If you are the shareholder of a company, you are the owner of that company. With that mentality, it becomes obvious that the management is there to serve you. The CEO is there to make sure your company is run in the most efficient and vigilant way. So, how do you find out if that management is actually efficient at its job? In this blog post, I will talk about 5 things that can help you determine how vigilant your management truly is.
- Low Debt – As Warren Buffett says, debt can disrupt even the best businesses because it limits flexibility and agility. Understand that businesses take on debt in order to expedite their growth. For example, Tesla might not have the production capability to meet the growing demands for its cars; instead of depleting its cash to build a new factory, it takes on debt to build a new factory. Think of business debt the same you think of personal debt. You might have student loans or home mortgages or car loans. As long as your debt is low and manageable even if you lose your job for a year, it shouldn’t matter. Similarly, companies taking on debt to boost their sales is fine, but they shouldn’t be taking on excessive debt. Debt to Equity Ratio can help you determine if the debt is under control or not. This ratio is used to determine a company’s financial leverage. So, you want the debt to equity ratio to be a positive number below 1. In the case of Tesla, its debt to equity ratio for the latest quarter is 2.13. In contrast, you can look at Fiat Chrysler Automobiles, which has a debt to equity ratio of 0.36. This clearly shows that in case of a downturn in the auto market, Fiat Chrysler is going to be more flexible and agile than Tesla is. Warren Buffett prefers the debt to equity ratio to be 0.5 or lower.
- High Current Ratio – Current ratio is simply the ratio of current assets to current liabilities. Current assets are cash and other assets (such as inventory, receivables, etc) that are expected to be converted to cash within a year. Similarly, current liabilities are debt obligations to be paid to creditors within twelve months. A company should always have enough current assets to satisfy its current liabilities. When a current ratio falls below 1, it means the company has to take on more long term debt to pay off its current obligations OR it has to sell some of its non-current assets to pay its creditors. When the current ratio falls below 1, the management focuses on how to satisfy its obligations for the next 12 months that it sometimes loses focus on the long term goals. Tesla’s current ratio is 0.83 and Fiat Chrysler’s current ratio is 0.82. Even though neither have a current ratio above 1, Tesla has a little bit better current ratio than Fiat Chrysler. Now, don’t forget about the Debt to Equity ratio we discussed in the previous bullet point. We know that Tesla has taken on a lot more debt; that debt could be long term, so it would not show up when calculating the current ratio. Given the current ratio and debt to equity ratio, I find Fiat Chrysler’s management to be superior to Tesla’s management. Warren Buffett likes to see a current ratio above 1.50; he claims that in order to maintain flexibility, the company should make sure it is getting in more than what is going out.
- Return on Equity – Return on Equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. ROE is considered a measure of how effectively management is using a company’s assets to create profits. Fiat Chrysler’s average ROE for the past 10 years is 7.51%, and Tesla’s average ROE for the past 10 years is -72.26%. Undoubtedly, Fiat Chrysler is giving you a better return on your money (shareholder’s equity) than Tesla is. In other words, Fiat Chrysler is doing a better job at using its assets to generate profits than Tesla is. Warren Buffett claims that a consistent ROE above 8% over a period of 10 years is a strong indicator of great management.
- Executive Compensation – It is important that management is incentivized properly. In other words, management should be paid on performance and long term goals. In case of Tesla, Elon Musk, CEO of Tesla, gets paid the minimum wage required by California law. Musk’s 2018 base salary was $56,160, and received stock options compensation of $2,283,988,504. Having a compensation structure like this incentivizes Musk to act in the best interest of the company and its shareholders. Fiat Chrysler pays about $1.5 million to its CEO; however, the Committee evaluates the Fiat Chrysler’s overall risk profile relative to the incentive components of compensation to ensure that officers are not overly incentivized to focus on short-term stock performance. Fiat Chrysler uses long-term equity incentive awards as a significant portion of total direct compensation and robust stock ownership guidelines are structured to ensure management is focused on the long term and not incentivized to take excessive risk. Buffett wants to see that management’s incentives are designed such that the management makes every decision while keeping the shareholders’ best interest in mind.
- Meeting Objectives and Addressing Issues – It is important that management is frank with its shareholders. Yes, shareholders want to always see profits grow; however, management has to be transparent when the company is having a hard time meeting its goals. Management needs to have integrity when things look bad. Additionally, when things look bad and management promises to deliver something or proposes a fix, you need to make sure that the management delivers that fix. You do not want to invest in a company whose management is all talk and no action.
Hope you learned a little and found this blog post helpful. We looked at 5 components that can help you determine if your company’s management is vigilant or not. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions.