Invest in What’s in Front of you: Important Metrics

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.

Valuation and Growth

Valuation and Growth


 Its okay to buy growth, just don't pay for it.

  Marty Whitman

This ties in closely to the idea of “Margin of Safety” and is more of a dynamic concept than most investors realize. Valuing a stock of a company depends on where the company is in its life cycle. It could be emerging growth (Micro Cap), growth (Small to Mid Cap and even Large Cap in some cases) or Value (Large Cap that has saturated its market and stopped growing). It could be a cyclical stock closely tied to vagaries of the business cycle. In my own investing my focus is on growth and  the small to mid cap area so that is what I’ll be discussing here. 

I've talked before about "buying cheap", which means buying a stock for less than its intrinsic value. The intrinsic value of a business is equal to all the cash it will generate in the future discounted back to the present time. The way I approach this problem is to focus on companies that have high rates of ROE and/ or ROIC that are currently trading at a low to reasonable P/E ratio and if they pay a dividend I want to see a low payout ratio. The pros deal with things like discounted cash flow analysis and the like but since I steal most of my ideas from the pros I don't bother with that. And I don't really believe that projecting cash flows out to 10 years in the future is a wise policy. Three years makes more sense to me. Just stick with the profitability ratios and a low P/E. I also look at Price to Operating Cash Flow as that metric has more Wager Value than the overused P/E. Operating Cash flow is also a much more difficult metric to manipulate, but use both of them when you can. Where do you see the profits of the company in the next three years? If things take off be prepared for an expanding P/E to compensate for the growth of the company. Another thing to remember is to try to use the forward P/E (based on next year's estimates) since we're dealing with growth companies.

There is more risk when investing in a emerging growth Micro Cap (under 100 million) but if you hit one that survives and prospers the rewards can be enormous. The key drivers to focus on in this area are the size of the potential market. It has to be huge to fuel the growth in revenues. As you move down the food chain in market cap, management becomes a more critical factor in the investment process. They have to manage the expenses of the growing enterprise as well as work on improving the profit margins of the company. If things grow too fast they can spin out of control very easily.  Access to capital is another key area and it helps a lot if the company has some key institutional investors behind it. and of course its needs above all a sustainable advantage over the competition in the form of patents, technology, growing network affects, distribution routes etc...

For larger growth firms (100 million to 2 or 3 billion) scalable growth with sustainable margins will come into play. you want companies that can diversify their product lines and cater to a wider customer base as they grow. Keep an eye on their profit margins. At this stage of the growth cycle revenue will begin to decelerate. The rate of deceleration will depend upon the size of the overall market for its products and services as well as the strength of the competition. The better growth companies will have their revenue growth decelerate at a slower rate. Management as always must steer the ship.

Remember focus on the profitability ratios and growing revenue streams. Are the companies adding value to their enterprise over time? When they stumble and miss their quarterly numbers, Mr Market will provide you an opportunity to make a good long term investment at a reasonable price.

A good little book covering this area of investing is The Little Book of Valuation by Aswath Damodaran.