Two metrics to assess a business
Use these two metrics to know how good a business for you to invest in it.
If you were to start a business, the utmost priority is to make profit and profit maximization. Every action that the business takes is guided towards that.
Profits or the future prospects of maximizing profits will bring in more investors and also these profits will help grow the business to produce even more profits.
So when you are looking for a business/company to invest, you should look for companies which earn more and likely to continue to earn more in the future.
Hence, As discussed earlier, no stock price will ever outgrow the earnings of the underlying business. The stock price might move up and down depending on the animal spirits of the market, but it will find its way back to the earnings it’s business is making.
Deduced, your focus must be on the earnings of the business but not on the movement of the stock price.
But you need companies which can make profit in the future as well. To know if a company is really keen on making profits in the future, you can check what actions the company is taking to make more profits or increase its earnings in the future as well.
Since numbers are readily available than any other information, and numbers give us the best approximation or speak the results correctly than the words said in public to appease. We will go with the numbers available from the balance sheet of the company.
You have two good metrics to understand how a company is planning to increase its earnings and stay profitable in the future as well. They are Revenue Growth and ROCE - Return on Capital Employed.
Let us try to understand what these are and why these two metrics give us the best information about a company’s possible future earnings.
ROCE - Return on Capital Employed:
ROCE is a metric that measures the efficiency of capital deployment for a company.
A company deploys capital in assets, which in turn generate cash flow(cash transferred in and out of a company) and profits. ROCE is to assess how good the employed capital is generating profits for the company.
ROCE is calculated as a financial ratio of Earnings before interest and tax in the numerator (EBIT) and capital employed(sum of debt liabilities and shareholder’s equity) in the denominator.
ROCE = EBIT/Capital Employed.
The higher the ROCE, the better is the company’s efficiency of capital deployment.
For not going into the details of EBIT and Capital Employed now, you can think of EBIT as how much a company earns on operations alone without the interest on debt or taxes and Capital Employed is similar to the capital invested in the business.
Back to ROCE, as a thumb rule, look for companies which has minimum ROCE of 15 percentage for a company operating in any of the developing economy like India.
If a company has ROCE more than 15 percentage, then it is worth further analyzing it, but if a company has ROCE less than 15 percent, then don’t mind giving it a pass.
Revenue Growth:
Revenue Growth is a metric to know how the revenue as increased over a period of time.
Revenue Growth is relative, and it is the rate of increase in total revenues divided by total revenues from the same period in the previous year.
Here, you are comparing the previous period’s revenue with the current period’s revenue. If this is usually done on an annual basis.
You can consider sales growth in place of revenue growth, as both are indicative of the change in revenue of a company at a given period of time.
More the increase in sales or revenue, more the profit, the company is going to make.
As a thumb rule, look for companies which has a revenue/sales growth rate of 10 percent every year from the past 10 consecutive years.
For a company, in a developing economy like India, the revenue/sales growth is expected to be a minimum of 10 percent a year as the economy itself grows at a nominal rate of 12-14 percent a year.
The higher the increase in revenue growth, the better the profits for the company.
To conclude, you must look out for companies which deliver good earnings and stock price will not give us the returns that the earnings made by the company.
ROCE and Revenue Growth are two good metrics to understand the earnings and future prospects of profit making of a company.
Until next time.
Peace out!