Financial evaluation is a methodical examination of possible investments utilizing well-defined, measurable metrics and risk assessment tools that will allow investors to make objective comparisons based upon structured data as opposed to reliance on emotional responses or trends in the market. By reducing investor uncertainty through the utilization of structured financial evaluations, investors can develop the discipline needed for effective capital allocation. The use of structured evaluations has been shown to enhance long-term performance for all types of investments (stocks, startups, etc.).
Analyze Cash Generation and Profitability
The ability of a company to create cash flow will determine if it will be able to continue operating and generating profits. A company’s profitability will be measured by its ability to remain profitable over time and will be evaluated by the use of a variety of metrics including but not limited to; revenue growth, operating margins and free cash flow. Investors will look to evaluate if the company is able to generate increasing levels of profitability and if those levels of profitability will remain stable over the course of time.
A company that does not have the ability to generate sufficient cash flow will be less likely to remain a viable investment opportunity over the long term.
Evaluate Risk and Volatility
Investors also need to evaluate the risks associated with any investment. Evaluating the risks of an investment includes evaluating the potential downsides of that investment. Potential downsides could be due to a number of factors including but not limited to; changes in the overall market, changes within the industry in which the investment is made, and the decisions made by the investment’s management team.
To minimize the amount of concentration of risk, investors should seek to invest in multiple investments at the same time. This will help to minimize the negative impact of poor performing investments on the entire portfolio. It would be beneficial for investors to identify their worst case scenario before making an investment so they know how much money they potentially stand to lose.
By taking the time to evaluate the risks associated with an investment, investors will be able to make informed decisions prior to making the investment and avoid making impulsive decisions after the investment has been made.
Evaluate the Investment’s Valuation Carefully
Once you have identified your target investment, the next step is to evaluate the investment’s valuation. An investment’s valuation will help you understand how reasonable the current price of the investment is compared to the underlying value of the investment. There are many different ways to evaluate an investment’s valuation, however some common methods include:
Price to Earnings Ratio (P/E) – The P/E ratio is a comparison of the stock price of a company to its earnings per share. For example, if the stock price of Company XYZ is $20 and the company earned $10 per share last year, then the P/E ratio would be 2 ($20 / $10). The higher the P/E ratio of a stock, the higher the stock price is in relation to the company’s earnings.
Price to Book Ratio (P/B) – The Price to Book ratio compares a company’s market capitalization to its book value. In other words, it measures what shareholders are willing to pay for each dollar of shareholder equity. For example, if the total shareholder equity of Company XYZ is $100 million and the company’s market capitalization is $200 million, then the P/B ratio would be 2 ($200 million / $100 million). Generally, companies that are trading at lower than average P/B ratios tend to be undervalued while companies that are trading above average tend to be overvalued.
While high-growth investments may warrant a premium price, the premium price needs to be justified by the underlying fundamentals of the company. When an investment is overpriced, it increases the investor’s margin of error, which ultimately can lead to reduced returns.
Determine How an Investment Will Support Your Long-Term Objectives
Finally, every investment should align with your long-term goals. Your investment goals may vary depending on your individual circumstances and preferences, but common goals include generating passive income, creating long-term wealth, or achieving diversification in your investment portfolio.
When your investments align with your goals, you will be less likely to make impulsive trades based on short-term market volatility and you will be better equipped to manage your portfolio in a disciplined manner.
In addition to providing you with clarity during uncertain times, purposeful investing also provides you with financial stability.
Conclusion
Using structured methods for financial evaluations will enable you to make smarter investment decisions. The structured financial evaluation methods we have discussed above will help you analyze your investments’ potential cash flows, the level of risk involved, the reasonableness of the investment’s current price, and how the investment will support your long-term financial objectives. These structured methods will help to eliminate emotional biases when making investment decisions and ultimately, they will help you allocate your capital in a more disciplined manner, which will lead to increased long-term financial success.
