THE BIG FIVE, NAHMEAN

There are five numbers that we have to look at to determine whether a business has a Moat. Moat, of course, is some sort of protection by which a business automatically wards off competitors.

Protection comes in a lot of flavors. Some bad boys protect their urban businesses with tech nines, nahmean. But we don' be investin' dere, bro, nahmean? We gonna move up to a better class of management that does their fighting with their brains, not their bullets. It's a lot safer and has a much more consistent success rate.

So we wantsome sort of Brand (when you want a Coke, a Pepsi just won't do), Secret (patents and trade secrets), Switching Cost (too much hassle & expense to switch from Windows to a Macintosh), Toll Bridge (can't advertise to all of Washington, D.C. without buying ad space in the Post), or Low Price Moat (Walmart).

Any of these offer protection without a lot of fighting. No tech nines. Just an occasional lawyer. The Big Five numbers are a clue that there is a big Moat in place. And if the Big Five are bad, ain't no moat, bro. You want to defend that castle you better count your ammo, nahmean?

The Big Five are just:

Return on Invested Capital (ROIC); and the growth rates for
EQUITY
EPS
SALES
FREE CASH

We want to see all of these at 10% or better and not dropping.

Of these ROIC (you can also find it here on MSN) and Equity growth rate are the most important.

ROIC tells us that the CEO is handling the most important thing a CEO can do - wisely investing the surplus from profits. If ROIC is below 10% or is dropping, run away. It's a sign the CEO is more interested in building an empire than giving the owners a great return on their investment.

Equity is the surplus from profits. We love to see steady equity growth, especially if the business is not giving back some of the equity to us owners (thats called a dividend). We love a business that can use all that surplus to grow and it keeps the ROIC high. That, my friends, is an awesome business. (More on how to calculate this growth below.)

And then we want to see EPS and SALES and FREE CASH growing at around the same rate as EQUITY. And we want to see them linear and consistent. By that I mean they go straight up, not bouncing all over the place, and the growth rate is consistent across the years.

I usually look at 10 years, 5 years, 3 years and 1 year. The idea is to see first if they are high enough long term and then if they are improving or falling.

We want 10% or better and holding steady or improving. If you are using a pro toolset like Success, most of this is done for you with the Trend tool. But you can do it in your head with a little practice.

Remember the Rule of 72 post? I use the Rule of 72 to do these in my head all the time. For example, go to MSN.com Money, select a stock, click on Financial Results, Key Ratios, Ten Year Summary and you'll see a column for 'Book Value /Share."

That's EQUITY broken into per share pieces. Here's a picture of Whole Foods: (click on it to see a larger view)

Using the Rule of 72 I start with the oldest number in the column: $3.82. That's about $4. So I double 4 once to 8. Then double it again to 16. That's pretty close to the highest number, $15.84, so I stop there. Two doubles in how many years? 96-97 is one year. And so on. I get 8 years. 2 doubles in 8 years means one double in 4 years. 4 into 72 is 18.

So the equity growth rate at WFMI is 18% for the last 8 years.

How about the last 5? A bit better. Call it 20%. And 3? About 24%.

And last year? Well, that's when it's nice to have an automatic tool. But you can do an Excel calculation if you want that last number. I did it. Here it is: