Wednesday, August 31, 2011

Value Investing: How to Evaluate Management Efficiency?

For all value investors it is very important to establish a set of guidelines that will help them to evaluate the efficiency of companies management. All established value investors believe that a set of self-decided guidelines and research work is probably more trust worth than a word of mouth. But value investors always take a note of the fact that the management of a company cannot do miracles till the nature of its business has some inherited competitive advantage.

So, what getmoneyrich would like to emphasize that for selecting a company for doing the management’s efficiency study, before make a note of its competitive edge. May be the company is run by Bill Gates and Warren Buffett but if they do not have a competitive goods/ services, they will be of no use. May be at that time these great minds may decide to diversify their business all together. The buzz word is “Companies must have competitive advantage”.

Very often you will see management singing ga-ga about their company. May be the profits of the company is going in drains since last five years but still they will self-proclaim that growths in future can be estimated. Value investors would like to work with those management who are both realistic and generous.

Value investors hates management who are always over optimistic (as always) about their future targets, but when financial year ending comes they miss their targets by miles. This is insane and very discouraging for value investors. This is the reason why Warren Buffett says that invest in companies which has ‘good, honest managers’ to manage its business. May be your profits are not must in short terms but over all returns in long run will be outstanding.

So what a small, retail investors can do to get a hint on the type of management that runs a company? But before answering this direct question best will be to know what is the primary functions of a Management Team:

(1)               Firstly they must maximize profits with efficient management.
(2)               Secondly, the profits they are generating in point one above should be used effectively to increase the shareholder’s value and
(3)               Thirdly, they shall continuously monitor the performance of shareholders value in long run. Basically all actions/ decisions taken to run the business shall be with the objective of increasing shareholder’s value.

So what facts and figures value investors can use to judge the efficiency of the management of a company. In order measure the profitability efficiency of a management, calculate the following parameters which has proves even helpful for world’s best value investor Warren Buffett:

How to know whether the management is maximizing profits with efficiently managing the business?

(1)        Profit per employee
(2)        Asset Turnover Ratio
(3)        Inventory Turnover Ratio

How to know whether the management is working to increase shareholders value?
Return on Invested Capital (ROIC) is the best metric to take a judgment on ‘increasing shareholder’s value’ of a company.   ROIC figures shall be notes for at least three to five years in the past and then the trend will be clearly visible for value investors.

How to know whether the management is working to increase shareholders value in long term as well?
There is one very useful figure which companies declare in their financial reports called as book value per share. There are some investors who also track the market price increase of share, but value investors do not follow this tracking strategy. Best is to track the increasing book value figures of the company which ultimately translates into shareholder’s value.

With increase in the book value figures of a company in after every financial year, a proportionate change will be the market price of share. Suppose a share which has book value of $1 in currently trading in stock exchange at market price of $5 (P/B=5). Suppose after one financial year the book value increases to $1.2, assuming same P/B ration of 5, we can estimate that the market price of share will rise to $1.2×5= $6 per share.

It must also be notes that shareholders not only benefit from the increasing book value but also from the incoming dividends. Shareholders shall track the dividend yield values of the company. Suppose that today a value invest buys shares at $1 which has dividend yield of 0.75%. After one year the dividend yield may rise to 1%, send year 1.25%, third year 1.6% an so on. This is also a good tracking parameter of evaluating the increasing shareholder’s value.
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