Analyze Like a Pro: A factor every investor must know
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Having studied a number of the most successful investors of all time, I have aggregated principles and strategies to analyze like a pro. Such investors include Warren Buffett, Benjamin Graham, Phil Fisher, and Howard Marks, among many others. Today I want to share with you my thoughts on analyzing stocks like a pro. What is the most important thing to review?
I have analyzed over a thousand financial reports since I started investing. I carefully review companies' 10K reports as well as the financial statements contained therein: income statements, balance sheets, cash-flow reports, etc. More than anyone, I realize how confusing these reports can be to evaluate, especially for those of you who don’t like to spend long hours trying to make sense of complicated numbers and formulas. This ends now.
In this post, I will dive into the single most important factor of financial analysis. It's exceedingly important because it's a huge driver of effective investment analysis. While such analysis should focus on a range of things, placing focus on this one element can truly guide you toward finding very rewarding investment opportunities. It will aid in effort to analyze like a pro. Let’s not waste any time.
It Starts with Cash
The ultimate goal of every investor is return on investment. You invest cash now to get more cash in the future. If you’re good at money management, you’ll eventually have a solid collection of assets that are generating strong cashflow as reflected in returns. This principle is easy to remember as it applies to us all. Furthermore, it's relatable to companies. They too have cash that needs to be invested at adequate levels to at least keep up with and hopefully exceed inflation.
In order to grow, companies can either invest in their own business or find opportunities elsewhere. It seems simple in practice but good investments are rare. And good CEOs with the skills to find them are even rarer. Therefore, the financial community found an easy way to assess a company’s success, and it will help you analyze like a pro as well.
The Return on Invested Capital (ROIC) Factor
In evaluating any company for potential investment, question whether management is good at money management. Is the company spending capital in ways that are productive and creating value? That is the single most important question you should ask yourself when analyzing a stock and assessing a company's management. There are multiple ways to assess that. However, I don’t want you to necessarily go looking for complex formulas. Let's keep it simple and straightforward.
As Warren Buffett puts it: “Investing is simple, but not easy.” To invest effectively and analyze like a pro, place focus on a simple but critical factor that I often use: Return On Invested Capital (ROIC).
Formula: ROIC = (Net Income - Dividends) / Invested Capital, where:
- Net Income = the company's net income (from the income statement)
- Dividends = the dividends paid to shareholders
- Invested Capital = the total amount of capital invested in the company (including equity and debt).
It's imperative this is fully understood, so let me borrow another minute of your time. ROIC is a calculation used to determine how well a company allocates its capital to profitable projects or investments. Expressed another way, ROIC is the amount of money a company makes that is above the average cost it pays for its debt and equity capital. It's a key metric and what I would consider the most important metric to be assessed within any stock investment analysis.
For example, a ROIC of 14.9% means that for every dollar invested in the company, it generates 14.9 cents in profit. This can be interpreted on a relative basis to assess if the company is effectively using its capital to generate returns for its investors. So after identifying the level of ROIC, then the next question and the related step follows.
What’s the ROIC of a Few Companies?
The chart below is perfect for you if you’re a visual learner.
This should give you an idea of how to quickly compare potential investments. Hone in on high levels of ROIC, and compare that metric versus key peers, as well as over time (at least 5-10 years) to determine how well a company is at deploying capital for strong returns. As you use this factor, you’ll quickly learn how to distinguish great companies from the average. And who knows, maybe you’ll find your next big investment using this as your starting point.
To analyze like a pro, refer to an earlier post of mine "How to Find Value When Evaluating Investments" for additional context surrounding the Twin Towers of investment analysis: ROIC and growth. Both are very relevant, but as a long-time value investor, I find ROIC to certainly be the more impactful. Just remember to buy with a large margin of safety. That's where identifying attractive companies at bargain prices comes into play. Take advantage of the Market's folly. Stay tuned for a future post related to Margin of Safety if you're not quite sure what that entails. Join my newsletter and get equipped with free tools and knowhow to build wealth and financial security.
The information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.