How to Evaluate a Company: 5 Key Valuation Metrics for Smarter Investing

The Big Five Numbers tell you whether a business has a real competitive advantage, a moat, that has proven itself over time. That is what I am actually looking for when I evaluate a company, and that is what most investors skip entirely.

In previous blogs, I have talked about how to find stocks that you understand, have meaning to you, and are competitive in their space to help you build a watchlist of potential investments.

For most people, this is where the research stops. They blindly put their money into the stock market and hope for the best.

There's a lot wrong with this method, mainly that it doesn't evaluate the financial health of a company. Nor does it use valuation metrics that can indicate a company's ability to generate future profits.

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If you've been following the Rule #1 Investing strategy, you know learning how to evaluate a company is a critical component of learning how to invest in stocks and understanding key business valuation principles.

• First, I evaluate a company based on The Four M's.

• Then, I evaluate the financial position of a company using the Big 5 numbers, which are essential financial ratios for stock analysis.

And, step #2 is exactly what I will cover here.

5 Key Financial Metrics to Value a Stock

If you want to make a smart investment but don't know what key metrics to evaluate a stock with, or where to even begin, the Big Five Numbers are the answer.

Calculating these five metrics will tell you whether a business is predictable, consistently profitable, and run by management that knows how to grow value over time. These numbers cut straight to the heart of a business.

But they do something most financial metrics do not. The Big Five are proof of a moat. When all five hold at 10 percent or better over 10 years, you are looking at a business that has protected and grown its value through recessions, competition, and market swings. That is the kind of company I want to own.

The most important of the five is Return on Invested Capital. I will explain exactly why when we get there.

Key Takeaway: As a good rule of thumb, a company is a good investment if all of The Big Five Numbers are equal to or greater than 10 percent per year for the last 10 years. Priority Order: Not all five carry equal weight. When I work through them, I apply this order: ROIC first, Equity growth second, EPS third, Sales fourth, Free Cash Flow fifth. ROIC is the most important signal. If it fails, I move on. The other four confirm what ROIC already told me.

These numbers reflect the same principles the world's greatest investors have applied to evaluate businesses for decades. And now they can be used by you.

You don't need to be a math wiz to crunch these financial terms. Once you know where to look, the Big 5 are easy to find and easy to calculate. I'll be using the company's three main financial statements, the balance sheet, income statement, and cash flow statement, to find and calculate these numbers. You can look at other factors like accounts receivable, total assets, and total liabilities as well. However, those are just extras.

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1. Return on Invested Capital

Return on Invested Capital is the first number I look at and the most important of the five. If ROIC fails, I do not need to look at the other four. A consistently strong ROIC is the clearest numerical proof that a real competitive advantage exists.

The ROIC measures how efficiently the company is using its capital to produce profits. This provides crucial guidance on whether you should consider investing in that company.

Tip: I look for companies that are being run and managed effectively. You can evaluate that in both subjective and objective ways.

The subjective way is to consider the ability and trustworthiness of the people running the company. The objective way is to look at ROIC. A consistently strong ROIC is the quantitative measure that tells you whether management is actually putting the company's capital to good use.

Warren Buffett put it simply:

“The best business to own is one that can employ large amounts of incremental capital at very high rates of return.”

That's exactly what a high and rising ROIC tells us, this business isn't just surviving, it's compounding shareholder value efficiently.

Because the ROIC will vary depending on the company and industry peers, it is a useful measure for comparing different companies to each other within an industry. It helps in comparing other industries to each other as well.

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How to Calculate a Rate of Return on Investment

To determine a company's ROIC, locate its income statement. On the company's income statement look for "net income" (sometimes called net profit) or "net profit margin" and "invested capital."

The % ROIC = Net profit after taxes divided by the equity and the long-term debt

I use a simple example to explain this number to new investors. Imagine your kid sets up a lemonade stand with $200. That covers supplies, a few flyers from the copy shop, and maybe a little help from a sibling.

After a week, your kid comes home with $300. Subtract the $200 in expenses and the profit is $100. ROIC is that profit divided by the invested capital: $100 divided by $200 is 50 percent.

Compare that to putting the same $200 in the bank at 2 percent a year, where it would have grown by less than a dime. The difference between 50 percent and less than a dime tells you everything you need to know about why ROIC matters

You can use this handy Return on Invested Capital calculator to calculate ROIC for you. Remember, you want to calculate ROIC for the past 10 years to get a good understanding of how efficient management is at using the company's assets to generate earnings and future earnings.

Important: A company whose ROIC meets these two tests is a good candidate to be a Rule #1 stock.

• The ROIC should be at least 10% per year

• The ROIC should be holding steady or going up over time

Financial Ratio: 2:1 Ratio of Liquidity

Another indicator of good management is how much cash flow a company has relative to its debt.

Has management overloaded themselves with short-term debt obligations and interest payments that could cause them to run out of cash?

Look at the balance sheet to find “current assets” and “current liabilities”. What you want to look for when evaluating a company is a 2:1 ratio of liquidity to debt or current assets to current liabilities. This ratio measures a company's ability to pay its short-term financial obligations.

There are a few scenarios where a good company has a liquidity ratio that is less than 2:1. They may have less cash flow but manage it really well, or they operate in an industry that isn't growing quickly and needs less liquidity.

Typically these are large companies that give excess cash to shareholders in the form of dividends. For newer companies, a liquidity ratio of at least 2:1 is incredibly important

2. Sales Growth Rate

The Sales Growth Rate, also called the Revenue Growth Rate, is pretty straightforward. It is the rate at which the total revenue earned by a company is growing (or not) year over year.

When sales are growing at a healthy rate, the company is more likely to be profitable, and your investment is more likely to do well. I want to see consistent growth over time. You can also use the sales growth rate to compare different companies in the same industry.

The sales growth rate is calculated by inputting past annual sales figures into the calculator, going back 10 years, if possible.

For example, if a company's sales were $100,000 two years ago and $112,000 last year, its Sales Growth Rate would have been 12%.

You can use the Sales Growth Rate Calculator to easily calculate the average sales growth rate. Be sure to look for a positive growth rate of at least 10%. To find the total sales or revenue, look at the top line of the income statement, comparing the most recent year to the previous years.

When reviewing sales growth since 2020, be aware that some companies may show abnormally high or low growth due to pandemic disruptions. I normalize this by looking at 5-year and 10-year averages, not just year-over-year performance, to get a true picture of the company's growth engine.

3. Earnings Per Share Growth Rate

The third of the Big 5 Numbers is Earnings Per Share, or EPS Growth Rate. This number shows the trend of how much the business is profiting per share of ownership over a given time period.

EPS = "Net Profit" divided by the number of outstanding shares

You can find net income on the last line of the income statement and the number of existing stock shares with a simple Google search.

Important: What I'm looking at is whether or not EPS is growing. Calculate the EPS for both the most recent year and the EPS from 10 years ago.

Then, plug these numbers into the Earnings Per Share Growth Rate calculator to get the average growth rate over the period of time. Once again, I'm looking for an average of at least 10 percent.

If you have heard of the price-to-earnings ratio, or P/E, here is how it relates to EPS. P/E is the stock price divided by earnings per share. The problem is that P/E tells you what the market thinks a company is worth right now, and the market changes its mind constantly.

EPS growth tells you what the business is actually producing. That is a more reliable signal. I use P/E later, in the Sticker Price calculation.

4. Equity Growth Rate

The Equity Growth Rate shows you if a company's pool of equity has grown or gotten smaller, and by how much, over the long term.

Why do we care if a company's equity is growing?

Well, if a company's equity is growing year over year, it means it has enough surplus money (after paying its bills and interest expense) to invest in tools that stimulate future sales and business operations. That tells me the business is generating real surplus and putting it to work. That is what I want to see.

A growing equity base also typically signals a healthy debt-to-equity ratio. The business is funding its growth through earnings, not borrowed money.

If a company's equity isn't growing, it means that it doesn't have the funds to spend on increasing its market presence or developing new products.

Tip: Look for companies where the equity growth rate is increasing at a rate greater than or equal to 10%.

The equity growth rate and ROIC work together. I look for companies that have both.

You can use the Equity Growth Rate Calculator to determine the average Equity Growth Rate over the past 10 years and get one step closer to seeing whether the company you're considering is a smart investment.

Also, look at how the company uses excess equity. Some companies increase shareholder value through share buybacks, which reduce the number of outstanding shares and increase the ownership value of each remaining share. This can be a good thing or a bad thing.

When a company buys back its own stock cheap, the remaining shareholders benefit. When it buys back at an inflated price, it works against them.

5. Free Cash Flow Growth Rate

The fifth and final Big Five number is Free Cash Flow Growth Rate. Free Cash Flow is the cash a business generates after paying for what it needs to keep operating.

Important: Free Cash Flow growth is a key measure of the long-term financial health of the company. Look for a Free Cash Flow growth rate of at least 10% per year.

You'll want to look at the cash flow statement to find "operating cash flow" or "cash flow from operating activities." From there, subtract capital expenditures to arrive at Free Cash Flow.

Free Cash (Owner's Cash) = Operating Cash Flow – Capital Expenditures (purchases of property and/or new equipment)

Use the Operating Cash Flow Growth Rate Calculator to calculate the growth rate over time. The growth rate tells you if the cash is growing with the company's profits, or if the profits are only on paper.

You are looking for real cash growth.

Free cash is money that can be used to give to the owners of the company or to reinvest. This means stockholders like you and me can receive dividends from the company, or the management can take the money and use it to grow the company faster and faster.

Free Cash Flow can be erratic, especially in businesses that are actively expanding. When a company is building new locations or investing in capital projects, Free Cash Flow can take a dive. That is not automatically a sign of trouble.

When Free Cash Flow is erratic or has recently declined, check the Operating Cash Flow on the same cash flow statement. Operating Cash Flow is the cash a business generates from its operations before capital spending decisions. It should be growing steadily from year to year. If Operating Cash Flow is growing while Free Cash Flow is jumping around, the volatility is likely expansion-related, not a business problem. If both are declining together, that is when I want to look closer.

How to Evaluate a Stock with These Financial Metrics

I use these financial metrics to evaluate the financial position of a company and determine if it would be a smart investment. They can reveal how solid a company is and if it will continue to grow in the future. While it may sound complicated now, the more you practice and the more familiar you become with financial statements, the easier finding and using the Big 5 numbers will become.

Before you start reading a company's financial statements,keep in mind that all companies can experience a dramatic change in their numbers in years when a Rule #1 "event" occurs. When evaluating a company, numbers from such years will be skewed, so it's important to pull data from a "regular year". This will give you a more accurate representation of the company's potential and business health.

Not all five numbers carry equal weight. When I work through the Big Five, I apply a priority order: ROIC first, Equity growth second, EPS third, Sales fourth, Free Cash Flow fifth.

ROIC is the clearest signal of a moat. When it is strong and consistent over 10 years, the business is compounding value well. The other four confirm the picture.

For a deeper look at the key financial metrics behind this framework, I have put together a video guide that walks you through each one.

Let me show you what this contrast looks like in practice.

Company A: ROIC: 18% Sales Growth: 14% EPS Growth: 16% Equity Growth: 15% Free Cash Flow Growth: 12%

Every number clears 10 percent and the trend is consistent. Strong ROIC tells me management knows how to deploy capital. Sales, earnings, and equity are all growing. Cash is real. That is a moat in the numbers. This company goes on my list.

Company B: ROIC: 5% Sales Growth: 3% EPS Growth: -4% Equity Growth: 2% Free Cash Flow Growth: Inconsistent

ROIC fails right out of the gate. I barely need to look at the other four. Sales are crawling, earnings are shrinking, equity is going nowhere. There is no moat here. I move on.

Once the Big Five check out, the next step is calculating the Sticker Price and the Margin of Safety. That is where these numbers convert into a buy decision.

Other Popular Investment Calculators

The Big Five are one piece of a complete system. If you are ready to learn the full Rule #1 process, the Virtual Investing Workshop is where to start. I teach the complete process live, including how to find the Big Five, calculate the Sticker Price, and identify companies available at a Margin of Safety price.

Margin of Safety Calculator

Once you have a Sticker Price, the Margin of Safety Calculator shows you whether the current market price gives you enough cushion to buy. I recommend buying at 50% of the Sticker Price. Patience is key.

The calculator determines intrinsic value based on a company's historic growth rate and on reasonable expectations of future growth.

I recommend buying companies when the market price is approximately 50% of the value.

Important: Smart investors want to minimize their risks. You can reduce your risk by making sure you have a substantial margin of safety whenever you invest in a company. Buying a company that is priced at a significant discount lowers the risk that the price will continue to decline after purchasing.

If the company you choose doesn't do as well as you expected, you'll still be protected from substantial losses because the price you paid was already low.

On the other hand, if the company you pick thrives and grows, then having a good margin of safety means your money gets boosted even more.

I know the importance of being patient. If you buy a stock with a healthy margin of safety and wait patiently, chances are good that the stock price could rise to match the company's market value.

Market Capitalization Calculator

The market capitalization calculator finds the current stock price of a company, not its value. Smart investors look for companies where there is a gap between the share price and intrinsic value.

What is Market Capitalization?

Often called the "market cap," market capitalization is calculated by multiplying the share price by the number of outstanding shares. It shows what the company would cost if you bought all the shares.

Retirement Calculator

Use the retirement calculator to find out how much you need to retire and what return you need to get there. Once you have a number, you can build a plan around it.

How Much Do You Need to Retire?

The retirement calculator breaks it down for you and guides you through the process by showing you what you need to take into account. The calculator then tells you how much you'll need to start saving every year.

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Once you have a specific number to aim for, then you can begin to make plans for how to accumulate and grow your savings. You'll gain peace of mind by knowing that you are saving enough to have the kind of retirement that you want and that you won't have to worry about your money running out.

Payback Time Calculator

Payback time tells you how long it takes to get your initial investment back from the company's earnings. Use the payback time calculator and look for less than eight years.

A good investment gets your money back quickly.

Use the payback time calculator and look for a payback time that is less than eight years.

Key Takeaway: Using any of these calculations, you can:

• Stay ahead of investors who make decisions based on emotion, follow the crowd, or act on random stock tips.

• Avoid common investing mistakes and focus on the numbers that actually predict performance.

• Have a solid plan for retirement, and you'll know how to carry it out.

• Minimize risk while staying focused on long-term results.

Valuation Metrics: Is the Company a Smart Investment?

Remember, making a smart investment is so much more than picking a company you like. The numbers are what separate a good story from a good investment. These are the value investing metrics that the world's greatest investors have used for decades.

The Big Five Numbers tell you whether you are looking at a business that is healthy, predictable, and consistent over time. When all five hold at 10 percent or better per year for 10 years, that is a strong signal you are looking at a real moat.

Start with The Four M's. The Big Five sit inside the second M, Moat, as the numerical proof of a competitive advantage. Once both check out, the final step is calculating the Sticker Price and Margin of Safety. That is when you know whether the company is truly worth owning.

To go deeper on how to evaluate a company using these metrics, the Rule #1 Investing Guide walks you through the complete framework.

The Big Five are one piece of a complete system. If you are ready to learn how to find wonderful businesses, evaluate them using these numbers, and buy them at the right price, join me at the Virtual Investing Workshop. That is where I teach the full process live.