Chapter 6:

# How to Evaluate a Company

## Important Financial Metrics and Investing Calculators to Analyze Stocks

In the last chapter, we 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 market and hope for the best.

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.

1. First, we evaluate a company based on the 4 Ms (which we did in the last chapter).
2. Then, we evaluate the financial position of a company using the Big 5 numbers.

And, step #2 is exactly what we will cover in this chapter. 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 and 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.

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 numbers.

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.

### 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. It is the single most important measure of whether a business is being run well, and it 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 assessment should be considered in light of the ROIC, which will give you an objective and quantitative measure that shows whether a company is succeeding financially.

Because the ROIC will vary from company to company and from industry to industry, the ROIC is a useful measure for comparing different companies to each other within an industry, and for comparing entire industries to each other.

#### 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 income statement look for “net profit” 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.

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

#### 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.

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 to each other.

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 and be sure to look for a positive growth rate of at least 10%. To find total revenue of sales, look at the top line of the income statement, comparing the most recent year to the previous years.

### 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 profit on the last line of the income statement and the number of existing stock shares with a simple google search.

Important: 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 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.

### 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) 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.

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.

### 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 I can receive dividends from the company, or the management can take the money and use it to grow the company faster and faster.

The Big 5 Numbers Cheat Sheet

Save this guide to financial metrics and calculator for later to help you evaluate all your future investments

## 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 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.

Now outside of the Big 5 Number, there are a few other helpful calculators that you may want to check out that can assist in all kinds of calculations from how much you need to retire to how long it will take you to make you’re money back.

Let’s check them out!

### Margin of Safety Calculator

As we talked about in the previous chapter, 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 lower.

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 lower after purchasing.

This protects you from large losses, even if you happen to make a mistake in choosing your investment. 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 value. If that happens, and you bought the company at a price that was half-off the value, the money you invested can double.

### Market Capitalization Calculator

Use the Rule #1 market capitalization calculator to find the current 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 shares. It shows what the company would cost if you bought all the shares.

Rule #1 investors know that the market cap 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. That creates an opportunity to buy companies “on sale.”

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.

#### 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, including your expected cost of living after retirement, how much money you’ll have available to invest when you retire, and how many years you want your retirement funds to last. 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 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 picture.

## 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 financial metrics so you can have confidence in its future success, and thus, the success of your 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.

The next chapter will teach you how to purchase your first stocks – so if you’re getting excited to start, read on!

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