How I rate a company - Part 2

In part 1 , I listed 12 criteria I use to rank all the companies I analyse, based on their historical performance. In this post, I’ll discuss each of the points and why I see them as important.

1. Average historical return on equity (ROE)

ROE is an indicator of how much profit a company is making based on the funds shareholders have contributed to the company. The better companies will obviously make more profit with less equity.  This is an indication of how good management is, how good the business is and how capital-intensive the business is. High levels of debt funding can skew ROE, so its important to consider ROE in conjunction with net debt to equity levels. I use the historical average to smooth out cyclical issues.

2. Average historical return on assets (ROA)

ROA is an indicator of how much profit a company is making on the assets it holds. Companies with higher ROA are preferred. As an example, if I have $100m in assets and I’m making $1m a year in profit, that’s obviously not as good as someone with $10m in assets and also making $1M in profit. (Theoretically, if they had the same assets as me (10 times more than them) , they could be making 10 times more profit).

3. Current net debt to equity ratio (Net Debt / Total Equity)

This ratio compares how much debt the company has borrowed compared to amounts of funding sourced from shareholders. Higher levels of debt can indicate that the company may face difficulty repaying that debt, if the business comes under pressure, such as during the Global Financial Crisis (GFC). Banks may be unwilling to rollover debt, or ask for it to be repaid, or roll the debt over but at much higher rates of interest. Companies with very low levels of debt to equity usually wont face this issue.  So this ratio is an indication of the company’s short-term viability, and likelihood of surviving a financial crisis.

4. Current free cash flow to operating cash flow

This measure indicates how much cash the company actually brings in after capital expenses are met. It’s an indication of how capital-intensive the business is. Generally you want to avoid capital-intensive businesses, as they need to spend most of their profits / cash flow on maintaining their assets. Steel  manufacturing and newspaper companies are examples of capital-intensive businesses.

5. Average historical shares growth

High increases in the number of shares generally indicates that the company is raising more equity from shareholders, either requiring the investor to put more capital into the business, or dilute the investor’s shareholdings. High levels of shares growth can indicate that the company has faced financial difficulties in the past, and these may occur again in the future. I generally look for low levels of shares growth.

6. Current interest cover

This is an indication of the company’s ability to meet its interest payments on its debt. If the company has no debt, then this is a non issue. Low levels of interest cover could indicate that the company may face financial difficulty. It can also indicate that the company has too much debt, and may be at risk of financial distress.

7. Current EBIT margin

This compares the leve of EBIT  to Revenues. This is a subjective measure, as different sectors have higher or lower margins. As an example, food retailing is a low margin, high turnover business, so it makes sense to compare the EBIT margin to companies within the same sector. Having said that, if any companies EBIT margin is very low (2 or 3%), this can indicate a company under pressure, with little or no competitive advantage. Higher EBIT margins are what I look for.

8. Return On Incremental Capital Employed (ROICE)

This measure compares the current profit on capital employed to profit on capital employed historically. (Capital employed is total debt plus shareholders equity). A positive value means that the company is earning a higher level of profit now than in the past, which is positive growth. Most companies have positive growth, but its the level that I like to look at. Some companies have only increased profit on capital employed by less than what you can earn in the bank, so you obviously want to avoid those companies. Some companies have increased their profits at the same time as reducing their capital employed, which gives them a great ROICE value.

9. Compound annual earnings per share (EPS) growth

I generally don’t like to use EPS to determine how good a business is. EPS can be manipulated by companies with no regard to the underlying performance of the business. However, measuring the EPS growth over several years tends to eliminate those factors. It’s a useful measure to compare against PE ratios, as in theory the PE ratio is an expectation of the future EPS growth.

10. Compound annual dividend growth

If a company pays dividends, then the fact that it can grow dividends over the years is a good sign that the company has been consistently profitable. That is a sign of a good business.

11. Stability in EPS growth

This measure indicates if the company is consistent, and stable which is a good sign. If the measure is low, it’s a good sign; if the measure is high, it can indicate that the company is cyclical or inconsistent. It can also show how good management are. Massive increases in shares will affect EPS, sudden drops in profit and impacts of abnormal items are examples of factors that can adversely affect this measure.

12. EBIT Margin Growth

This measure indicates if the company has some competitive advantage, by being able to increase the margins on its products at no additional cost. Likewise, a decrease can indicate a company losing market share or its competitive advantage.

So there you have it. My list of factors for assessing companies. It’s not a definitive list by any means, but hopefully it captures most of the important aspects of a company’s financial performance.

Note that these measure are mainly applied to industrial type companies and not to banks, insurance companies, property trusts or speculative resources companies.

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