Don't Invest in the Blind. [The Importance of Financial Benchmarks]

Picking a poor business with poor returns is easy to do. Most investors choose poor companies because they invest on Euphoria and Excitement. So how do you find and pick these great businesses? You establish financial benchmarks. By the end of this article, you will become proficient at creating financial benchmarks which will support you in picking higher quality businesses.

What is a benchmark? A benchmark is a tool by which you measure something, and the only measurable thing is a number. A financial benchmark is your yardstick when it comes to evaluating a business. If the company meets or exceeds the number on your yardstick, you put it on your list for further evaluation. If the financial Benchmark doesn’t meet your minimum measurement, you move down your list to find another company that meets your mark. In this article, we look at The Importance of a Benchmark, Our First Benchmark: the Operating Margin, Our Second Benchmark: the Cash Flow Margin, then We Look at a List of Other Benchmarks to Support You in Evaluating a Business.

The Importance of a Benchmark

Why are benchmarks important? They are important because they support you in picking high-performing businesses. At the Red to Black Podcast, we define a high-performing business as a business that has a 20% margin or better. (20% Margin is our Benchmark) Benchmarks guide investors into making rational decisions versus emotional decisions. We discover a business that we think is sleek and sexy. The Benchmark will tell us if sleek and sexy equals highly profitable. The Benchmark is our guide stick, and it helps us to avoid poor investment decisions. The Benchmark provides you with a target. It weeds out the poor companies, which is relative to the investors establishing the Benchmark. Maybe some investors set their Benchmark at a 10% Operating Margin, and others put it at 30%. The selection of your Benchmark is subjective. You decide what Operating Margin percentage is your base percentage.

Why set a benchmark? A benchmark keeps you on point. It supports you in listening to your rational thoughts and not listening to your emotions. It’s easy to get caught in euphoria, excitement, and FOMO (Fear of Missing Out). FOMO, when it comes to investing, is one of the most dangerous emotions out there. FOMO will drive you to buy poor businesses. If you heed your benchmarks, FOMO will have no influence over you. When you see that new company with its brand new, never seen technology and incredible upside, a quick analysis will tell you whether it meets your Benchmark. If it doesn’t, then it’s all hype and no performance. Your benchmarks are your guide. When you see the shiny object, your guide says, look at it from this angle. The benchmark will tell you if the object is dull and cracked. Benchmarks are your guide to create exceptional investment performance over the long run.

The First Benchmark: Operating Margin

I briefly pointed to the Operating Margin above in one example of how to set a benchmark. Why is the Operating Margin so important? Because it tells you how effective a business is at making a profit from its operations. The operations of any business either produce a product or service. The company will spend money (expenses) and sell those products or services for money (revenue). A high-performing business has a more significant delta between income and expenses. IE: A database company like Oracle has a Delta of 40 cents on every dollar earned. Meaning for every dollar they spend, they keep 40 cents. An oil company only keeps 5 cents.

What’s the better business? Oracle because it requires fewer expenses to earn a dollar. TO calculate the Operating Margin, you divide 40 cents by 100 cents ($1), and you get a 40% Operating Margin. The oil company has a 5% margin. What business will you choose as your investment? If you don’t have a benchmark, you will fall prey to euphoria and excitement. Your Benchmark will steer you towards businesses that have a 20% Operating Margin or better. Over the long term, you will continually pick great performing businesses.

The Second Benchmark: The Cash Flow?Margin

The Operating Margin is your starting point. The margin quickly enables you to determine how efficient a business is at producing profit. Once you find a 20% Operating Margin business or better, you then look at the actual cash the company retains at the end of the year. This number is the Cash Flow from Operating Activities. Compare the Cash Flow number to the Income from Operations. If the cash flow is significantly less, the company uses various non-cash items in expenses to get their income as low as possible for tax avoidance. Non-cash items are depreciation and other write-offs that are not actual expenses. I look for companies where the cash flow margin is similar to the operating margin.

To determine the Cash Flow Margin divide the Cash Flow from Operations Total by Total Revenue. This percentage will tell you how much cash a company retains in its coffers from its revenue. The cash flow margin is one of the top metrics I assess when viewing a company. Why? Because companies that are cash cows do lovely things with their cash, such as paying dividends, buying new profitable companies, and more. As an investor, I am looking for businesses that pay me to own them. If a company consistently produces cash and always delivers a dividend, I assume that I will receive a dividend payment in the future. I don’t care if the stock goes up or down because I will consistently receive a dividend. A dividend in a consistent company is more valuable than the price of an asset. Prices will fluctuate due to investor behavior, and dividends will fluctuate based on the performance of a business. If the company is consistent in its performance and increases its revenue each year, the dividend will remain constant and grow over the years.

What to Look For in the Cash Flow Statement

Another benchmark I look for on the cash flow statement is positive, negative, negative. What in the heck does that mean? There are three sections in the Cash Flow Statement: Cash Flows from Operating Activities, Cash Flow from Investing Activities, and Cash Flow From Financing Activities. Below is a list of these three areas with the Positive, Negative, Negative associated with the respective area and an explanation.

Cash Flow From Operating Activities — Positive

-This means the company makes cash from its operations.

Cash Flow from Investing Activities — Negative

-This means the company is investing in other assets or businesses to grow their current wealth.

Cash Flow from Financing Activities — Negative

-This means the company is buying back shares or paying down debt. To improve the value of its shares and become more efficient by having less debt. If this number were positive, the company would be using debt or equity to fund its operations. I look for companies that make their money off of their Operations and not their Financing.

The Positive, Negative, Negative tells us that the company makes money from its Operations then uses this cash to improve the business, which grows that wealth of the business.

Closing Thoughts

These benchmarks are a starting point. You can establish multiple other benchmarks which will become integral to your investing strategy. Benchmarks are measurable numbers that will steer you towards the best-performing businesses. Benchmarks are a check on your emotions. They will support you in overcoming excitement and euphoria for a company that doesn’t perform well. You will now be more proficient at picking high-performing businesses with the knowledge in this article. The only thing that will blind you is your emotions.

Originally Published at www.RedtoBlackPodcast.com