Rule #1: The Five Numbers

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Rule #1During this final week in 2006, The Simple Dollar is reviewing one of the top investment book of the year (based on Amazon.com sales). What does Phil Town’s Rule #1 really all about, and does it bring anything useful to the plate that we didn’t already know? This week, we aim to find out.

In Rule #1, the author, Phil Town, is pretty adamant about ensuring that any business that you invest in be surrounded by what he calls a Moat. In other words, you should only invest in businesses that have a track record of stability and show no signs of losing that stability over time.

In order to ensure that the business that you’re considering an investment in has a large moat, Phil recommends that you look at five key numbers, which he refers to as “The Big Five”:

  • ROIC (Return On Investment Capital)
  • Sales growth rate
  • Equity growth rate
  • EPS growth rate
  • Cash growth rate

Each of these numbers should be above the 10% margin over the past year. In addition, the average of each of these numbers over the past five and the past ten years should be over 10%.

Why are these numbers important? Together, they indicate the health of a company. Is the investment of capital returning anything? Are the sales growing? Is it earning more per share? Is the company building up equity and cash? All of these questions should be answered with a clear “yes” if your company is doing well.

It’s important to note that these numbers really only serve to ensure that the company is in fact stable, not answer whether or not the company is a good investment. Town’s philosophy is that you should always invest in stable companies that you like, not chase after the pot at the end of the rainbow just because the numbers look sweet.

Tomorrow, we’ll look at how you can dip your toes into applying Rule #1.

You can jump to other parts of this review of Rule #1 by following these links:
Overview
The Four Ms (and an addendum)
The Five Numbers
Implementing The Rule
Buy or Don’t Buy?

Rule #1 is the eighth of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.

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