We’re going to do something that’s hard for most people in today’s essay…
It involves some math. It involves thinking hard about rather abstract ideas. For most of you, it will involve learning new jargon, which is probably the hardest part. No, it’s not as hard as walking across a giant desert for 40 days.[ad#Google Adsense 336×280-IA]But it’s something most people will go to great lengths to avoid.
So let me tell you why you should first calculate these four things every time you buy another stock.
What you’ll find below is a nearly foolproof way to evaluate the quality and the value of any business.
This four-part test will allow you to quantify, with surprising precision, exactly what makes a given business great, average, or poor.
This knowledge will allow you to make vastly better and more-informed decisions about what any business is worth and what you should be willing to pay for it on a per-share basis. But that’s not the best reason to learn this four-part test…
The real secret is, once you develop the discipline to always do this work before you buy any stock, you’ll never make a quick decision to buy a stock ever again. Once you add something that’s hard to do, that requires a little bit of time, a little rigor, and a little discipline to your investment process, you’re going to greatly reduce the number of stocks you buy.
You’re also going to radically improve the quality of the stocks you’re willing to invest in because you’ll have the skills to do so. And that will eliminate more than 90% of your investment mistakes. Remember… you don’t need to find a great investment every month, or even every year. You just need to find them every now and then… and have capital ready to put to work.
As I explained yesterday, I believe the No. 1 thing you need to know to be successful as an investor in common stocks is what type of business makes for a great investment.
Investment legend Warren Buffett says the same thing. He puts it this way…
Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10, and 20 years from now.
So… what makes a great business? How can you be certain its earnings will materially grow over reasonable periods of time? To figure it out, let’s take one of Buffett’s most famous investments – Coca-Cola (KO).
Coke sells addictive (caffeine-laced) sugar water for more than the price of gasoline all around the world. It has integrated its brand into people’s lives through decades of advertising spending – an investment that has paid off tremendously. Coke has one of the world’s most universally recognized and admired brands.
But how do these advantages translate into hard numbers? The most obvious characteristic of a great business is high profit margins. High profit margins are proof of a great brand, a superior product, or some form of regulatory capture that permits greater-than-normal profitability. On every dollar of revenue last year, Coke earned nearly $0.25 in cash. And it brought in $46 billion in revenue.
To figure out exactly how much money Coke earns in cash, we simply look at the company’s cash flow statement, under the line: “total cash flow from operating activities.” We see that in 2014, this was $10.6 billion. (You can get this by looking at the company’s annual report, Yahoo Finance, or any number of other online databases, like Bloomberg. Here’s a link to Coke’s cash flow statement on Yahoo Finance.)
Next, we divide those cash profits by the company’s total revenue ($45.9 billion), which you can find on the income statement. Doing the math gives you a fraction that is commonly expressed in percentage form: 23%. Coke’s cash operating profit margin is 23%. It’s earning $0.23 in profit on every dollar it generates in sales. In our experience, businesses with cash operating profit margins in excess of 20% are world-class. If you were putting together a checklist, you could start there. A great business must have cash operating profit margins greater than 20%.
The next “mile marker” you’re looking for is something we call capital efficiency. This is another concept that, like profitability, is easy for most people to grasp. All you’re trying to understand with this test is how much capital the company requires to maintain its facilities and grow its revenues. For example, oil and gas companies are notorious for spending every penny they make on drilling more holes and building more facilities. Their capital-spending programs leave little of their profits to be distributed to shareholders (often less than zero).
We’ve developed a sophisticated way to measure, in precise terms, the capital efficiency of any business using several factors in our monthly Capital Efficiency Monitor – a part of our supplemental Stansberry Data service.
But you can use a much simpler equation as part of our four-part test of a great business. All you need to do is figure out whether the company in question distributes more capital back to shareholders… or spends more money “on itself” via capital-spending programs.
A great business is able to distribute more profits to its shareholders than it consumes via capital investments. Coke, for example, spent $2.4 billion on capital investments in its own business in 2014. It spent $5.35 billion on dividends and $2.63 billion on share buybacks in the same period. You can see that Coke is spending far more on its shareholders than it spends on itself. (By the way, all of these numbers are labeled clearly on the cash flow statement I linked to earlier.)
What’s powerful for investors about businesses like these is that you don’t have to depend on a “greater fool” to come along and pay you more money for your shares than they’re really worth. You don’t need lower interest rates or a raging bull market to be successful. As these businesses grow, they’re going to increase their payout amounts, year after year. It’s the compounding effect of this growth that will make you wealthy – not the misguided actions of foolish investors. That’s why Buffett says you should never buy a stock you wouldn’t be happy to hold for a decade, even if the stock market was closed.
The third part of our four-part litmus test for great businesses is return on invested capital. (Here comes the jargon.) Yes, it’s a mouthful. But I promise, with just a little practice, you’ll be able to easily calculate this figure in your head. We use this metric because there’s no purer way of determining the value and the power of a company’s “moat” – the degree to which the company is sheltered from profit-eliminating competition.
The business school formula for determining the precise amount of invested capital is complex and requires several different numbers (and judgments about each of them). It’s a pain. And there’s a much easier way to get a ballpark figure – just add the total amount of a company’s long-term debt and the total value of the company’s equity capital. You’ll find both numbers as simple line items on the balance sheet.
Coke has $30 billion worth of equity capital and $42 billion worth of debt (adding the current position of long-term debt to long-term debt). So in our book, the company has invested capital of $72 billion. On this capital last year, the company reported $7 billion worth of net income, or “earnings.” You’ll find Coke’s net income on the key statistics page, or you can look at the income statement directly. Once you have the numbers, you just do the basic math (seven divided by 72) to derive another percentage: 10%. As you’ll see, this is where Coke falls a bit flat. The beverage market is ultra-competitive and Coke’s brand only provides a small measure of protection against competitive pricing.
The last part of our great business test is also a bit “wonky” and will make you sound like a finance geek. It’s called return on net tangible assets. This number gives you the best overall measure of the quality of any business. It’s similar to the more commonly used return on equity (ROE) with two important differences.
First, measuring returns against net tangible assets takes goodwill out of the calculation. So companies with large amounts of goodwill (like companies with great brands) will typically show a much higher return. Second, this measure of quality rewards companies that can borrow most of the capital they need because their results aren’t cyclical.
Calculating this number is also really easy. Yahoo Finance lists “net tangible assets” among its balance sheet statistics. All you have to do is compare this number with the company’s net income for the last year. In Coke’s case, net tangible assets total only $3.9 billion. Coke earned a profit equal to 179% of its net tangible assets – a truly outstanding figure.
(Note: In some cases, a company will actually have more liabilities than it has tangible assets. In those cases, the math you see above no longer works because you can’t divide using a negative net tangible assets figure. When that happens, we’ll subtract out only the long-term portion of total liabilities. This provides a more meaningful number, while still measuring the company’s ability to safely replace equity with debt in its capital structure.)
Putting all of these factors together, our test of business greatness starts with profits. How much money, in cash, does a business earn from its operations, expressed as a percentage of its sales? The higher the margins, the better. This tells us that the company owns high-quality brands and products, and market position. We expect great businesses to produce cash operating margins of at least 20%.
Our second test is capital efficiency. Does the business produce substantial amounts of excess capital, and does management treat shareholders well? We test this by seeing whether shareholders receive at least as much capital each year as the business reinvests in itself.
The third test is return on invested capital, which is the best measure of a company’s moat. Here again, we would expect to see returns on invested capital of at least 20% to qualify as a great business.
Finally, our last measure of great companies – return on net tangible assets – is the single best overall measure of the quality of a business. It combines brand value, capital efficiency, the quality of earnings, etc. No surprise, we expect returns on net tangible assets in excess of 20% annually.
Business quality is extremely important, but the stock price is equally important for investment outcomes. Our best advice is to value high-quality businesses by the amount of cash they earn before interest, taxes, depreciation, and amortization. In finance jargon, this measure of profits is called “EBITDA.” You can’t use this measure with lower-quality businesses, but it works well for high-quality businesses because it allows you to quickly judge companies in different industries against each other.
Now, let me show you a trick that will show you when to buy a high-quality company. We try to avoid paying more than 10 years’ worth of EBITDA per share when we buy a business. We measure the cash earnings against the enterprise value of the business (the value of all of the shares and all of the debt, minus the cash in the business). But you don’t need to do all of this work yourself. You can find this multiple on Yahoo Finance on the key statistics page for any given stock. Valuing businesses is a lot more difficult than evaluating their performance. You should be willing to pay more for a high-quality business that’s growing.
Below, you’ll find nearly 40 different companies we consider great businesses, according to their results over the last three years. Roughly half of these companies are trading at or close to reasonable prices. Not including the valuation figure (No. 5), the numbers below were compiled using the last three years of operating metrics, so these numbers may look a little different than the ones you calculate at home, if you’re only using current figures.
The Four-Step Test of Greatness:
No. 1. Cash operating profit margin: cash from operations / revenue (should be greater than 20%).
No. 2. Shareholder payout ratio: capital returned to shareholders / capital expenditures (should be greater than 1).
No. 3. Return on invested capital: net income / long-term debt + shareholder equity (should be greater than 20%).
No. 4. Returns on net tangible assets: net income / net tangible assets (should be greater than 20%).
No. 5. Share price multiple: enterprise value / EBITDA (ideally less than 10).
Source: Daily Wealth