What is a perfect company? I would say it is one that can give us near certainty for gains if we invest in them. But how do we find and – to borrow the words of a popular mobile game at the moment – catch ‘em all? Here are some ways to start tracking them down. Strong returns on equity Most great companies are able to generate strong returns on equity (ROE) without depending on high levels of debt. The ROE is calculated by dividing the net income of a company by its shareholders’ equity at the beginning of the…
What is a perfect company? I would say it is one that can give us near certainty for gains if we invest in them.
But how do we find and – to borrow the words of a popular mobile game at the moment – catch ‘em all? Here are some ways to start tracking them down.
Strong returns on equity
Most great companies are able to generate strong returns on equity (ROE) without depending on high levels of debt. The ROE is calculated by dividing the net income of a company by its shareholders’ equity at the beginning of the year. It measures how much profit a company can earn with each dollar of shareholders’ equity held.
A company that is able to generate a ROE of 10% means that it is able to earn $10 for every $100 of shareholders’ equity. A good example of a company with an impressive ROE would be local super market operator Sheng Siong Group Ltd (SGX: OV8). It had a ROE of 24% in 2015 while having zero debt on its balance sheet.
Positive free cash flow
Another sign of a great company is the ability to generate free cash flow. Great companies tend to have very strong free cash flows. The number can be calculated by subtracting a company’s capital expenditure from its operating cash flow.
The presence of positive free cash flow means that a company is able to have left-over cash from its daily business operations even after spending money to maintain its business at their current states.
Inflight caterer and airport ground handling services provider SATS Ltd (SGX: S58) is an example of a company that has produced strong free cash flow over the past few years. You ca see SATS’s historical free cash flows in the table below:
Source: S&P Global Market Intelligence
This is a sign that SATS can sustain its growth internally without having to take on too much debt; indeed, SATS’s latest balance sheet has S$564 million in cash and just S$121 million in debt. The company’s ability to produce strong free cash flow is also a sign that it has a better chance of being able to protect its dividends.
Growing dividends, earnings, and revenue
Growth is an essential part of a great company.
Companies that have been able to grow their businesses over the long-term have proven their business models and thus have a better chance of succeeding in the future. Companies that have been growing over the past 10 years include Hour Glass Ltd (SGX: AGS), Vicom Ltd (SGX: V01) and Top Glove (SGX: BVA)
A Foolish Summary
But, we have to bear in mind that businesses are dynamic. Past results do not necessarily guarantee the future. A company with all the above characteristics might still become a bad investment if it is facing some structural changes in its businesses.
We shouldn’t base our investing decisions on quantitative numbers alone. It is always important to invest in companies that we understand and with long-term futures we feel confident about.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.