I. Baseline Potential
To start, each investment must have the potential to produce 15% a year or 100% over a 3 to 5 year period. How I arrive at this estimate is based on a principle I call payback theory. For example: a small town has two bakeries that sell similar products, have similar customer demographics, and earn the same amount of capital. One is priced at $300,000, the other at $500,000. All things being equal, the company that pays you back the fastest is the best investment.
While there is no magic bullet for success, it is worth noting that every year since 1977; Warren Buffett has mentioned the upward growth of the shareholder equity (book value) of his conglomerate — Berkshire Hathaway. If every dollar in retained earnings can generate at least the same in market value, then the company has added value to shareholders.
II. Future Prospects
I spend a considerable amount of time thinking about two things: longevity and future earnings, starting with two questions. Will the company be around in 10 years selling the same products or services? Will the need for those products and services still be relevant? My estimates are based on intrinsic value, which comes down to future estimates built on company history and current market trends. Every publicly traded company is valued by a multiple earnings, equity, sales, and cash. One way to forecast value is to calculate the historic growth rate and price multiple to extrapolate a future EPS figure with appropriate discount rates. Then, multiply that EPS number by the historic price to earnings ratio to get an estimate. This can be done on virtually any type of assets.
The future is what matters, not the past. Yet in most cases, a company cannot grow faster in its future than it did in its past. This is a reason that I look for low price to earnings (P/E) multiples in line with the payback theory. The S&P 500 index historically trades with a price multiple around 15 over any 5 year period. Logically, finding companies that momentarily trade for less than the market, or their own historical average, could be a sign of a mis-priced investment. However, P/E Ratios alone do not determine value, they are just a good starting point.
The average returns generated by owning the S&P 500 over the last 50 years were roughly 10% annually with dividends. To do better than that, you have to look for better than average companies where the stock is trading at undervalued prices. The following are some core tenets that I follow:
- Consistent Growth in Sales
- Consistent Growth in Earnings
- Consistent Growth in Book Value
- Debt to Income Ratio under 5
- Return on Equity Average over 12%
- Operating Costs to Income under 75%
- CapEx to Income under 75%
- Gross Profit Margins over 25%
- Price to Earnings Ratio under 12
- $1 for $1 retained to market growth
- Meet 15% baseline growth estimate