Today I’m going to talk about how to decide if a CEO has great skills.
This is the second part of the Value Investing Principle #3: The management of the business is honest and skilled. To read more about how you can tell if a business meets principle #3, check this article out. If I can be fully transparent, this has been one of the most difficult portions of learning Value Investing for me. It involves shifting through financial numbers, creating spreadsheets and punching numbers into online calculators (or creating formulas in your spreadsheet). I will say that once I got over the initial hump of the intimidation of this step, the knowledge these numbers provide makes it absolutely clear on whether or not you would want to invest with that business. There are 5 financial numbers you need to pay attention to for each business you’re considering investing in. They are: Sales, Equity, Cash, Earnings Per Share and Return on Investment Capital. I had to learn what these numbers meant as remember, I didn’t go to business school. Here’s what the numbers mean in terms that helped me understand them. Sales Sales numbers are the total amount of money the business received from its consumers for selling its services. Equity Equity is the amount of money left over if the business was to sell off everything and pay off its debt. This is similar to the amount of money left over in your bank account at the end of the month when you’ve paid all your bills and living expenses. It’s the money that’s left over. Cash Cash is the amount of money the business has in its bank account. After a payday I have a big chunk of money in my bank account, but remember, a business has expenses just like you do and sometimes those expenses add up to more than you were paid on payday which isn’t a fun place to be in. Earnings Per Share (EPS) When a business is available to buy on the stock market, aka “it’s gone public”, it is split up into shares in the exact same way a pizza is cut into slices. How many pieces a pizza can be cut into varies - it could be 2, 12 or 20 slices. How much each slice will be sold for will likely depend on the slice of the pizza. I would sell a larger slice for more money than a smaller slice. A business is split up and sold in the same way except you don’t get to eat it like you do with delicious pizza. It’s divided up into many slices called shares. Each represents a portion of the company. These shares are then sold based on how much of the company they represent. People like you and I buy these shares and the business takes that money and puts it back into bettering the company. As time goes on and that business does well, you divide the earnings of the business by the number of shares to result in EPS. As the business does well, the EPS will grow. Return on Investment Capital (ROIC) ROIC tells you how the business is doing with managing the money coming into the business in relation to it going out of the business. Ideally, there should be money left over. Looking back at the numbers over the last 10 years of the business will tell you how the company has been doing. If these 5 numbers have gone up at least 10% per year over the last 10 years, this means the CEO has great skills. While this doesn’t mean that the company is going to keep growing in the same manner that it has in the last 10 year, the knowledge this provides along with the other 3 principles can help you decide if you want to invest in that business or not.
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