Evaluating a Company - 10 Simple Rules
1. Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?
2. Do you understand how the company works? Do you have intimate knowledge of, and experience with using the product or services of the company?
3. Is the company conservatively financed?
4. Are the earnings of the company strong and do they show an upward trend?
5. Does the company allocate capital only to those businesses within its realm of expertise?
6. Does the company buy back its own shares? This is a sign that management utilizes capital to increase shareholder value when it is possible.
7. Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.
8. Is the company's return on equity (ROE) above average?
9. Is the company free to adjust prices to inflation? The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.
10. Do operations require large capital expenditures to constantly update the company's plant and equipment? The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.
Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options. Let the market price determine the buy decision.
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Overall Summary of the Entire Framework
This 10-rule framework provides a holistic method for evaluating a company:
Rules 1-3 (The Foundation): Identify a high-quality business with a strong moat, that you understand, and is built to last with conservative finances.
Rules 4-7 (Management & Performance): Assess whether the business is profitable, growing, and run by a management team that is disciplined, focused, and skilled at allocating capital to enhance shareholder value.
Rules 8-10 (Efficiency & Durability): Confirm the company is highly efficient (high ROE), has pricing power to withstand inflation, and generates strong free cash flow by not being burdened by high capital demands.
The final, overarching rule is valuation: The wonderful business must be available at a fair or wonderful price.
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SUMMARY
Rule #1 (The Moat) identifies a high-quality business—one with a defendable castle that allows it to generate superior profits.
Rule #2 (Circle of Competence) ensures you are qualified to judge that quality. It forces intellectual honesty and prevents you from investing in fads or complex schemes you don't understand.
Rule #3 (Conservative Financing) ensures the company has the staying power to endure hard times and continue operating long enough for its competitive advantages to pay off for shareholders.
Rule #4 (Earnings Trend) confirms the company's business model is working effectively in the real world, translating its advantages into growing profits.
Rule #5 (Capital Allocation) ensures that management is disciplined and focused, reinvesting those profits wisely to strengthen the core business rather than chasing risky fads.
Rule #6 (Share Buybacks) shows that management is aligned with shareholders, using excess capital to directly enhance per-share value when other high-return opportunities are scarce.
Rule #7 (Return on Retained Earnings) confirms that management is a good steward of capital, skillfully reinvesting profits to create more value for shareholders.
Rule #8 (High ROE) quantifies the company's operational efficiency, proving it can generate high profits relative to its equity base. This is the result of a good moat and good management.
Rule #9 (Pricing Power) demonstrates the real-world strength of its competitive advantage, allowing it to maintain profitability through economic cycles and protect itself against inflation.
- Rule #10 (The Cash Flow Machine vs. The Cash Furnace) evaluates a company's financial efficiency and the quality of its earnings by examining its need for constant reinvestment.
This is an excellent set of rules for fundamental analysis, heavily influenced by the philosophies of investors like Warren Buffett. Let's expand on the first three points, which form the critical foundation for the entire analysis, and then provide a summary.
Expanded Analysis of Points 1 to 3
These initial questions are about understanding the nature and fundamental safety of the business. A "yes" here doesn't guarantee success, but a "no" often signals significant risk or a business that is inherently difficult to manage.
1. Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?
This is the cornerstone of the analysis, asking: "What is the company's competitive advantage (or 'moat')?"
Consumer Monopolies & Brand-Name Products (The "Moat"):
What it means: A company with a "moat" has a durable competitive advantage that protects it from competitors and allows it to earn above-average profits over the long term. This is the ideal.
Indicators:
Brand Power: Can the company charge a premium price because of its name? (e.g., Coca-Cola, Apple, Nike). Customers are loyal and seek out the brand specifically.
Pricing Power: Can it raise prices without significantly losing customers? (This connects directly to Rule #9).
Regulatory Advantage: Does it hold a government license or patent that prevents competition? (e.g., a utility company, a pharmaceutical company with a patented drug).
Switching Costs: Is it difficult or expensive for customers to switch to a competitor? (e.g., Adobe's Creative Cloud, or complex enterprise software).
Network Effect: Does the product or service become more valuable as more people use it? (e.g., Visa/Mastercard, Facebook, Airbnb).
Commodity-Type Products (The "No Moat"):
What it means: The company sells a product that is identical to those of its competitors (e.g., crude oil, basic chemicals, paper, wheat, or un-differentiated semiconductors). Competition is based almost entirely on price.
Why it's a red flag: In a commodity business, the lowest-cost producer usually wins. Profit margins are typically thin, and the company has little control over its destiny, being at the mercy of market prices. These are often poor long-term investments unless you are certain they are the industry's lowest-cost operator.
2. Do you understand how the company works? Do you have intimate knowledge of, and experience with using the product or services of the company?
This is the principle of "staying within your circle of competence."
Understanding the Business Model:
What it means: Can you clearly explain, in simple terms, how the company makes money? What are its primary products, its customers, and its key costs? If you cannot understand its financial statements or its core technology after a reasonable effort, it is outside your circle of competence.
Example: It's easier for most people to understand how McDonald's makes money (sell burgers and fries) versus a complex biotechnology firm working on gene therapy.
Intimate Knowledge & Experience:
What it means: Have you used the product? Do you know people who work in the industry? Are you a customer? First-hand experience provides invaluable insight that numbers alone cannot.
Why it's critical: Using a product can tell you about customer loyalty, product quality, and the company's competitive position. If you love a company's product and observe that your friends do too, that's a powerful qualitative data point that supports the quantitative analysis from Rule #1.
3. Is the company conservatively financed?
This question addresses financial risk and long-term survivability. A company can have a wonderful business but go bankrupt if it is poorly financed.
What "Conservatively Financed" Looks Like:
Moderate to Low Debt: The company's debt level should be manageable relative to its earnings power. Key ratios to check:
Debt-to-Equity Ratio: Compare this ratio to the company's industry peers. A significantly higher ratio is a warning sign.
Interest Coverage Ratio: (Earnings Before Interest and Taxes / Interest Expense). This shows how easily the company can pay the interest on its debt. A ratio below 3-4 can be risky; the higher, the better.
Strong Cash Flow: The company should generate consistent and growing cash flow from its operations, which can be used to pay down debt, reinvest, and pay dividends.
Ample Liquidity: It should have enough cash and short-term assets to cover its short-term liabilities (a healthy Current Ratio).
Why it Matters: A conservatively financed company can survive industry downturns, economic recessions, and unexpected crises. It doesn't need a government bailout or favorable debt markets to stay alive. It gives management the flexibility to make strategic decisions from a position of strength, not desperation.
Summary of Points 1 to 3
These first three rules work together to filter for a specific type of investment:
Rule #1 (The Moat) identifies a high-quality business—one with a defendable castle that allows it to generate superior profits.
Rule #2 (Circle of Competence) ensures you are qualified to judge that quality. It forces intellectual honesty and prevents you from investing in fads or complex schemes you don't understand.
Rule #3 (Conservative Financing) ensures the company has the staying power to endure hard times and continue operating long enough for its competitive advantages to pay off for shareholders.
In essence, these rules ask: "Is this a wonderful business, within my understanding, that is built to last?" A "yes" to all three means you have found a promising candidate worthy of further analysis using the remaining seven rules.
These three points shift the focus from the business's fundamental nature to the quality of its performance and management. They assess whether the company is not just good, but also well-run and shareholder-friendly.
Expanded Analysis of Points 4 to 6
4. Are the earnings of the company strong and do they show an upward trend?
This question assesses profitability and growth. Consistent earnings are the engine that drives a company's long-term value.
What to Look For:
Strong Earnings: Look for a consistent history of profits (Net Income). The company should be reliably making money, not posting frequent losses.
Upward Trend: The key is consistency and a general upward trajectory. You are looking for a pattern of growth in earnings per share (EPS) over a period of 5-10 years. Avoid companies with wildly volatile or consistently declining earnings.
Quality of Earnings: Ensure the earnings are backed by actual cash flow from operations (see Rule #3). Earnings that are generated through accounting tricks or one-time events are not sustainable.
Why it Matters: A strong, upward trend in earnings indicates a healthy, expanding business that is effectively capitalizing on its competitive advantage (from Rule #1). This consistent growth is what will ultimately increase the value of your investment over time.
5. Does the company allocate capital only to those businesses within its realm of expertise?
This evaluates management's discipline and focus. It asks if the leadership is sticking to its "circle of competence."
What to Look For (and Avoid):
Focus: The company reinvests profits back into its core business to strengthen its moat, improve efficiency, or expand in areas it understands deeply.
Avoiding "Diworsification": Be wary of management using excess cash to make expensive acquisitions in unrelated, "hot" fields. A classic example would be a stable food company suddenly acquiring a speculative tech startup. This often destroys shareholder value.
Successful Acquisitions: When acquisitions are made, they should be logical extensions of the current business, easily integrated, and paid for at a reasonable price.
Why it Matters: Management teams that venture outside their area of expertise often fail, wasting the capital that shareholders have entrusted to them. A disciplined management team that allocates capital wisely within its proven domain is a tremendous asset.
6. Does the company buy back its own shares? This is a sign that management utilizes capital to increase shareholder value when it is possible.
This probes capital allocation and shareholder alignment. It asks what management does with excess profits when there are no high-return internal projects (from Rule #5).
What it Means: A share buyback is when a company uses its cash to purchase its own shares from the open market, which are then retired.
Why it's a Positive Sign:
It increases your ownership stake: With fewer shares outstanding, each remaining share represents a larger ownership percentage of the company.
It boosts Earnings Per Share (EPS): With fewer shares, the company's earnings are divided by a smaller number, increasing EPS (connecting back to Rule #4), which often leads to a higher stock price over time.
It signals confidence: Management is effectively saying, "We believe the best investment we can make right now is in our own company, as we think it's undervalued."
A Caveat: Buybacks are only beneficial if the company is buying back shares when the price is reasonable or undervalued. Buying back shares at exorbitant prices destroys value.
Summary of Points 4 to 6
These three rules work together to evaluate the execution and capital stewardship of the management team:
Rule #4 (Earnings Trend) confirms the company's business model is working effectively in the real world, translating its advantages into growing profits.
Rule #5 (Capital Allocation) ensures that management is disciplined and focused, reinvesting those profits wisely to strengthen the core business rather than chasing risky fads.
Rule #6 (Share Buybacks) shows that management is aligned with shareholders, using excess capital to directly enhance per-share value when other high-return opportunities are scarce.
In short, a "yes" to these questions indicates you have found a company that is not only good on paper but is also being run by a capable and shareholder-oriented management team.
These rules delve deeper into financial efficiency and competitive strength, focusing on how effectively management uses shareholder capital and the company's power within its market.
Expanded Analysis of Points 7 to 9
7. Does the management spend the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.
This is a crucial test of management's capital allocation skill. It moves beyond what they do with excess cash (buybacks, dividends) to what they do with the profits they reinvest back into the business.
What it Means: "Retained earnings" are the portion of a company's profit not paid out as dividends. This is capital that belongs to shareholders but is left with management to reinvest for future growth.
How to Evaluate It: The key is to see if these reinvested earnings are generating a strong return. A simple way to gauge this is to observe the trend in Earnings Per Share (EPS). If retained earnings are being used effectively, EPS should show a steady, upward trend (linking back to Rule #4).
Why it Matters: Poor management can destroy value by reinvesting profits into projects that yield low returns. Excellent management compounds value by consistently earning a high return on every dollar of profit they reinvest. This is the engine of long-term wealth creation.
8. Is the company's return on equity (ROE) above average?
This is a key profitability metric that measures how efficiently a company generates profits from the money shareholders have invested.
What it is: Return on Equity (ROE) = Net Income / Shareholders' Equity. It answers the question: "How much profit does this company generate for each dollar of shareholder equity?"
What to Look For:
Above-Average: The company's ROE should be consistently higher than the average for its industry and certainly higher than the return on low-risk investments like government bonds.
Consistency: Look for a stable or improving ROE over a 5-10 year period. A high but wildly volatile ROE can be a red flag.
Why it Matters: A consistently high ROE is a hallmark of a company with a durable competitive advantage (a strong "moat" from Rule #1). It indicates that the business does not require massive capital investment to grow its earnings, which leads directly to the next point.
9. Is the company free to adjust prices to inflation? The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.
This is the ultimate test of the strength of the consumer monopoly or brand identified in Rule #1.
What "Pricing Power" Means: It is the ability to raise prices without causing a significant drop in the volume of goods or services sold. This is the opposite of a commodity business.
Indicators of Pricing Power:
A strong, valuable brand that customers are loyal to.
Products or services that are a small part of a customer's budget but are critically important (e.g., a specialized software license, a key ingredient in a formula).
Lack of viable substitutes or high switching costs.
Why it Matters: Pricing power protects the company's profit margins during periods of inflation. It means the company can pass increased costs (e.g., raw materials, wages) onto its customers, thereby preserving its earnings and the real value of its cash flows. This is a critical defense mechanism for long-term investments.
Summary of Points 7 to 9
These three rules are interconnected indicators of a high-quality, efficiently-run business with a strong market position:
Rule #7 (Return on Retained Earnings) confirms that management is a good steward of capital, skillfully reinvesting profits to create more value for shareholders.
Rule #8 (High ROE) quantifies the company's operational efficiency, proving it can generate high profits relative to its equity base. This is the result of a good moat and good management.
Rule #9 (Pricing Power) demonstrates the real-world strength of its competitive advantage, allowing it to maintain profitability through economic cycles and protect itself against inflation.
A "yes" to these questions points to a company that is not just profitable, but efficiently and defensibly profitable, with the ability to sustain and grow those profits over the long term.
Point 10: The Burden of Capital Expenditure
This final rule assesses the company's cash flow dynamics and operational efficiency. It distinguishes between businesses that are "cash cows" and those that are "cash furnaces."
What it Means: "Capital Expenditures" (or CapEx) are the funds a company uses to purchase, maintain, or upgrade its physical assets like property, factories, and equipment.
The Ideal Scenario (Low CapEx): A company with low capital expenditure requirements doesn't need to constantly reinvest most of its profits just to maintain its competitive position. The money it earns is free cash flow—profit that can be used to benefit shareholders through buybacks, dividends, or strategic acquisitions, or to fund its own growth.
The Red Flag (High CapEx): Companies in industries like manufacturing, telecommunications, or heavy machinery often require constant, significant investment. This means a large portion of their earnings must be plowed back into the business just to stay afloat, leaving less true "profit" for the owners (shareholders).
Why it Matters: This rule identifies businesses that are inherently more efficient and profitable. A low CapEx business can compound in value faster because its earnings are not drained by the high costs of maintaining its assets.
Rule #10 (The Cash Flow Machine vs. The Cash Furnace) evaluates a company's financial efficiency and the quality of its earnings by examining its need for constant reinvestment.
The Final Step: The Price You Pay
The article concludes with the most critical step of all: Valuation.
The Core Principle: Even if a company passes all ten rules with flying colors, it can still be a poor investment if you pay too much for it. The market price of the stock is the ultimate determinant of your future return.
The Process:
Identify the Quality Business: Use the 10 rules to find a wonderful company.
Calculate the Value: Determine what the company is intrinsically worth based on its future earnings potential.
Compare Price to Value: Let the market price determine your buy decision. You should only buy when the stock is trading at a price that offers a margin of safety—a significant discount to your calculated intrinsic value.
Meet Your Return Hurdle: This purchase price must promise a return that meets or exceeds your personal target return and is better than your other investment options.
In essence, the 10 rules help you find a "wonderful business," but the final price you pay determines whether you get a "wonderful investment."
Overall Summary of the Entire Framework
This 10-rule framework provides a holistic method for evaluating a company:
Rules 1-3 (The Foundation): Identify a high-quality business with a strong moat, that you understand, and is built to last with conservative finances.
Rules 4-7 (Management & Performance): Assess whether the business is profitable, growing, and run by a management team that is disciplined, focused, and skilled at allocating capital to enhance shareholder value.
Rules 8-10 (Efficiency & Durability): Confirm the company is highly efficient (high ROE), has pricing power to withstand inflation, and generates strong free cash flow by not being burdened by high capital demands.
The final, overarching rule is valuation: The wonderful business must be available at a fair or wonderful price.
