There are hundreds of metrices available for a value investor to look into while valuing the company and sometimes it can be extremely confusing.
Normally, I tend to look for these measures while valuing a company and try to separate the wheat from the chaff:
- Debt to equity - This should be as low as possible. Less than 0.3 is what I normally put the filter on.
- Unpledged promoter holding - This should be as high as possible. Normally I select more than 45-50%. Promoter running the business must have skin in the game.
- Pledged percentage - it must be zero. I don’t like companies where promoter has pledged their shares to raise capital.
- FCF to Invested Capital - Over a period of 3, 5 and 10 years, CAGR of ratio of Free cash flow to firm and invested capital should be very high. This ratio shows how much free cash flow the firm is generating for the capital invested in the firm. It’s needless to say that I don’t like the companies who aren’t generating positive OCF and FCF over 5-10 year periods.
- Reinvestment Rate - High reinvestment rate from both debt + equity and purely from equity capital perspective. It basically shows how much management is reinvesting in the company back from the earnings it got. Higher this rate, higher the conviction of the management to grow the business.
- ROIIC - High return on incremental capital invested over last 10 years. Again, this should be calculated from both debt + equity and purely from equity point of view. It’s a much better measure than ROCE in my opinion. It shows the return generated by the company based on the incremental capital over a period of time.
- Value compounding rate of the company - This should be as high as possible. This is calculated as the product of reinvestment rate and ROIIC. If a company can retain 25% of its capital and reinvest that capital at a 10% return, we’d expect the value of the company to grow at a rate of around 2.5% per year (10% x 25%). Stockholders will likely see higher per-share returns than that because of dividends and buybacks, but the total value of the enterprise will likely compound at roughly that rate.
- Comparison of Value compounding rate with stock price CAGR over the years - we can quickly compare value compounding rate of the company vs stock price CAGR over 10 years. This is basically a comparison of how much value addition company is creating with the infusion of capital vs the stock price CAGR. If stock price CAGR is less than value compounding rate, its screaming undervalued. If its extremely high then its overvalued in my opinion and with mean reversion, we can expect the price to drop soon to match with the value compounding rate.
Once these basic criteria are met, I then look into other important ratios such as SSGR, fragility scores, movement of FCF, OCF, pricing power through increasing net profit margin, margin of safety, management quality etc. But above are the initial checks that I do and if any company fails to meet those criteria, I will skip it more often than not.