How To Value A Business

Finding successful investments is really hard work. We believe stocks aren’t just pieces of electronic paper but view them as businesses. Therefore we conduct ourselves as business owners with investment capital at our disposal.

Our number one goal is to acquire a portfolio of successful businesses that will help increase our wealth over time. Here are the 6 questions we ask ourselves before moving forward with further research of a company…

Does The Company Offer a Dividend?

This is a very black and white question. It’s also a deal breaker if the answer is no, there are indeed great companies who do not offer dividends. However, we prefer to get paid two ways when we invest. The first through dividend payments (profit sharing) and the second through our assumption of capital gains some time in the future.

It is important to remember capital gains may not come as quickly as we analyzed and can even turn into a loss. Receiving initial shares of profit along the duration of our investment can generate gains in our investment portfolios if the stock price goes no where or even help even out losses if the stock underperforms.

How Long Has The Company Been In Business?

This may sound like a shallow question to consider but it’s the truth. We’d much rather have a veteran company who has shown solid performance over decades versus a newly formed company. Think about it for a moment, a company is going to face a number of obstacles throughout its lifetime:

  • Increased Competition
  • Financing & Managing Resources
  • Marketing & Customer Loyalty
  • Government Regulations
  • Problem Solving & Risk Management
  • Recessions
  • Law Suits

We would personally prefer to see a company who has navigated these obstacles for quite sometime versus taking a risk on a newly formed company. We fully understand we are missing out on some of the best companies however our number one goal is to limit risks in our investment portfolio.

Let us put it another way.

Johnson & Johnson was founded in 1886, they have dedicated over 120 years to the healthcare industry here in America. There is a 95% chance every single one of our subscribers consistently uses one of their products. J&J has over 260 operating companies in more than 60 countries employing approximately 125,000 people.

Facebook was founded in 2004, since then they have been at the forefront of social networking. This company boasts a strong presence online with 1.2 billion active users a month. They currently employ just over 10,000 employees.

Having read the information above…

  • Which company do you believe the world would miss more Johnson & Johnson or Facebook?
  • Which company would you sleep better at night owning?

Before you answer, consider these two questions as well…

Would you believe us if we told you as of November 1, 2015 Facebook is currently valued higher as a business than Johnson & Johnson? Facebook currently holds a price tag of $287 Billion while Johnson & Johnson comes under a bit shy at $279 Billion.

Would you still believe us if we told you for the last 12 months Facebook generated net income of $2.7 Billion while Johnson & Johnson generated net income of $16.1 Billion?

Remember net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. This number is found on a company’s income statement and is an important measure of how profitable the company is over a period of time.

In short, Johnson & Johnson makes almost 6 times more money than Facebook yet has a lower price tag. How in the world can that be? But we are getting ahead of ourselves.

Is This Company Number One In Their Industry?

Great businesses can be defined a number of ways, but the majority of them share some common traits. It is our belief, the most important traits is known as a moat or competitive advantage. In short, it’s an advantage over the competition that is likely to last for a long time… and often has already lasted for a long time. These advantages are often:

  • Recipes – Coca Cola
  • Patented Products – iPhone
  • Brand Recognition – Hershey

You get the idea right?

In capitalism, when a company becomes extremely successful, it only makes sense for competitors to come in and try to copy your success. If a company is making an 80% gross margin in their business operations, why wouldn’t you come in and say, “I’m going to undercut them and earn a 70% gross margin. After all they’ve already proven the business model works.” After you come into the industry, someone else will likely come along and say, “I’m perfectly happy with 60%.” Before you know it, it’s not 80% anymore… it’s 8%.

So when a company is able to sustain superior performance over a long period of time without giving up revenue or margins, that’s a sign of a moat or competitive advantage. It is a very rare thing in business and therefore one of the best companies to own.

Do you remember Blockbuster? It was a brick and mortar behemoth who’s business operations consisted of purchasing movies from production companies and renting them out to consumers like us. It was a very simple operation that did well for years, their competitive advantage was their size and ability to provide a number of movie titles to the consumer.

Until…

Netflix stepped on the scene 1999. Initially they offered the exact same service Blockbuster did but they shipped their movies to customers and instead of charging per movie they charged one low monthly fee. They were able to cut costs for the consumer significantly because they did not have the overhead expense of brick and mortar stores.

As time moved on Netflix offered its streaming service which has since been cloned by Amazon’s Prime Video and Hulu. There are a couple others but those are the main competitors. We personally did not like Netflix as an investment in 2008 because we felt they had no competitive advantage.

But this all changed in 2012

Netflix began producing its own award winning exclusive content for subscribers and even made a deal with Marvel to produce additional content as well. This is the type of competitive advantage we look for in a company.

Does The Company Continue To Increase Revenue and Earnings?

Determining the answer to this simple question will save you loads of time and money. Determining if a company has the ability to increase revenues and earnings lets you quickly see whether the company has been successful at growing sales and profits.

Continual growth in these two metrics is important because it typically means the products and services the company provides are enjoying greater demand over time. Remember, companies that get bigger and better over time are exactly what we’re looking for.

We use Morningstar to conduct our research of company financial statements. They provide statements for the last 5 years for free. Simply go to their website:

  • Type in the quote of the stock you’re researching.
  • Click the “Financials” tab
  • This will bring you to the “Income Statement”
  • Revenue will be the first line item
  • “Net Income” will be further down
  • You want to see revenue and net income increasing every year for the last 5 years.

Try doing it yourself, research Johnson & Johnson (JNJ) and Dean Foods (DF).

It will become very apparent which company is better than the other.

What Is The Company’s Return On Capital?

This tells you how much cash a company generates in relation to the amount of capital tied up in its business.  As ROIC numbers increase, all else being equal, a business gets better and better.  The reason is that when you own a business, the higher your ROIC, the more money you are able to pocket every year in relation to the money you have invested in the business.

Think of it this way.

You are an investor looking for a financial advisor to manage your money. Since you are investing for the long term, you interview multiple advisors while reviewing their 10-year average return. Financial advisor A has managed to deliver 15% annual gains to his clients, while financial advisor B has delivered just 5%. Clearly, your money would have grown faster by being with financial advisor A, as he would have better allocated your dollars to achieve wealth.

The concept is no different in business. Management has to decide how to allocate their capital.  Do they spend money to grow sales organically or do they pay to acquire new business lines? Or are opportunities so limited they should just sit on my cash or pay it back to shareholders? These decisions are at the core of senior management, and the effectiveness of these decisions are reflected in the return on capital metric. A business with a higher return on capital, like a fantastic financial advisor, will deliver more wealth to it’s shareholders over the long term.

Does The Company Generate Free Cash Flow

The last thing we look for when starting the evaluation of a company is its ability to generate free cash flow.

We determine this by going to the Cash Flow Statement, if you go to Morningstar:

  • Type in the quote of the stock you’re researching.
  • Click the “Financials” tab
  • Click “Cash Flow”
  • Free Cash Flow will be the last line item at the bottom

It’s important to remember free cash flow is what gives equity its value. This is the surplus capital management has at its disposal to grow the business, reduce debt, and give back to shareholders through dividends and share repurchases.

In a perfect world we like to see companies that generate growing free flow over an extended period of time. Of course companies do have hiccups and we understand that. But if a company was unable to generate even a moderate amount of free cash flow over the last three years, we generally lose interest in it as a potential investment idea.

Let’s Put This All Together

It’s important for investors to remember there are almost 7,000 companies listed on the three major U.S. stock exchanges: NYSE, Nasdaq, and NYSE MKT. Finding the handful of businesses that will translate into successful investments is hard work.

Having a plan like the one outlined above helps us eliminate many subpar businesses from consideration quickly… and focuses our attention on those that are worthy of our investment capital.

As you conduct your own research, we highly recommend you follow the steps in this guide. This is how we individually evaluate companies for the dividend stocks we recommend in our Federal Thrift Savings Plan Newsletter.