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  • Writer's pictureDaywey Chen

Spotting a good investment from financial statement

You don't have to be a professional to pick out good investment. Looking at a few easy trends and ratios will get you a long way.

First rule: A great business will have earnings that show a smooth upward trend

The business should have some level of competitive advantage over its competitors, as result providing the business with pricing power. For instance Disneyland, there are many theme parks but Disneyland is Disneyland, this is where you have to go to see Micky Mouse, this is where you have to be see Donald Duck. Disney has its uniqueness, therefore consumer wouldn't bargain over the price of the tickets. For those that have kids, would you really say no to your kids if Disney raise their tickets price by 10%?. As result the business is able to maintain a smooth upward tend in earnings.

Second Rule: A great business will show a consistent return on equity(ROE) above 20%

This gives you a sense of the net profit generated from the worth( total assets of the company minus its total liability) of the company. The higher the ROE the higher the efficiency of the company. However, we want to distinguish the companies that REALLY have a high ROE, and not companies that have a high ROE due to the large debt that it took on.

Third Rule: A great business will show a consistent return on total capital(ROTC) greater than 15%

The return on total capital is similar to ROE, but take long term debt into consideration. For formula for ROTC is (net income + interest expense)/ (share holders equity + long term debt)

Fourth Rule: Invest in companies where the long-term debt could be paid off using 4 years or less of net profit

A some debt is beneficial to the company in terms of planning for the long term. However, if the company starts to take on too much debt, the company will be exposed to more risk. Therefore, a rule that Buffet follow is that, he would usually look for companies that can pay off their long term debt using 4 years or less of its annual net profit.

Fifth Rule: A great business pays a dividend or buys back stock

Paying dividend can mean that the company is generating more cash than they need to maintain their market share. If the cash generated could not be reinvested back into the business at a reasonable return, the company returns the cash back to its investors!

Source: "Invest like Warren Buffet" by Matthew R. Kratter

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