What is it that determines whether or not a business is best-of-breed?
Part of the answer lies in analyzing the businesss fundamentals in order to see if it has the potential to be one of the best in its industry.
To determine the financial health of a business, you will need to assess several growth rates that will give you a clearer picture as to whether the business is able to consistently generate increasing amounts of both free cash and equity for you the shareholder.
The most meaningful growth rates to keep tabs on are:
1. Return on Investment Capital (ROIC)
2. Equity or Book Value Per Share (BVPS)
3. Earnings Per Share (EPS)
4. Sales or Revenue
5. Free Cash Flow.
You would like to see all of these growth rates equal to or greater than 10% per year for the last 7 years, 5 years and 1 year. Having these three numbers gives you a better sense of how the company is doing over a period of time. Ideally, you want all of these numbers going up or at least staying the same. Fundamental to all the numbers is consistency, either in an upward growth trend or the maintenance of an acceptable level of annual growth.
Free internet sites such as Yahoo Finance and MSN Money track many of these numbers for you. However, some numbers you may need to calculate on your own or pay for those calculations from subscription websites.
The proof that some sort of economic moat exists shows up when these numbers are all consistently more than 10% year after year.
A second factor to consider in determining the degree of competitive advantage a business has over another is the effect of long-term debt on the enterprise. Ideally, this should be zero thus enabling the business to readily respond to drastic changes in the economy. However, consider businesses that are able to pay off their long-term debt within three years from either free cash flow or net income as being good candidates.
All of this information can be recorded either in a notebook or in an Excel Spreadsheet. Although taking a little more time to set up, a spreadsheet affords the greatest future ease of use for both the calculations and updating information. To download a free spreadsheet, please check out the link at the end of this article.
Finally, a helpful indicator when comparing two or more like businesses together is the PEG ratio. The PEG is the Price-to-Earnings Multiple (P/E) divided by its growth rate. As a rule of thumb, healthy companies have PEG rates less than 1, whereas a PEG rate over 2 is expensive.