Invest in What’s in
Front of you: Important Metrics
As a follow up to my previous post I want to say that I try
to invest in what’s in front of me. When I wrote about “the marginal utility of
information” awhile ago I listed seven things I look at when I’m investigating
a company. Four of the items were financial metrics (revenue, free cash flow, return on invested capital and operating margin) while the other three were
about placing those numbers in the specific context of the companies business model, the industry structure the company operates in as well as the capital allocation ability of its management. All of this information is available in the companies annual report. The Morningstar website is a good source of this information as well, especially for the financial numbers of a company.
Let's break down the financial metrics one at a time. One thing I should mention. You should always look at the numbers over a period of years. This is referred to as trend analysis. You want the numbers to steadily increase over time and if they don't you want to read about the companies operating history to find out why? You may even have to refer to previous annual reports...sorry.
Revenue represents the cash and promises to pay from customers for either services provided or goods delivered over the past year or quarter. It indicates how much business the company is actually doing. You want to see revenues grow over time as this is the engine for the company to grow and prosper as an ongoing business.
Free cash flow is what is left over after the company has paid all it's bill and expenses. They can raise the dividend, pay down debt, make acquisitions, buy back shares, invest in research and development and/or hire new and skilled employees. It is the ability of a company to self-fund making them less reliant on debt and raising additional equity. It makes them more self reliant. If the corporation's ongoing operations are consuming more cash than they produce it makes them more vulnerable to their creditors and places them at a competitive disadvantage to other companies in their industry.
Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.
Operating Margin reflects how well a company can control its costs. the higher the margins, the better the cost containment and the higher the profits will be. It indicates how well a company is running its entire business from an operational standpoint.
Taken together theses metrics will indicate which companies are operating more efficiently for the benefit of their shareholders. The CFOs of these corporations will have the financial flexibility to build the company over time by increasing dividends, investing in R&D (constant innovation helps keep them ahead of their rivals) and make strategic mergers and acquisitions (helping the company to grow its market share and pricing power).
As everybody has access to these numbers you will often find the stocks of these companies priced to perfection. Sometimes its worth investing in them anyway but it often makes more sense to wait for a decline in the entire market. The forced selling that occurs during that time can put these stocks temporarily on sale for the value investor to take advantage of. Another investing opportunity can occur when a good company misses it quarterly numbers causing its stock price to be punished and driven down. A small cap company can sometimes have these good metrics and be overlooked just because of it's size offering the investor another chance to buy an under valued asset.
In my next post I will finish up with the three remaining items that place the financial metrics of a company within the context of a companies business model etc.....whew.
Let's break down the financial metrics one at a time. One thing I should mention. You should always look at the numbers over a period of years. This is referred to as trend analysis. You want the numbers to steadily increase over time and if they don't you want to read about the companies operating history to find out why? You may even have to refer to previous annual reports...sorry.
Revenue represents the cash and promises to pay from customers for either services provided or goods delivered over the past year or quarter. It indicates how much business the company is actually doing. You want to see revenues grow over time as this is the engine for the company to grow and prosper as an ongoing business.
Free cash flow is what is left over after the company has paid all it's bill and expenses. They can raise the dividend, pay down debt, make acquisitions, buy back shares, invest in research and development and/or hire new and skilled employees. It is the ability of a company to self-fund making them less reliant on debt and raising additional equity. It makes them more self reliant. If the corporation's ongoing operations are consuming more cash than they produce it makes them more vulnerable to their creditors and places them at a competitive disadvantage to other companies in their industry.
Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.
Operating Margin reflects how well a company can control its costs. the higher the margins, the better the cost containment and the higher the profits will be. It indicates how well a company is running its entire business from an operational standpoint.
Taken together theses metrics will indicate which companies are operating more efficiently for the benefit of their shareholders. The CFOs of these corporations will have the financial flexibility to build the company over time by increasing dividends, investing in R&D (constant innovation helps keep them ahead of their rivals) and make strategic mergers and acquisitions (helping the company to grow its market share and pricing power).
As everybody has access to these numbers you will often find the stocks of these companies priced to perfection. Sometimes its worth investing in them anyway but it often makes more sense to wait for a decline in the entire market. The forced selling that occurs during that time can put these stocks temporarily on sale for the value investor to take advantage of. Another investing opportunity can occur when a good company misses it quarterly numbers causing its stock price to be punished and driven down. A small cap company can sometimes have these good metrics and be overlooked just because of it's size offering the investor another chance to buy an under valued asset.
In my next post I will finish up with the three remaining items that place the financial metrics of a company within the context of a companies business model etc.....whew.
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