How to Evaluate a Company: 5 Key Valuation Metrics for Smarter Investing

In previous blogs, we've talked about how to find stocks that you understand, have meaning to you, and are competitive in their space to help you build a watchlist of potential investments.

For most people, this is where the research stops. They blindly put their money into the stock market and hope for the best.

There's a lot wrong with this method, mainly that it doesn't evaluate the financial health of a company. Nor does it use valuation metrics that can indicate a company’s ability to generate future profits.

If you've been following the Rule #1 Investing strategy, you know learning how to evaluate a company is a critical component of learning how to invest in stocks and understanding key business valuation principles.

• First, we evaluate a company based on the 4 Ms

• Then, we evaluate the financial position of a company using the Big 5 numbers, which are essential financial ratios for stock analysis.

And, step #2 is exactly what we will cover in this blog. Let's get started!

5 Key Financial Metrics to Value a Stock

If you want to make a smart investment but don't know how to evaluate a stock, or where to even begin, the Big Five Numbers are the answer!

Calculating these financial metrics will tell you whether you're looking into a business that is predictable. It tells so much of a company's profitability, whether they can be trusted to deliver great returns year after year or not.

The Big 5 Numbers will also help determine whether a business can provide a good return to us each year. That's what we're really after as Rule #1 investors. These five metrics cut straight to the heart of a business.

They tell you if a company is predictable, if it’s consistently profitable, and if management can be trusted to deliver solid returns year after year. That’s the whole point for us Rule #1 investors. We’re looking for businesses that can keep putting money in our pockets every single year.

In today's volatile economy—marked by inflation concerns, rising interest rates, and rapid innovation—evaluating a company using the Big 5 Numbers helps Rule #1 investors cut through the noise. These numbers offer a consistent, proven framework to assess a company's true long-term financial performance, especially when investor sentiment or market cycles are swinging dramatically.

🎯Key Takeaway: As a good rule of thumb, a company is a good investment if all of The Big Five Numbers are equal to or greater than 10 percent per year for the last 10 years.

These metrics have been used by thousands of investors, including the best of the best, namely Warren Buffett, to evaluate a company. And, now, they can be used by you.

Don't worry – you don't need to be a math wiz to crunch these financial terms.

Once you know where to look, the Big 5 are easy to find and easy to calculate. We'll be using the company's three main financial statements – the balance sheet, income statement, and cash flow statement – to find and calculate these numbers. You can look at other factors like accounts receivable, total assets, and total liabilities as well. However, those are just extras.

1. Return on Invested Capital

The first of the Big 5 Numbers you should look at is Return on Invested Capital (ROIC). This is the rate of return a business gets on the cash it invests in itself every year.

The ROIC measures how efficiently the company is using its capital to produce profits. This provides crucial guidance on whether you should consider investing in that company.

✅Tip: Rule #1 investors seek companies that are being run and managed effectively. You can evaluate that in both subjective and objective ways.

The subjective way is to consider the ability and trustworthiness of the people who are running the company. That will give you an objective and quantitative measure that shows whether a company is succeeding financially.

Because the ROIC will vary depending on the company and industry peers, the ROIC is a useful measure for comparing different companies to each other within an industry. It helps in comparing other industries to each other as well.

How to Calculate a Rate of Return on Investment

To determine a company's ROIC, you'll first have to locate its income statement. On the company’s income statement look for “net income” (sometimes called net profit) or “net profit margin” and “invested capital.”

The % ROIC = Net profit after taxes divided by the equity and the long-term debt

You can use my handy Return on Invested Capital calculator to calculate ROIC for you. Remember, you want to calculate ROIC for the past 10 years to get a good understanding of how efficient management is at using the company’s assets to generate earnings and future earnings.

📌Important: A company whose ROIC meets these two tests is a good candidate to be a Rule #1 stock.

• The ROIC should be at least 10% per year

• The ROIC should be holding steady or going up over time

Financial Ratio: 2:1 Ratio of Liquidity

Another indicator of good management is how much cash flow a company has relative to its debt.

Has management overloaded themselves with short-term debt obligations and interest payments that could cause them to run out of cash?

Look at the balance sheet to find “current assets” and “current liabilities”. What you want to look for when evaluating a company is a 2:1 ratio of liquidity to debt or current assets to current liabilities. This ratio measures a company's ability to pay its short-term financial obligations.

There are a few scenarios where a good company has a liquidity ratio that is less than 2:1. They may have less cash flow, but manage it really well. They can be in an industry that isn't growing quickly, and so, they need less liquidity. Typically, these companies are big companies that give excess cash to their shareholders in the form of dividends. For newer companies, a liquidity ratio of at least 2:1 is incredibly important.

Warren Buffett once said,

“The best business to own is one that can employ large amounts of incremental capital at very high rates of return.”

That's exactly what a high and rising ROIC tells us—this business isn't just surviving, it's compounding shareholder value efficiently.

2. Sales Growth Rate

The Sales Growth Rate, also called the Revenue Growth Rate, is pretty straightforward. It is the rate at which the total revenue earned by a company is growing (or not) year over year.

✅Tip: When sales are growing at a healthy rate, the company is more likely to be profitable, and your investment is more likely to do well. As an investor, we want to see consistent growth over time. You can also use the sales growth rate to compare different companies in the same industry

The sales growth rate is calculated by inputting past annual sales figures into the calculator, going back 10 years, if possible.

For example, if a company's sales were $100,000 two years ago and $112,000 last year, its Sales Growth Rate would have been 12%.

You can use my Sales Growth Rate Calculator to easily calculate the average sales growth rate. Be sure to look for a positive growth rate of at least 10%. To find the total sales or revenue, look at the top line of the income statement, comparing the most recent year to the previous years.

When reviewing sales growth since 2020, be aware that some companies may show abnormally high or low growth due to pandemic disruptions. Rule #1 investors should normalize this by looking at 5-year and 10-year averages, not just year-over-year performance, to get a true picture of the company's growth engine.

3. Earnings Per Share Growth Rate

The third of the Big 5 Numbers is Earnings Per Share, or EPS Growth Rate. This number shows the trend of how much the business is profiting per share of ownership over a given time period.

EPS = “Net Profit” divided by the number of outstanding shares

You can find net income on the last line of the income statement and the number of existing stock shares with a simple Google search.

📌Important: What we're really concerned about is whether or not EPS is growing. So, you need to calculate the EPS for both the most recent year and the EPS from 10 years ago.

Then, plug these numbers into my Earnings Per Share Growth Rate calculator to get the average growth rate over the period of time. Once again, we're looking for an average of at least 10 percent. This growth should also be compared to the price-to-earnings ratio or P/E ratio for a more complete picture of the company’s valuation and growth potential.

4. Equity Growth Rate

The Equity Growth Rate shows you if a company's pool of equity has grown or gotten smaller, and by how much, over the long term.

Why do we care if a company's equity is growing?

Well, if a company's equity is growing year over year, it means it has enough surplus money (after paying its bills and interest expense) to invest in tools that stimulate future sales and business operations. A healthy equity growth rate can indicate a strong debt-to-equity ratio and effective use of total assets.

If a company's equity isn't growing, it means that it doesn't have the funds to spend on increasing its market presence or developing new products or intangible assets like intellectual property. If the latter is the case, Rule #1 investors don't want to invest in the company.

✅Tip: Look for companies where the equity growth rate is increasing at a rate greater than or equal to 10%.

Additionally, the equity growth rate and ROIC work together, so look for companies that have both a high equity growth rate and a high ROIC.

You can use my Equity Growth Rate Calculator to determine the average Equity Growth Rate over the past 10 years and get one step closer to seeing whether the company you're considering is a smart investment.

Also, look at how the company uses excess equity. Some companies increase shareholder value through share buybacks, which reduce the number of outstanding shares and increase the ownership value of each remaining share. When evaluating equity growth, consider both retained earnings and the company's capital allocation strategy.

5. Operating Cash Flow Growth Rate

The final financial metric to look at is the Operating Cash Flow Growth Rate. This measures the rate of growth of operating cash, which is the money that is actually coming into the bank from business operations.

📌Important: The operating cash flow growth rate is an important measure of the long-term financial success of the company.

Again, when considering whether to invest in a company, you should look for a positive operating cash growth rate that is at least 10%.

You'll want to look at the cash flow statement to find “operating cash flow” or “cash flow from operating activities”. You can then use my Operating Cash Flow Growth Rate Calculator to calculate the growth rate over time. The growth rate tells us if the cash is growing with the company's profits or if the profits are only on paper.

You are looking for real cash growth.

Once you've done that, you can also calculate Free Cash Flow.

Free Cash (Owner's Cash) = Operating Cash Flow – Capital Expenditures (purchases of property and/or new equipment)

Free cash is money that can be used to give to the owners of the company or to reinvest. This means stockholders like you and me can receive dividends from the company, or the management can take the money and use it to grow the company faster and faster. For example, if the company owns valuable assets, reinvesting can further increase value and support long-term growth.

🚨A key red flag to watch for is when operating cash flow is flat or declining while net income is rising. This can indicate earnings manipulation or poor cash conversion. As a Rule #1 investor, you want to see profits supported by real, growing cash.

How to Evaluate a Stock with These Financial Metrics

We use these financial metrics to evaluate the financial position of a company and determine if it would be a smart investment. They can reveal how solid a company is and if it will continue to grow in the future. While it may sound complicated now, the more you practice and the more familiar you become with financial statements, the easier finding and using the Big 5 numbers will become.

Before you start reading a company's financial statements, though, it's important to acknowledge that all companies can experience a dramatic change in their numbers in years when a Rule #1 “event” occurs. When evaluating a company, numbers from such years will be skewed so it's important to pull data from a “regular year”. This will give you a more accurate representation of the company's potential and business health.

This may be extra effort but understanding customer lifetime value and customer lifetime can also be important for evaluating companies. Most especially in sectors where repeat business and long-term customer relationships drive profitability.

Other Popular Investment Calculators

Beyond the Big 5 Numbers, there are a few other handy calculators that can really help sharpen your investing decisions. Let’s dive in.

Margin of Safety Calculator

As we talked about in the previous blogs, the margin of safety calculator shows you whether you should invest in a company given its current market price, or whether you should wait for the price to decrease.

The calculator determines intrinsic value based on a company's historic growth rate and on reasonable expectations of future growth.

I recommend buying companies when the market price is approximately 50% of the value.

📌Important: Smart investors want to minimize their risks. You can reduce your risk by making sure you have a substantial margin of safety whenever you invest in a company. Buying a company that is priced at a significant discount lowers the risk that the price will continue to decline after purchasing.

If the company you choose doesn't do as well as you expected, you'll still be protected from substantial losses because the price you paid was already low.

On the other hand, if the company you pick thrives and grows, then having a good margin of safety means your money gets boosted even more.

Rule #1 investors know the importance of being patient. If you buy a stock with a healthy margin of safety and wait patiently, chances are good that the stock price could rise to match the company's market value.

Market Capitalization Calculator

Use the Rule #1 market capitalization calculator to find the current stock price (not the value!) of a company.

What is Market Capitalization?

Often called the “market cap,” market capitalization is calculated by multiplying the share price by the number of outstanding shares. It shows what the company would cost if you bought all the shares.

Rule #1 investors know that the market capitalization does not necessarily reflect the actual value of a company. Smart investors look for companies where there is a gap between the share price and the company's intrinsic value.

As long as the company is a good company, this gap creates the buying opportunities that are one of the keys to the Rule #1 strategies for creating wealth.

Retirement Calculator

You can't make effective plans for your retirement until you know how much money you're going to need. The task may seem daunting because there are many factors that go into figuring out how big a nest egg you should be creating. This can even include tax reporting and projected investment returns.

How Much Do You Need to Retire?

The Rule #1 retirement calculator breaks it down for you and guides you through the process by showing you what you need to take into account. The calculator then tells you how much you'll need to start saving every year.

Once you have a specific number to aim for, then you can begin to make plans for how to accumulate and grow your savings. You'll gain peace of mind by knowing that you are saving enough to have the kind of retirement that you want and that you won't have to worry about your money running out.

Payback Time Calculator

Payback time is how long it will take you to get back your initial investment from the company's earnings, based on the company's past earnings per share and its rate of growth.

A good investment is one where you can recoup your initial investment from a company's earnings relatively quickly.

Use the Rule #1 payback time calculator and look for a payback time that is less than eight years.

🎯Key Takeaway: Using any of these calculations, you can:

• Pull ahead of all the investors who make their investment decisions based on emotions, such as greed and fear, or who follow the crowd, or who act impulsively on random stock tips.

• Avoid making all of these common investing mistakes, and instead will be able to consider the data that really matters as far as predicting how well an investment is likely to perform.

• Have a solid plan for retirement, and you'll know how to carry it out.

• Minimize risk, while keeping your eye on the long term success.

Valuation Metrics: Is the Company a Smart Investment?

Remember, making a smart investment is so much more than picking a company you like. You need to assess the financial health of a company using credible metrics. This includes financial ratios and valuation metrics so you can have confidence in its future success. Ultimately, the success of your investment.

The Big 5 Numbers are a huge clue as to whether or not you're looking into a business with good business health, is predictable, and can be trusted to deliver at least 15% year after year. It's not the only clue, though. Remember to evaluate a company first using the 4 Ms.

Once you've checked off all of the 4 Ms and all of the Big 5, you'll know whether or not the company's performance is smart to invest in. Whether you're looking at true investment opportunities.