Do you have photographic memory like Warren Buffett?
I can’t remember every accounting ratio, stock valuation method or detail about a company.
But I do have a set of favorite “go to” stock valuation ratios that I like to refine and improve. My top 10 tends to change over the years as I find better ideas to replace my existing one.
You see, the way you think and value stocks should be similar to how you run your portfolio.
If you find a better idea, replace the one that is inferior.
If you come across a valuation ratio, analysis technique or learning method that improves your investing, replace your outdated or inferior method.
This is what helps keep Charlie Munger young in his thinking.
Here’s my 10 best stock valuation ratios. I use these on a daily basis with the OSV Stock Analysis tool and they are the cornerstones allowing me to quickly analyze and value stocks.
The valuation ratios are listed alphabetically.
#1. Cash Conversion Cycle
Not a “valuation” ratio, but a crucial part of analyzing a company.
The cash conversion cycle gives you insight into how efficiently the business manages its cash.
Every company’s goal is to turn cash over quickly and the entire cash conversion cycle is a measure of management effectiveness.
The lower the better, and a great way to compare competitors.
Here’s an image that explains how the cash conversion cycle works.
In a previous article, I showed how you can use the cash conversion cycle to determine winners and losers.
How to Use the Cash Conversion Cycle
The cash conversion number is a relative number. You can’t look at a single cash conversion number and determine whether it’s good or not.
You need a frame of reference.
And that reference is it’s historical averages as well as the industry competitor cash conversion numbers.
E.g. compare Costco, Target, Wal-Mart and you can get some deep insight into how each business is run simply by comparing.
Look for trends where the cash conversion number is decreasing. Be cautious with big increases as it indicates possible cash shortage and inventory issues.
#2. Cash Return on Invested Capital – CROIC
CROIC = FCF/Invested Capital
CROIC is a variation of ROIC. CROIC focuses on the returns made with FCF instead of net income.
This lets you see how well management utilizes the cash that isn’t part of the business. It’s a great way to measure the skills of the managers.
On the numerator, I interchange FCF with owner earnings depending on the company and situation.
For many years, I used the Invested Capital formula taught by F Wall Street but recently switched to the following.
Invested Capital = Shareholders Equity + Interest Bearing Debt + Short Term Debt + Long Term Debt
This is now in line with Morningstar’s definition of invested capital.
Invested capital is a very murky formula. It’s totally non standard. There are lots of variations floating around.
Check out this old school value thread where a group of us try to understand which invested capital formula is correct. There are 5 different formula’s you can use.
But a couple of reasons why I’m changing formulas.
- Finding excess cash is hard. It’s a lot like trying to calculate maintenance capex. It’s brutal.
- In some cases, CROIC came in much higher and totally unsustainable. I needed a balanced version after all these years.
How to Use CROIC in Your Analysis
I like to see CROIC growing or consistent above 13%. If a company exceeds a CROIC of 13% consistently, it’s also a sign of a moat.
Companies with negative FCF will obviously show negative CROIC. By achieving 13+%, you can tell that FCF is positive and the business is a strong performer in the industry.
Look for some levels of consistency too. It’s not going to be flat line consistent since FCF is a lumpy figure.
Check out AAPL’s CROIC.
For all the critics out there saying how AAPL has lost its touch, it’s becoming MSFT or other nonsense, the numbers don’t tell the same story.
If this valuation metric sounds good to you, go get some free ideas based on companies with strong increasing CROIC.
#3. EV/EBIT Valuation Ratio
EV/EBIT = Enterprise Value / Earnings Before Interest and Tax
I’ve come to appreciate EV/EBIT more over the years. Greg Speicher has a good discussion on using EV/EBIT over PE. There are good thoughts in the comments too.
I’ve also read a lot that Buffett’s rule of thumb is to pay 10x pretax when acquiring businesses.
And although Buffett is buying out the entire private company, that doesn’t mean you can’t apply it to public markets too. After all, if it’s Buffett, you know he’s going to stick to his methodology whether he is buying stocks or whole businesses.
Check out this post by Brooklyn Investor discussing Buffett’s past purchases. Most fall in the 10x pretax earnings range.
Even when I run EBIT valuations, many companies trade around a multiple of 10.
How to Use the EV/EBIT Valuation Ratio
Since EBIT is not an after tax number, you can use it to compare across industries.
In the Cash Conversion example, you can’t compare Costco to a company like AAPL, but by EV/EBIT, you can compare the valuation of each.
You still need to take a look at industry and historical averages though.
Here’s AAPL again.
Now if I apply that to the EBIT calculator from the Value Analyzer using a revenue of $176B and factor in all the cash it has, the 10x multiple gives AAPL a fair value close to the mid $700?s.
Here’s a link to the youtube video on how the EBIT model works.