This is my version of technique to select a "good" company. Some may call this "value investing" or the intrinsic value behind the company. There are 4 areas: profitability, safety, valuation and growth.
Profitable :
(1) ROE >15%
(2) Net profit >10%.
Safety :
(1) Cash flows from operating activities / Net income > 50%
(2) Free cashflow >0
(3) Debt-to-equity ratio < 0.5
Valuation: ???
Growth: Compound revenue growth rate(CAGR)>10%.
(Note: This book use "Business", "Management", "Numbers" and "Valuation" Personally, I strongly agree that qualitative analysis of a company is important, but this should come after quantitative analysis, i.e. after use number to filter out non-performing companies.)
Some explanation:
(1) ROE: Return on equity=Net Income/Shareholder's Equity. Company's money come from 2 sources: Loan from bank etc(call debt) or share holders' money (call equity). So, this measure how much you can get from the company you invested. 15% means if you invest $100, $15 is the profit company generated by using your $100.
(2) Net profit %: How much profit company generated at the end of each period. 10% means if the revenue is $100, company can get $10 at the end.
(3) Cash flows from operating activities / Net income : these two figures can get from Cash Flow Statement. This measures how much cash the company can collect compare with money earned. Company can earn $100 but it may not collect $100 cash. The cash it can receive back is also important. Analyse 5 years trend.
(4) Free Cashflow : "Cash flows from operating activities" minus "Cash flows used in investing activities". This is to check whether company like to burn money. If this is negative, that means company invests more on what it earns for that period. We should analyse about 8 years trend (about 1 economy cycle).
(5) Debt-to-equity ratio: Company will not bankrupt if it owe share holders' money but definitely in deep shit if cannot pay bank money(debts). So, this ratio is measuring how heavy a company relies on debts. Higher means riskier.
(6) Compound revenue growth %: an average growth rate over a period of several years. You can use Revenue, Net profit, EPS or operational cash flow. Formula = (FV / PV) ^ 1/n -1. FV : current year value. PV : Previous year value. n: no of years between FV and PV.
A good company must be profitable in its core business. Why core business? Sometime company may earn a lot when strike Toto but it may not strike Toto every year. So, we need to understand where the profit come from. Other one-off profit may be: gain from selling land/building/assets, tax gain, one-off investment gain etc. There are much more "window dressing" method that can make the annual report look nicer, it needs skill to detect it.
Did you notice I skipped the valuation part? Many book will teach you valuation technique like Dividend discount model(DDM), Net Asset valuation, Margin of safety etc. Personally, I think buying price or selling price should based on technical analysis and understanding the economy. Simply because all these calculation won't warn you if economy crisis is coming.
The indications above are just some basic measurements. The more you understand the company, the well-verse and more confident you will be. One last important point, when analyzing a company, we should analyse a few years and see the trend. A stable company should have stable performance over time.
I will share step by step method on how to choose a "good" company in next post.
You may read more on this book :財報狗教你挖好股穩賺20%
(website: http://statementdog.com/)
or book: Value Investing In Growth Companies: How To Unearth High Growth Businesses & Generate 40% To 400% Investment Returns
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