Key Metrics for Business Valuation

Hi everyone, New Jersey Forensic accountant here. And today's topic, we're gonna talk about two key metrics for evaluating the performance of a company. And in our firm, we use these a lot to take a look at businesses, all kinds of businesses. And what we find is that there's a lot of confusion out there as far as how do you actually judge whether management is doing a good job with the company? And it's all kinds of stuff. And it obviously can go into lots of detail, but just two quick and really good metrics that tell you how a company is doing. And I'm gonna take you through these. I'm gonna talk about how they calculate. I'm gonna show you how they calculate. I'm gonna show you how we use it in court for testimony.

Now, return on investment, right? Okay. That's what people are looking at. We have a little bit different take on this. We like to say return on invested capital. But companies create value when an investment into business yields a return in future cash flow. There's no way around it. Cash flow is the most important thing in a company because whether it's this year, next year, or 10 years out, that's what people are doing. They're saying, "I'm putting X amount of money in and when I take the net present value of those cash flows, it exceeds that," right? Generally, when return on invested capital is higher than opportunity cost, loss rate of return, value is created, right? And this is how you fairly judge a management team.

If you look at growth in sales and return invested capital over a 5 or 10-year period or a 3-year period, you really get a good view of this. Now, when I say, you know, return on invested capital has to have a high return, higher than the cost of capital. For example, if I invest in a company and they are giving me 8% for my investment, well, they have to make more than 8% with that money, right? They gotta make 10%, 12% or 15% because not only do they have to pay me the 8%, but they have to pay their salaries and they got to attract other capital. So they need to make a higher return. It's kinda, like, if I could pay someone to cut my lawn for $50 but I make $100 an hour and if I cut my lawn, well, I'm losing $50, right? I'm better off paying someone 50 and working and making, you know, the 50. So it's, kind of, the same theory and that's how this return on invested capital works.

Now, let's talk about the first key metric: growth. Okay. Growth, right, growth in what? Growth in sales. And you could see, this is ideally in any company what you'd love to see, right? Okay. It's going up. But we need a way to judge that. We use what's called Compounded Annual Growth Return. You've probably heard this before, CAGR. And this is the formula for CAGR. It's pretty simple. And what we do is we basically take the sales and we look for growth or negative growth, okay? This is a real good indicator of what's going on in the company. Now, companies may not have great growth and you have to look at other factors. Just because it's not growing a lot, doesn't mean it's a bad company, but it's a concern, right?

And so what's our other key metric? It's what? Return on Invested Capital. We're gonna go through this calculation. I'm gonna show you some stuff we did in court just to understand how this... I'm gonna simplify it, of course. But it's important to understand Return on Invested Capital and some people... Return on Investment. Okay? This is the capital. And again, we're gonna go through it. It's basically long-term debt plus equity minus cash. Now, the formula for this is super simple. Really, you'll memorize in a second. Here's the formula. Obviously we have psi here, pi...only kidding, this is not the formula for invested capital. Just a little joke there.

So let's talk about how we use these two key metrics and we'll go through how we calculate them, okay? How we use growth and return on invested capital analysis in our firm. So, first thing is with privately held companies. Now, when you have a privately held company, it's great to, you know, take the sales and put them on Excel and then figure out the return on invested capital, do the calculations and compare it. But remember, when you have privately held companies, they're a little bit more tricky than public companies because you gotta make a lot of economic adjustments. You know, maybe rent isn't fair, maybe there's people who work in a company who aren't paid, so you have a lot more adjustments. But you still can use these two metrics.

We use them pretty much every time we look at a company. Also, asset analysis. You could use growth, you know, is it growing over time? What's the return on your capital? That kind of stuff, we use it for that. But it really shines when you're looking at public companies because public companies have lots of data, audited statements, you can go and get their 10Ks and all that good stuff.

And the example I'm gonna give you now is a company that we actually used this at trial. And the company that we did that had the court testimony was MetLife. And a great website to get information on companies, that's free, is right here, okay? It's MetLife. Okay. So now, here is some information they're giving you on...of course, here's MetLife right there. And you could see that they're giving us the summary here, which is a lot of good stuff, ask, buy, the bid, 52-week range, PE ratio. You know, look at this stuff. I don't know if this is a good company. Here's the beta PE ratio. I mean all this stuff is... You know, but in a vacuum, it doesn't really tell me anything. And so what we like to do is we look at the financial statements. And you could see here, you know, you have revenue from 2016 going up. Is that good or bad? We don't know, right? Net income, it went up quite a bit. You know, is that good or bad, though? I don't know because we need to compare it, right, compare the numbers to each other and also to other companies.

It looks like they got a lot of cash, $19 billion, right, 25. that's going down from '16, '18. Let's look at retained earnings. That's going down too. So, let's look at what... Here is... You could see here what we did was we have Netflix, Facebook, MetLife, Apple, and IBM. And this is what we did in the testimony. And then here we had... Again, this is for growth and this return on invested capital. We had from '16 to '18 for growth. These are the sales. And here's our CAGR we talked about. And you could see that Netflix had a 21% CAGR, Facebook, 26. Oh, oh, MetLife, 2%, Apple, 4%. IBM was actually negative. We have the stock performance. Now this is as of... We're sitting in January 1st, 2019 and we're saying, "How is this company doing?" Well, here's how the stock did. You know, Netflix stock went up 53%. Facebook's went up 56%, MetLife, 27%, Apple,109% and IBM, 15%, right? Again, so they all look like they did pretty good, but we've gotta compare it to something.

Let's see how they did, compared to the S&P 500. No. So now, when I state the difference here, Netflix still is 22%. Facebook has 26%, MetLife has a -4%, and Apple, 76%, 79%, IBM, 16%. But we have to also look at the dividend because they have a dividend. Here's the dividend yield. So when you look at MetLife, their dividend was a little over 3%. So basically, you know, maybe they're losing 1% or breaking even, compared to the S&P 500. So it's not a good sign, right? So you can basically buy the S&P 500 rather than buy MetLife. That's what it's telling you. So not good, but it doesn't...

Let's look at return on invested capital, okay? Return on invested capital is pretty simple. You just take the equity, you add the debt, and you subtract the cash and you divide it into net income. And when we do this, you could see, look at this. Surprisingly, Netflix has a 7%, Facebook is 44%, MetLife is 15%, Apple's, 41%, and IBM's 11%. And you could see MetLife really knows that they're not doing anything here because their sales are not that great. I mean, they have a 2% growth rate. And they realize that because that's why they're focusing on getting the return on invested capital up, right?

So what this is telling us and what we did was the executives in this company, some were taking out up to $50 million a year. A lot of them were 10 and 20 million. And we basically said, listen guys, this company's performance is horrible, okay? Management should probably be making a couple hundred thousand dollars not $10 million, $20 million or $50 million. So obviously MetLife was really upset with our testimony, but that's the truth of the matter when these numbers basically tell you that the company is not doing that well. It's basically, you know, this company's been around for 100 years, all they do is sell insurance, take the insurance, invest it, and pay out claims. Very simple, right? Maybe, you know, an 18-year-old kid could do this stuff. We don't need a rocket scientist making $50 million. So that was our testimony.

That's how we use this metric. So, guys, hopefully, you enjoyed this. If you have any questions, leave them below. I'll get back to you or one of my analysts. If you like this, please subscribe to my YouTube channel. Thanks a lot.