Financial Metrics and Ratios

Financial Metrics and Ratios

I’m a growth investor with a value bent so I want to buy growth but I don’t want to pay for it. That being said I want to focus on the metrics of a company that shows me it’s growing and becoming a larger more profitable enterprise. As always I try to keep things simple. I prefer to look at the operating metrics of a company first and let things fall into place after that. The following is a list of metrics that I like to see growing over time.

Revenues

Operating Income or (EBIT, earnings before interest and taxes)

Operating Margin                               (gross profit - operating expenses)

Operating Cash Flow

Book Value per Share                          

Free Cash Flow                                     (operating cash flow – capital expenditures)

Free Cash Flow per Share

Return on Invested Capital (ROIC)

Return on Equity (ROE, the Dupont formula which breaks ROE down into three components…

1)      Net Margin                    (net income / sales)

2)      Asset Turnover              (sales / assets)

3)      Financial Leverage        (assets / equity)

I also check to see if the company has retained earnings on its Balance Sheet. This allows the company to re-invest in their business for future growth. As I prefer smaller to mid cap companies I’m looking for scalable growth. I don’t want them growing too fast although that can be a good opportunity to get into a great situation early but it also increases the risk of the company getting ahead of itself and blowing up so you have to be careful.

Don’t get hung up on the precision of the numbers, they are only there to put you in the ballpark. Remember they are based on a lot estimates and assumptions on the Income Statement and the Balance Sheet.  The numbers should be your servant not your master. Following the trend in metrics like operating income, operating margin, operating cash flow, book value per share and return on invested capital can tell you a lot about the growth prospects of a company. (cannibalizing my own stuff already)

Management is especially important in a smaller company. Not only do they have to grow the revenues of the business, they also have to control the costs and risks of growing those revenues. They are responsible for allocating any surplus capital in order to expand the business of the company as well as negotiating financing needs with third party entities.So management is important. You might want to read about the CEO, CFO and maybe about some of the directors on the board as well. Now if I could only follow my own advice.

I guess that’s all for now. This was only meant to be a quick overview of a rather large subject. I’ll post more about financial ratios in the future. The learning process never really stops once you get your nose into this stuff. But if you like it, its fun and in the end empowering as you are developing a skill set nobody can ever take away you from.

ROIC is the after tax operating income relative to the capital invested in the firm, where capital is defined as the sum of the book value of debt and equity, net of cash and marketable securities.

ROE relates profits to the equity investor (net profit after taxes and interest expenses) to the book value of the equity investment.

These are profitability ratios which show how much value management is adding back to the company over time. Probably, two of the most useful ratios in all of investing.

The growth of book value or equity per share is a key item as it shows that the value of the investment dollar of the equity holder is increasing and therefore creating additional wealth over time.

Books and Resources

The Edgar Online Guide to Decoding Financial Statements by Tom Taulli

Financial Intelligence by Karen Berman and Joe Knight