Friday, May 7, 2010

Evaluating a Good Business

Historically, stocks have provided the highest returns of any asset class over most extended periods of time. It is also widely known that individual stocks can be extremely volatile over the short term, thus the general conviction that "stocks are risky." It makes sense however that if you have a long investment horizon and are able to endure the daily, monthly, and even annual price fluctuations, your portfolio should be primarily comprised of equities. Here is the first of some basic principles that should be followed when selecting individual stocks.

Is It a Good Business: High Return on Invested Capital

Stocks are not simply floating ticker symbols with moving prices. They represent ownership stakes in companies. As such, you should be looking for companies that are able to consistently generate a lot of free cash (i.e. profits left over for the owners) relative to what the stock and bondholders have invested in the business. This metric is also known as the return on invested capital. In order to calculate this return, simply divide the free cash flow (excluding any irregular or nonrecurring capital expenditures) by the sum of the total shareholder's equity and the interest-bearing liabilities.

ROIC = Free Cash Flow / (Shareholder's Equity + Interest-Bearing Liabilities)

If these cash flows are consistently upward of fifteen to twenty percent of invested capital, then you are probably looking at a good business. If the company is regularly blessed with much fatter returns, then you likely have a great business on your hands. Furthermore, it would be ideal to see those returns on invested capital increasing year over year. This is a sign that management can deploy incremental capital at higher and higher rates of return.

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