Decode Investing | Part 2 | How to identify a wonderful business

To avoid losing money in the stock market, we should only invest in wonderful businesses. As value investors, we want real evidence that a business is wonderful, not just a good story. Therefore, we always start by looking at a business’s financial history dating back multiple years. A good rule of thumb is to only invest in companies that have been around for at least 10 years, which allows us to analyze 10 years of their financial history and make a good, informed decision on whether the business is wonderful or not.

The Management Team Performance

The first thing value investors look at is the performance of the company’s management team over the last 10 years. This is very simple to determine; we only need to look at the company’s ROIC or ROE numbers. If the numbers are consistently above 10%, we know that the management team is doing a great job. Consistent and growing numbers are a positive sign for the company’s future.

ROIC stands for Return On Invested Capital. This number tells us how well the management team is reinvesting the business’s proceeds and the kind of returns they are making. If the numbers are consistently negative, it means that the management team is doing a bad job running the business. This is a red flag; value investors always want to see consistency.

If the ROIC is not available, we can use ROE (Return On Equity) as a proxy, which tells us the return on the shareholders’ equity. Just like ROIC, this number is also an indicator of the management team’s performance. We should look at the company’s ROE for the last 10 years, and again, we want it to be consistently above 10%.

It is important to note, however, that ROE does not include debt, so it’s possible for a company to have a high ROE simply because of debt. ROIC is a much more telling number, because debt is included in its calculation.

Determining whether a business has wonderful financial performance doesn’t require too much effort; it will easily stand out, so we don’t have to over analyze it. If a business has remarkable fundamentals, it should be almost immediately obvious.

Where to Find ROE and ROIC Numbers

If you look up a company on our site here, and scroll down to the Key Historical Financials section, you will see its ROE and ROIC numbers for the last 10 years (and we are continually improving our data). You can also find these numbers on some paid sites, such as Phil Town’s Rule One Toolbox and GuruFocus.

Don’t Forget about Debt

Too much debt is dangerous; any business with a lot of debt could suddenly run into crisis during an economic downturn. Ideally, a wonderful business would have $0 in debt, but a small amount is acceptable. We are not overly concerned about short-term debt (i.e. debt that is expected to be paid off within a year); our concern is with long-term debt only. Long-term debt is considered manageable if it can be paid off within three years from the free cash flow the business generates.

Let’s say a small business makes $100,000 in revenue and generates $30,000 in free cash flow per year, and it has a long-term loan of $60,0000 that needs to be paid off in seven years. This level of debt is reasonable, since the business can pay it off in two years with the free cash flow it generates. (Note that a public company is much more stable than a small business, so this level of debt would be even more reasonable.)

To determine if a company’s level of debt is reasonable, we divide the long-term debt by the free cash flow. If the result is equal to or less than 3, then that level of debt is reasonable. If it is greater than 3, that is a huge red flag.

If free cash flow (FCF) data is not available, we can use cash flow from operations (operating cash flow) as a proxy. The advantage of operating cash flow is that it’s easy to find on a Cash Flow Statement. FCF is not on the cash flow statement; it needs to be calculated by finding the capital expenditure value and subtracting it from the operating cash flow.

FCF is the discretionary cash left over after the business has reinvested capital short-term to fund its operations. It is the value you will use to determine the business’s true cash flow. Operating cash is similar, but it contains some noise, as it includes capital expenditures (CAPEX). If a business has $10,000 in cash flow from operating in a year (operating cash flow) but has to re-invest $9,000 every year to continue running the business, then its true FCF is only $1,000, not $10,000.

When you look up a company on our site, navigate to the Key Historical Financials section, where we have a column called Debt Pay Off. This column shows the number of years it will take the company to pay off its long-term debt with its free cash flow (which is calculated by dividing the long-term debt in the LT Debt column by the Free Cash flow).

The Big 4 Growth Rate Numbers

Next, we want to determine if the business has a strong competitive advantage, also known as a durable moat. If you understand a business, you can probably already tell if it has a durable moat, but to accurately calculate its strength we have to look at the financial records. When a business truly has a massive competitive advantage, it is immediately obvious from taking a quick look at its historical financial data, particularly its Big 5 growth numbers: revenue, operating cash flow, EPS, and book value.

We are not so interested in the specific numbers here, but rather the rate at which these numbers are growing over time. This will help us predict the growth rate of the entire business later. The more years of financial data we have, the more accurately we can predict the business’s growth rate. Businesses do not remain wonderful forever; they have their prime years, and though these can last for decades, they do come to an end at some point. Ideally, we want to buy a business during its prime years when it is still wonderful, and even better if it’s still growing. The Big 4 numbers will tell us if a business is in its prime years or not, and the safest bet is to analyze 10 years of financial records (less than five years of financial data is not enough).

The first number to consider is revenue, which is the total amount the business made from sales or services. We start here because it is a simple metric. We don’t care about the actual numbers, only their compound annual growth rate (CAGR). We want to see the rate at which this business is growing its revenue per year and look at its ten-, seven-, five-, three-, and one-year CAGR. We consider the numbers good if they are all at least 10% or higher.

The next number we want to look at is operating cash flow. Again, we don’t care about the actual cash flow numbers here, just the rate at which the business is growing its cash from business operations. We want to see the CAGR of operating cash flow for the last 10 years.

Next, we want to look at the business’s EPS growth rate. EPS indicates how profitable the business is by telling us what it earns for every share. (If you own a company, EPS is what the business is earning for each share you own.) We want to look at the rate at which this business is growing its earnings per share, and we only care about the compound annual growth rate, not the actual EPS numbers.

The last number we have to look at is the equity growth rate, and it is the most important. Equity, also known as book value, is what is left for the shareholders if the business ceases operation today. We don’t care so much about the actual equity numbers, but the rate at which the business is growing its book value (CAGR) over a 10-year period. An alternative number to use in place of equity is book value per share (BVPS); either number that is available is fine for this calculation.

For all the growth rate numbers (revenue, operating cash flow, EPS, and Equity), we only need the CAGR for the past one, three, five, seven and ten years. If the business has a very strong competitive advantage (or a durable moat), all these growth numbers will be at least 10% or above. This is an important factor we look for when determining if a business is wonderful.

Where to Find the Big 4 Growth Rate Numbers

All of these numbers are available on our website. When you look up a company, scroll down to the Historical Growth Rate section. If the numbers are consistent and growing, it’s a good sign that the business is predictable and has a durable moat. If the growth numbers are all above 10%, this is very solid evidence that a business has a solid competitive advantage. Even without understanding the business, we can get an overall sense for it from its financial performance. However, we always want to make sure we fully understand a business before investing in it.

You can also find the Big 4 Growth Numbers on Phil Town’s website Rule One Toolbox or on GuruFocus, If you want to learn more about how to calculate these numbers by hand or from financial statements, I recommend Town’s books Rule One Investing and Payback Time, where he goes into more details on the Big 4 Growth Numbers and why they are important. They are invaluable books for anyone that wants to get into value investing.

If you are starting out as a new value investor, you need to be strict and only invest in wonderful businesses. This ensures you don’t lose money and sets you up to make significant gains.

Our Checklist for Financial Metrics:

1. The business’s ROE/ROIC must be at least 10% or higher each year for the last 10 years (alternatively, we can look at one, three, five, seven and ten year ROE/ROIC numbers). This indicates that the management team is doing a great job reinvesting the proceeds from the business operations.

2. All the historical Big 5 Growth Rate numbers must be at least 10%. This means that the business is predictable, and it is very strong evidence that it has a massive competitive advantage.

3. The business should only have a reasonable amount of long-term debt, if any at all. Reasonable debt could be paid off in three years with the current free cash flow generated by the business.

Our website follows these principles when evaluating companies. To see an example of these metrics in action, check out our evaluations of Amazon and Adobe.

Can You Trust the Management Team?

Before we buy a stock, we have to be sure that we can trust the management team running the business. At the extreme, a truly bad management team could be cooking the books and committing fraud. This is very rare for public companies, and illegal activity shouldn’t be a huge concern, as it will be uncovered fairly quickly, but there is a lot of other funny business that could be going on within a company that is completely legal. That is what we need to worry about the most. It’s perfectly possible that the management team doesn’t have the shareholders’ interest at heart, and they may be misusing shareholders’ equity or cash generated from business operations.

This all starts with the CEO. Before you invest in a company, you have to ask yourself if you can trust its CEO. Remember that as value investors, we view buying a stock as if we are buying the entire company outright, so we need to think as if we are entering into an important partnership with them. Do some research on the CEO’s background, look up their public interviews and try to get a sense for if this is someone you can trust.

Signs of a Good CEO

1. If the CEO or Chairman/woman is also a founder of the company, this is great news, and this business is very likely in good hands. Founders have a lot at stake, and they usually have the best interest of the company and shareholders at heart. They are also usually a majority shareholder in the company, so they personally benefit from its success. Note that even if the CEO is a founder of the company, you still need to do the proper research to ensure they are trustworthy. An untrustworthy CEO is a major red flag, and you should not invest in the company if this is the case, even if they are a co-founder.

2. If the CEO and executive team have been with the company for a long time, this is also a great sign. It shows dedication, loyalty and skin in the game. It points to their satisfaction with the company and also indicates that insiders believe in the company’s future prospects.

3. If company insiders own a lot of the company stock, or if they are actively buying company stock, this is also a great sign that shows they are personally invested and optimistic about its future.

4. If the CEO’s compensation is way below average for companies of similar size, this is another great sign. Remember that Jeff Bezos’ annual salary as CEO of Amazon was $81,840, and his total compensation was only $1,681,840. Warren Buffet’s salary was $80,000 for more than 25 years, and his total compensation in 2019 was only $374,773. Most legendary CEOs are known for taking very little total compensation, as they have skin in the game and make most of their money from the company’s stock value appreciation. You can easily find CEO salary and compensation information for public companies at salary.com.

Red Flags to Notice When Evaluating a CEO

1. If the CEO is an executive for hire who has also been a CEO at other companies, this is not a good sign (although it isn’t a deal breaker).

2. If the senior executives get a very high salary, bonus and total compensation, while also not a deal breaker, this is another red flag, especially if it is significantly higher than the average compensation at companies of a similar size.

3. If senior executives leave the company frequently, or if the company is often changing its senior executive team, this is a bad sign.

4. If the CEO often makes inaccurate statements or exaggerates about product plans, product features and other company-related matters, this is also a red flag, and I personally consider it a deal breaker. It means that I can’t trust the CEO to tell the truth when things go wrong.

5. If the CEO is overly concerned about the stock price or pays too much attention to the company’s short interest or the short sellers of its stock, this is also not a good sign.

Do You Understand This Business?

If all the numbers look good and you decide you can trust the management team, the final thing to consider is whether you truly understand the business. Do you know why the numbers are good, and are you familiar with the industries that this business is operating in? Will you be able to recognize if trends start changing and the business starts losing its competitive advantage? If you understand and like the business, that is a good indicator that you should invest in it. If you love the business and feel that it aligns with your values, that is even better. If everything checks out up to this point, then it’s time to calculate the business’s true value (or intrinsic value), which will tell you how much you should pay for the stock.

Continue reading to learn how to calculate the true value (or intrinsic value) of a business: https://decode-investing.medium.com/decode-investing-part-3-how-to-calculate-the-true-value-of-a-business-700dbbd0b728