Pre-Investing Checklist – the three most important ratios that you should be looking for when evaluating a business?
What are the three most important ratios that you should be looking for when evaluating a business?
You may assume it has to be a debt-to-equity ratio, but it is not in the top three.
So now, without much ado, let’s look at the three most crucial ratios to consider when investing.
The most important of all ratios is ROCE, or return of capital employed.
Every business needs capital to expand and grow. So if a company can generate returns better than the fixed deposit rates in the market, it makes sense to invest in that business.
For example, I tell you to give me 10L Rupees at 4% annualised returns. But, you will ask, why should I give it to you when a bank offers me 8%?
The same applies when partnering with anyone in the stock market. If a business cannot generate returns better than a certain level, there is no point in investing in that business.
I prefer ROCE to be above 15 or 20 per cent, and you will seldom find a company where I have invested has a ROCE of under 10.
There are one or two exceptions that I have invested in my open portfolio, and generally, it has been invested with the viewpoint that the ROCE is improving.
However, if it is not improving, either I am out of it or, in some cases, I have very little exposure to the other ratios being very, very good for it, and ROCE will improve over a more extended period.
The second most important ratio I look for is the operating profit margin or OPM.
You know that I prefer to invest in companies that have little to no competition. So, they are unique businesses.
Once the businesses are unique, they can demand much better-operating profit margins because they can sell the product at a much higher price than the cost of the product itself.
OPM helps me understand how good is the pricing power for the business, the competitive landscape, as well as the domain expertise of the team.
Again, you seldom find companies in my portfolio with a single-digit OPM.
Again, every rule has an exception, with one or two exceptions. The reason is that the OPM is set to increase in the near future as the management focuses on increasing the OPM.
Companies are in the early growth stage of the business. So they may have to take a hit on the OPM, but once they start to optimise their business processes, the OPM will increase.
The third and most important ratio I consider when investing in a company is the past 5 and 10 years’ growth and what growth I expect in the next ten years.
What I mean is I invest in high-growth companies available at a reasonable price than looking for value companies available at a discounted price.
In other words, I don’t look for companies available at a very low price-to-earnings ratio. So I don’t expect the price-to-earnings ratio to expand.
Instead, the companies keep growing, and even if the PE Ratio comes down, I still make decent CAGR returns.
So, I am looking for companies that can do profit growth of at least 25 to 26 percent if the company has been doing it in the past and can keep doing it in the future (organic or inorganic).
So, once I expect the profit to continue growing at 26 percent, the share price will have a decent CAGR even if the PE contracts to half or one-fourth.
If I have to choose the fourth and fifth one, it will be free cash flow and the debt-to-equity ratio.
I know free cash flow is also important, but cash flows are generally good when a company has a ROCE of 15 to 25 percent.
So these are some crucial ratios I look for before analysing any business. What are your most important ratios when investing in a business? Please share them in the comments below.