“What gets measured gets managed” – Peter Drucker
Two men walked into a barbing saloon at the same time. But there was only one barber. It was a weekend, so the queue was long. The both men had to wait patiently till their turn reaches for a haircut.
The first man is not an experienced business person. As he waited patiently, he thought to himself I can employ some barbers. I should get some clippers, tell some few friends about my business, hopefully the business will do well and I earn some money from barbing services.
The second man also thought to himself. This could be a lucrative business. He estimates the startup capital and the cost of running such a business.
He reasons the scarcity of barbers, availability of the market, cost of rent, cost of employing skilled barbers, cost of energy consumption, cost of marketing the business, maintenance costs and expected returns.
Now, between both men, who do you think will draft out a better business plan? I will say the second man because he is able to analyze the fundamental business metrics.
The first man will not be able to draft out a good business plan because he doesn’t understand the factors that makes a good business.
The point is that a good entrepreneur/investor knows what and where to focus on. Bad entrepreneurship and investing can be as a result of optimism with lack of knowledge. One makes decisions based on feelings.
As an investor you should be able to measure the metrics that makes a business good/great.
What quantitative metrics should you be measuring and using to manage your investments?
Below are the 5 categories of a business metric an investor should master:
I think this is probably the first aspect of quantitative metric investors usually check first. This is when you want to know the worth of the company. If it is cheap or overpriced. It consists of metrics like price to earnings ratio, discounted cash flow, price to books ratio, dividend payout ratio etc.
The goal of every business is to make profit. Here you want to check if the company is actually generating revenue that will surpass its expenses. Metrics involved here are Return on Assets, Return on Equity, profit margin, gross margin etc.
Cash is king. The liquidity tells if a company has the ability to pay its short term debts. How quickly are they converting profits to cash. There needs to be availability of cash to keep the business running. If there is lack of cash, it affects business operations.
The business need to have a positive working capital (current assets > current liabilities). Here you check metrics like quick ratio, current ratio, free cash flow, cash burn rate, quality earnings (cash > net income) etc.
Here you want to know if a company is able to pay its long term debt. You don’t want to invest in a company that owes a lot of money. It is a very risky investment. Metrics like debt to equity ratio and interest coverage ratio.
- Management effectiveness:
You can tell how effective the executives are running the business. Are they selling? How fast are they selling? Are they producing enough products or services? How long does the company take to pay its bills? How long does it take the company to collect its bills? Metrics involved here are asset turnover ratio, inventory turnover ratio, account receivable turnover ratio etc