A lot of people simply pick stocks based on what the news is saying about them or if they like the company. There’s a lot wrong with this method, mainly that it doesn’t evaluate the financial position of a company.
Financial metrics are key to determining whether or not a company is worth your investment and will make you money down the line.
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.
First, we evaluate a company based on the 4 M’s (meaning, management, moat, and margin of safety). Then, we evaluate the financial position of a company using the Big 5. That’s what we’re going to cover today.
The Big 5 Numbers are five important financial metrics that help determine whether a business can provide, at least, a 15% return each year. That’s what we’re after as Rule #1 investors.
They 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.
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, even, to begin, the Big Five Numbers will help.
Calculating these financial metrics will give you a big clue as to whether or not you’re looking into a business that is predictable and can be trusted to deliver great returns year after year.
Once you know where to look, the Big 5 are easy to find and easy to calculate. We will use the company’s financial statements: the balance sheet, income statement, and cash flow statement, to find and calculate these numbers.
We’ll get into how to calculate each of these key financial metrics below and what each of them can tell you about the financial health of a company.
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.
1. Return on Investment Capital
The first of the Big 5 Numbers you should look at is Return on Investment Capital (ROIC). This is the rate of return a business gets on the cash it invests in itself every year. It tells you if a business is being run well or not.
So, if a company doesn’t have a healthy ROIC, that is, equal to or greater than 10% each year on average over the last 10 years, then it’s not worth your time.
You also want to make sure that, on average, the ROIC is going up over time. This indicates that management is achieving better returns year after year.
To determine a company’s ROIC, you’ll first have to locate its income statement. On the income statement look for “net profit” and “invested capital”.
ROIC = Net profit divided by invested capital
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.
2:1 Ratio of Liquidity
Another indicator of good management is how much cash a company has relative to its debt.
Can the company you’re looking at pay back everything it needs to in the next year or has management overloaded themselves with short-term debt and obligations 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.
There are a few scenarios where a good company has a liquidity ratio that is less than 2:1. They may have less cash but manage it really well, or 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.
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 money earned by a company is growing (or not) year over year.
For example, if a company’s sales were $100,000 last year and $110,000 this year, its Sales Growth Rate would be 10%.
You can use my Sales Growth Rate Calculator to easily calculate the average sales growth rate for the past 10 years, or however far back you can find data for the company you are evaluating.
To find total revenue or sales, look at the top line of the income statement, comparing the most recent year to the previous years.
This metric is a good indication of if the company is growing. As an investor, we want to see consistent growth over time because we hope the company will continue to grow and be more productive so that we experience a return on our investment.
3. Earnings Per Share Growth Rate
Number 3 of the Big Five Numbers is Earnings Per Share Growth Rate, 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 profit on the last line of the income statement and the number of existing stock shares with a simple google search.
But the math doesn’t end there. 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 for 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 at least an average of 10 percent.
4. Equity Growth Rate
The Equity Growth Rate is the rate at which a company is growing its equity or its net worth. 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) to invest in tools that stimulate future sales.
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. If the latter is the case, we Rule #1 investors don’t want to invest in the company.
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.
5. Operating Cash Flow Growth Rate
The next and 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.
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 (or 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 I can receive dividends from the company, or the management can take the money and use it to grow the company faster and faster.
How to Evaluate a Stock with These 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 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 Rule #1 Events occur.
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.
Is the Company a Smart Investment?
The Big 5 Numbers are a huge clue as to whether or not you’re looking into a business that 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 everything you need to know to decide whether or not to invest in a company.
When you’ve done that, you’re ready to buy. Follow my beginner’s guide on How to Buy Stocks once you reach this point.
Always Assess These Financial Indicators
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 financial metrics so you can have confidence in its future success, and thus, the success of your investment.
These numbers will help you understand how well the management handles the money it has, if the company is growing, and if the company produces enough cash to continue growing.
All of these components will influence how much of a return you can expect in the future.
If you’re eager to learn more about investing in stocks the right way, join me at my next webinar, where I’ll cover all of this and more.
If you can’t make it, download my guide to investing in stocks and continue on your journey to finding wonderful companies that will bring you wonderful returns.
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.