One of the first steps when performing due diligence prior to a potential investment is the ability to evaluate the potential for growth associated with a specific company. Some would even argue that this metric is just as important as its current market capitalisation and the products that it produces. Below, we look at some of the most effective methods to evaluate whether a company is worth investing in.
Examining Financial Characteristics
The fiscal traits of any company are considered the very “backbone” which will determine its future success. From a general point of view, these can be broken down into four discrete categories.
- Their industry position
- How they use working capital
- Anticipated future returns
Let’s imagine that we are considering investing in a firm which mines gold. In terms of industry position, we are referring to its branding, is valuation when compared to peers and how long it has been in operation. Although there is no discrete formula to these aspects, industry position often makes or breaks an investment.
Their use of working capital is just as critical. For instance, is the mining firm pumping funds back into core operations or utilizing this capital to increase its market share? How open and transparent are their books? Companies which efficiently employ in-house capital are those which are likely to minimize any financial turmoil in the future.
Profitability is an obvious concern. This can be categorized in two different ways (operating margins and net margins). An operating margin is essentially a measurement of the financial return associated with the core operations of a business (such troy ounces of gold per tonne of ore or how much money was generated through the use of new drilling equipment). For complete newbies, net margin is simply the value of revenue after all operating expenses have been deducted.
Finally, what type of future ROI (return on investment) can you reasonably expect? Companies with predicted returns of between 10 and 20 per cent per annum are generally worthwhile ventures to consider.
Looking at Past and Present Growth
Past and present conditions will often dictate the future state of a firm. This is where the power of chart analyses and historical records come into play. You’ll need to consider the following:
- What type of dividends has the gold mining firm offered its investors?
- What is the YTD (year-to-date) growth rate?
- Have their previous earnings fulfilled expectations?
- Have share prices been stable or have they fluctuated based off external variables (in this case, the price of gold could be relevant)?
Determining these metrics will help you to make an informed decision.
Other Important Factors
There are other factors to address. In the case of our gold mining venture, we should ask questions such as if they are planning to expand their operations or if any type of share split is anticipated. Additional variables to address include:
- The market capitalisation.
- The number of current shareholders.
- The return on equity (the ability of management to turn a profit).
Determining the growth potential of a company is as much of an art form as it is a science. Keep these recommendations in mind to make an informed (and profitable) decision, and bear in mind the advice of Warren Buffett and invest in a company where you intend to keep the investment for a long period of time. “Passive investment has always been Buffett’s investment philosophy.” Says Yan. Handle the investment as if it were your own company – Sound investments are the ones with longevity.
Author Bio: Ron Short is a former financial advisor to FTSE 500 companies, he now lives in Spain where he works as a freelance finance writer.