How to Find Great Businesses and Avoid Bad Ones

Editor's note: Is your portfolio full of "impulse buys"? Doing your homework on a company's financials doesn't have to be overwhelming. If you know where to look – and how to use the right tools – it's easier to separate the winners from the losers... And according to our founder Porter Stansberry, a simple "cheat sheet" can help you do just that (plus, it might save you from making silly mistakes).

This essay was originally published in a Stansberry Digest from 2015. We've left the numbers unchanged, but as you'll see, it's just as relevant today. In it, Porter shares a four-step guide to understanding quality... and explains how to find companies that outclass their rivals by the cold, hard numbers.

We're going to do something that's hard for most people...

It involves some math. It involves thinking hard about rather abstract ideas. For most of you, it will involve learning new jargon, which is probably the hardest part.

It's something most people will go to great lengths to avoid... but it's well worth the effort.

Today, I outline a nearly foolproof way to evaluate the quality and the value of any business. This four-part test will allow you to quantify, with surprising precision, exactly what makes a given business great, average, or poor.

This knowledge will help you make more informed decisions about what any business is worth and what you should be willing to pay for it on a per-share basis.

But that's not even the best reason to learn this four-part test...

Here's the real secret... Once you develop the discipline to always do this work, you'll never make a quick decision to buy a stock ever again. By adding something that's hard to do to your investment process – that requires a little bit of time and rigor – you're going to greatly reduce the number of stocks you buy.

You're also going to radically improve the quality of the stocks you're willing to invest in because you'll have the skills to do so. And that will eliminate more than 90% of your investment mistakes. Remember... you don't need to find a great investment every month or even every year. You just need to find them every now and then... and have capital ready to put to work.

I believe the No. 1 thing you need to know to be successful as an investor in common stocks is what type of business makes for a great investment. Investment legend Warren Buffett says the same thing. He puts it this way...

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher five, 10, and 20 years from now.

So... what makes a great business?

How can you be certain its earnings will materially grow over reasonable periods of time? Let's use our four steps on one of Buffett's most famous investments – Coca-Cola (KO) – to figure it out.

Coke sells addictive (caffeine-laced) sugar water all around the world. It has integrated its brand into people's lives through decades of advertising spending – an investment that has paid off tremendously. Coke has one of the world's most universally recognized and admired brands.

But how do these advantages translate into hard numbers?

The most obvious characteristic of a great business is high profit margins. High margins are proof of a great brand, a superior product, or some form of regulatory capture that permits greater-than-normal profitability. On every dollar of revenue in 2014, Coke earned nearly $0.25 in cash.

To figure that out, we simply look at the company's cash-flow statement, under the line: "total cash flow from operating activities." We see that in 2014, this was $10.6 billion. (You can get this by looking at the company's annual report or by using other online databases.)

Next, we divide those cash profits by the company's total revenues ($45.9 billion), which you can find on the income statement. Doing the math gives you a fraction that is commonly expressed as a percentage: 23%. Coke's cash operating profit margin is 23%. It's earning $0.23 in profit on every dollar it generates in sales.

In our experience, businesses with cash operating margins in excess of 20% are world-class. If you were putting together a checklist, you could start there.

The next "mile marker" you're looking for is something we call capital efficiency...

Like profitability, this is another concept that's easy for most people to grasp. All you're trying to understand with this test is how much capital the company requires to maintain its facilities and grow its revenues.

For example, oil and gas companies are notorious for spending every penny they make on drilling more holes and building more facilities. That leaves little of their profits to be distributed to shareholders (often less than zero).

Stansberry Research has developed a sophisticated way to measure in precise terms the capital efficiency of any business using several factors. [Editor's note: It's part of our new, breakthrough system that does the legwork of finding high-quality stocks for you... You can learn more about it here.]

But you can use a simple equation to get a broad sense of this, too. All you need to do is figure out whether the company in question distributes more capital back to shareholders... or spends more money "on itself" via capital-spending programs.

A great business is able to distribute more profits to its shareholders than it consumes.

Take Coke, for example. It spent $2.4 billion on capital investments in its own business in 2014. It spent $5.35 billion on dividends and $2.63 billion on share buybacks in the same period. You can see that Coke spent far more on its shareholders than it spent on itself. (By the way, all of these numbers are labeled clearly on the company's cash flow statement.)

When investing in businesses like these, you don't have to depend on a "greater fool" to come along. You don't need lower interest rates or a raging bull market to succeed.

As these businesses grow, they're going to increase their payout amounts, year after year. It's the compounding effect of this growth that will make you wealthy – not the mistakes of foolish investors. That's why Buffett says you should never buy a stock you wouldn't be happy to hold for a decade.

The third part of our four-part litmus test for great businesses is "return on invested capital."

Here comes the jargon. And yes, it's a mouthful... But I promise, with just a little practice, you'll be able to easily calculate this figure in your head.

We use this metric because there's no purer way of finding the value of a company's "moat" – the degree to which the company is sheltered from losing profits to the competition.

The business-school formula for determining the precise amount of invested capital is complex. It's a pain. You can get a ballpark figure much more easily – just add the total amount of a company's long-term debt and the total value of the company's equity capital. You'll find both numbers as simple line items on the balance sheet.

In 2014, Coke had $30 billion worth of equity capital and $42 billion worth of debt (adding the current position of long-term debt to long-term debt). So in our book, the company has invested capital of $72 billion.

The company also reported $7 billion worth of net income, or "earnings," on this capital in 2014. (You can find this on Coke's income statement.)

Once you have the numbers, you just do the basic math (seven divided by 72) to get another percentage: 10%. This is where Coke falls short. The beverage market is ultra-competitive, and Coke's brand only provides a little protection against competitive pricing.

Now, let's get to the last part of our "great business" test... It's called return on net tangible assets.

This number gives you the best overall measure of the quality of any business. It's similar to the more commonly used ROE ("return on equity"), with two important differences.

First, measuring returns against net tangible assets takes the intangible assets (what we call "goodwill") out of the calculation. So companies with large amounts of goodwill (like companies with great brands) will typically show a much higher return percentage. Second, this measure rewards companies that can borrow most of the capital they need because their results aren't cyclical.

Calculating this number is also easy. All you have to do is compare this number with the company's net income for the last year. In Coke's case, net tangible assets total only $3.9 billion. Coke earned a profit equal to 179% of its net tangible assets – a truly outstanding figure.

(Note: Sometimes, a company will have more liabilities than it has tangible assets. In those cases, this math no longer works because you can't divide using a negative net-tangible-assets figure. When that happens, we'll subtract out only the long-term portion of total liabilities. This provides a more meaningful number, while still measuring the company's ability to safely replace equity with debt in its capital structure.)

Let's put all of these factors together...

  1. Cash operating profit margin: cash from operations/revenue (should be greater than 20%).

Our test of business greatness starts with profits. How much cash does a business earn from its operations, as a percentage of its sales? The higher the margins, the better. This tells us that the company owns high-quality brands and products. We expect great businesses to produce cash operating margins of at least 20%.

  1. Shareholder payout ratio: capital returned to shareholders/capital expenditures (should be greater than 1).

Our second test is capital efficiency. Does the business produce a lot of excess capital, and does management treat shareholders well? We test this by seeing whether shareholders receive at least as much capital each year as the business reinvests in itself.

  1. Return on invested capital: net income/long-term debt + shareholder equity (should be greater than 20%).

The third test is return on invested capital, which is the best measure of a company's moat. Here again, we would expect to see returns on invested capital of at least 20% for a company to qualify as a great business.

  1. Returns on net tangible assets: net income/net tangible assets (should be greater than 20%).

Finally, our last measure of great companies – return on net tangible assets – is the single best overall measure of quality. It combines brand value, capital efficiency, the quality of earnings, etc. No surprise, we expect returns on net tangible assets above 20% annually.

This might seem overwhelming. But you don't need to do all of this work yourself. One system collects all of these factors into a simple score... ranking the highest-quality stocks – and exposing the stocks to avoid. Get the details here.


Porter Stansberry

Editor's note: Almost a decade ago, Porter began methodically searching for "capital efficient" stocks. Our company has worked behind the scenes to streamline that laborious process. Now, finally, we're releasing a system that can easily grade 4,817 stocks... and that could have turned every $100,000 into $254,000 in our backtesting, even through the 2020 crash and the boom that followed.

Last week, Porter joined editor Whitney Tilson to discuss this breakthrough. They walked through how this strategy works – and even shared two free recommendations. You can still watch a replay of the demo before it goes offline... Click here for the details.

Further Reading

"If it looks too good to be true, it likely is," Porter writes. It might sound exciting to get behind the latest market trend. But think before you jump in. The "fear of missing out" can cause even the most knowledgeable investors to make the wrong choices... Read more here.

"If your goal is to develop superior investing performance over time, you must put in the work to find undervalued stocks," Whitney Tilson writes. Knowing how to pick the best stocks is half the battle as an investor. Here are three steps to help you get started... Learn more here.