Cunningham
For example, Arista’s ROA, ROE and ROIC are very high both compared to competitors and averages across Corporate America:
Source: Arista Networks, Inc.
If you can see that ROA and ROIC are consistently above 20% for at least 5–10 years, the company probably has a competitive advantage, or management is very skilled at operating the business.
Sometimes I accept low returns on capital, If I can see that the company is growing fast and investing heavily in R&D or marketing, which is fine in the early stages. If believe in the business, their product and management then I invest even if current profitability is low.
5. Revenue growth
Growth is key in investing. According to BCG, revenue growth accounts for 71% of total shareholder return generated over a period of 10 years. You can make money by buying a dollar for 50 cents and selling it when it approaches its fair value. Or you can buy an asset for a dollar, that’s growing 12–15% per year and hold it for a long time. If a company is not growing, then you can make money by improving margins and resulting higher valuation, or by buying it for a large discount to its intrinsic value and selling it as it approaches that level. You can make very good returns this way, but it’s very hard to do and you need to find many, many opportunities like that for it to work.
I prefer investments, where I have to make only one decision, it’s much easier that way. If I buy a business that can grow 15–25% for 10–15 years, the returns will be outstanding even if I pay a slightly higher price for it. In addition, I will defer taxes for many years, which is really awesome!
So I look for companies that are growing by at least 10–15% per year.
There many other metrics both qualitative and quantitative that I examine later, after the company has passed these initial ones.
Source : https://www.quora.com/What-is-the-first-metric-you-look-at-when-researching-a-stockThank You for Visiting My Website