Rule #1 Finance Blog

With Investor Phil Town

5 Red Flags When Valuing a Company

When you’re searching for companies to invest in, there are endless resources that will tell you what you NEED to do to make sure you’re buying the right stocks and taking the least risk. But, one of the main principles of Rule #1 Investing is sticking to what you know.

Here are 5 things I see people do all the time with company valuation that causes more heartache than you need.

1. Don’t Listen to Anyone Telling You to Buy a Stock

Tips from friends, unfortunately, are not the way Rule #1 Investors choose companies.

As Charlie Munger said, “We, (Warren Buffett and I,) recognized early on that very smart people do very dumb things…”

The most important thing for YOU to remember about investing is that this is absolutely true when it comes to the stock market as well.

Heck, don’t even listen to me!

What I mean by that is that you’ll NEVER hear me give specific advice about stocks to buy. Things change, and if you’re not keeping up with the research and the activities of that specific company, then no ‘tip’ is going to help you.

I harp on this because I’ve seen plenty of smart people lose big money in the market by following the advice of someone else. Stock advisors, finance news headlines, “special reports you can buy”… sometimes it seems like the whole world has an opinion on what you should do with your money. Don’t listen to them!

Always do your own, independent research to find out if you like the company and if you understand it. Stop listening to people and do your own due diligence and you’ll be far more confident – and successful – with the entire process.

2. Don’t Invest in a Company That Isn’t Growing

One of the most important qualities that you’re looking for when investing is consistency.

If a company isn’t consistently growing, it probably isn’t one that you should be investing in – at least right now. Look for businesses with consistent growth rates of at least 10% per year for the best results.

Dive deep into every aspect of their financials, from ROIC to sales growth rate to EPS, equity, and cash flow. All of these numbers will tell you pretty quickly whether or not you’re on the right track.

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3. Don’t Ignore a Company’s Debt

All companies have debt. But to determine whether or not a company’s debt is reasonable, find out if it can pay off its current debt within three years. To do this, divide the total long-term debt by the current free cash flow.

Similar to a friend who racks up credit card bills to have the newest iPhone or to book a fancy cruise but is behind on their mortgage, bad companies spend money on stupid stuff they think they need right now without thinking about the long term.

4. Don’t Buy A Company Without a Competitive Advantage

If a company is worth investing in, it should have more than just a hot product or service that it’s known for. It needs to have something truly special that protects it from similar companies and gives you the confidence that it would recover from an ‘event’ it may face.

Whether it’s brand recognition like Apple or Coke, or a secret formula like 3M, or something else entirely doesn’t actually matter – for a company to be worth your time and effort, there needs to be a competitive advantage at play.

If the company you’re valuing doesn’t have the ability to stand out in a crowded marketplace, it’s a surefire indicator that the next several years aren’t going to play out successfully.

5. Be Wary of Insider Trading

You should always be extraordinarily wary of CEOs that are selling off their shares of the company.

When people hear “insider trading,” they probably think of situations like Martha Stewart going to jail for this practice. But, what a lot of people don’t realize is that insider trading is essentially legal if the CEO in question notifies the SEC that they’re doing it within 48 hours of the sale.

Do you understand the company and why their mission is important? Does it have a genuine, tangible competitive advantage? Is it run by good people? Is it on sale? By getting the answers to these critical questions, the “right move for the right time” will more or less reveal itself – and make no mistake, that’s a position that most seasoned investors would kill to be in.

Have you invested in a company that someone recommended to you? How did it work out? Learn how to invest the Rule #1 way from my free investing webinar.

Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.