A four-step test for great investments... How to eliminate more than 90% of your investment mistakes... Breaking down one of Warren Buffett's most famous investments... Putting it all together...

Editor's note: We're wrapping up our special "celebration" series in the Digest today...

So far this week, we've been celebrating the 20th anniversary of Stansberry Research with an updated collection of essays from our founder Porter Stansberry that originally appeared in 2014 and 2015. In short, they're the essential tools every investor should know to survive...

On Monday, Porter explained three things you need to "cross the desert" of investing, as well as four steps to always beat the market. In yesterday's Digest, he detailed the power of insurance stocks. And today, Porter will show you exactly how to spot a great business...

A Four-Step Test for Great Investments

By Porter Stansberry

Today, we're going to do something that's hard for most people...

It involves some math. It involves thinking hard about rather abstract ideas. It will likely involve learning new jargon, which is probably the hardest part.

This is something most people will go to great lengths to avoid. So let me tell you why you should first calculate these four things every time you buy another stock...

This four-part test is a nearly foolproof way to evaluate the quality and the value of any business. It will allow you to quantify, with surprising precision, exactly what makes a given business great, average, or poor.

This knowledge will allow you to make vastly better and more informed decisions about what any business is worth and what you should be willing to pay for it on a per-share basis. But that's not the best reason to learn this four-part test.

The real secret is, once you develop the discipline to always do this work before you buy any stock, you'll never make a quick decision to buy a stock ever again. Once you add something that's hard to do, that requires a little bit of time, a little rigor, and a little discipline to your investment process, you're going to greatly reduce the number of stocks you buy.

You're also going to radically improve the quality of the stocks you're willing to invest in because you'll have the skills to do so. And that will eliminate more than 90% of your investment mistakes. Remember... you don't need to find a great investment every month or even every year. You just need to find one every now and then... and have capital ready to put to work.

I believe the No. 1 thing you need to know to be successful as an investor in common stocks is what type of business makes for a great investment. Investment legend Warren Buffett says the same thing. He puts it this way...

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10, and 20 years from now.

So... what makes a great business? How can you be certain its earnings will materially grow over reasonable periods of time? To figure it out, let's take a look at one of Buffett's most famous investments – Coca-Cola (KO)...

Coke sells addictive (caffeine-laced) sugar water for less than the price of gasoline all around the world. It has integrated its brand into people's lives through decades of advertising spending – an investment that has paid off tremendously. Coke has one of the world's most universally recognized and admired brands.

But how do these advantages translate into hard numbers? The most obvious characteristic of a great business is high profit margins.

High margins are proof of a great brand, a superior product, or some form of regulatory capture that permits greater-than-normal profitability. On every dollar of revenue in 2018, Coke earned nearly $0.22 in cash. And it brought in $34 billion in revenue.

To figure out exactly how much money Coke earns in cash, we simply look at the company's Statement of Cash Flows, under the line: "total cash flow from operating activities." We see that in 2018, this was $7.6 billion.

(The Statement of Cash Flows is one of four financial statements published in every Form 10-K with the U.S. Securities and Exchange Commission, along with the Income Statement, Balance Sheet, and Statement of Comprehensive Income. You can access these statements by looking at a company's annual report, which is available on the "Investor Relations" section of its website, or by using Yahoo Finance or any number of other online databases, like Bloomberg.)

Next, we divide those cash profits by the company's total revenue ($34 billion), which you can find on the income statement. Doing the math gives you a fraction that is commonly expressed in percentage form: 22%. Coke's cash operating profit margin is 22%. It's earning $0.22 in profit on every $1 it generates in sales.

In our experience, businesses with cash operating margins in excess of 20% are world-class. If you were putting together a checklist, you could start there. A great business must have cash operating margins greater than 20%.

The next "mile marker" you're looking for is capital efficiency, which we've covered extensively at Stansberry Research. This is another concept that, like profitability, is easy for most people to grasp. All you're trying to understand with this test is how much capital the company requires to maintain its facilities and grow its revenues.

For example, oil and gas companies are notorious for spending every penny they make on drilling more holes and building more facilities. Their capital-spending programs leave little of their profits to be distributed to shareholders (often less than zero).

One simple way to assess a company's capital efficiency is to figure out whether the company in question distributes more capital back to shareholders... or spends more money "on itself" via capital-spending programs.

A great business distributes more profits to its shareholders than it consumes via capital investments. Coke, for example, spent $1.3 billion on capital investments in its own business in 2018. It spent $6.6 billion on dividends and $436 million on net share buybacks in the same period.

You can see that Coke spends far more on its shareholders than it spends on itself. (By the way, all these numbers are labeled clearly on the cash flow statement.)

What's powerful for investors about businesses like these is that you don't need lower interest rates or a raging bull market to be successful. As these businesses grow, they increase their payout amounts, year after year.

It's the compounding effect of this growth that will make you wealthy. That's why Buffett says you should never buy a stock you wouldn't be happy to hold for a decade, even if the stock market was closed.

The third part of our four-part litmus test for great businesses is "return on invested capital." (Here comes the jargon.) Yes, it's a mouthful. But I promise, with just a little practice, you'll be able to easily calculate this figure in your head. We use this metric because there's no purer way of determining the value and the power of a company's "moat" – the degree to which the company is sheltered from profit-eliminating competition.

The business school formula for determining the precise amount of invested capital is complex and requires several different numbers (and judgments about each of them). It's a pain. But there's a much easier way to get a ballpark figure – just add the total amount of a company's long-term debt and the total value of the company's equity capital.

You'll find both numbers as simple line items on the balance sheet.

Coke has $20 billion worth of equity capital and $30 billion worth of debt. So in our book, the company has invested capital of $50 billion. On this capital in 2018, the company reported $6.4 billion worth of net income, or "earnings." Its return on invested capital is about 13%.

A great business will have returns on invested capital of at least 20%.

You'll find Coke's net income on the aforementioned income statement. Once you have the numbers, you just do the basic math ($6.4 billion divided by $50 billion) to derive another percentage – about 13%. As you'll see, this is where Coke falls a bit flat... The beverage market is ultra-competitive, and Coke's brand only provides a small measure of protection against competitive pricing.

The last part of our great business test is also a bit "wonky" and will make you sound like a finance geek. It's called "return on net tangible assets." This number gives you the best overall measure of the quality of any business. It's similar to the more commonly used ROE ("return on equity") with two important differences.

First, measuring returns against net tangible assets takes goodwill out of the calculation. So companies with large amounts of goodwill (like companies with great brands) typically show a much higher return.

Second, this measure of quality rewards companies that can borrow most of the capital they need because their results aren't cyclical.

Calculating this number is also easy. You can use the company's balance sheet to calculate the number yourself.

Simply subtract Total Liabilities, Goodwill, Trademarks, and Other "Intangible" Assets from Total Assets. Then compare this number with the company's net income for the last year. In Coke's case, net tangible assets total $16.8 billion. Coke earned a profit equal to 38% of its net tangible assets.

A great business will have a return on net tangible assets of more than 20% annually. So Coke's 38% return is a truly outstanding figure.

(Note: In some cases, a company will have more liabilities than it has tangible assets. In those cases, the math you see above no longer works because you can't divide using a negative net tangible assets figure. When that happens, as is the case with Coke in 2019, we'll subtract out only the long-term portion of total liabilities. This provides a more meaningful number, while still measuring the company's ability to safely replace equity with debt in its capital structure.)

Putting It All Together

Putting all these factors together, our test of business greatness starts with profits...

How much money, in cash, does a business earn from its operations, expressed as a percentage of its sales? The higher the margins, the better. This tells us that the company owns high-quality brands and products, as well as market position. We expect great businesses to produce cash operating margins of at least 20%.

Our second test is capital efficiency...

Does the business produce substantial amounts of excess capital, and does management treat shareholders well? We test this by seeing whether shareholders receive at least as much capital each year as the business reinvests in itself. We expect a great business to distribute more profits to its shareholders than it consumes via capital investments.

The third test is return on invested capital, which is the best measure of a company's moat... Here again, we would expect to see returns on invested capital of at least 20% for it to qualify as a great business.

Finally, our last measure of great companies – return on net tangible assets – combines brand value, capital efficiency, the quality of earnings, etc. We expect returns on net tangible assets to exceed 20% annually.

Business quality is extremely important, but the stock price is equally important for investment outcomes. Our best advice is to value high-quality businesses by the amount of cash they earn before interest, taxes, depreciation, and amortization. In finance jargon, this measure of profits is called "EBITDA."

You can't use this measure with lower-quality businesses, but it works well for high-quality businesses because it allows you to quickly judge companies in different industries against each other.

Now, let me show you a trick that will show you when to buy a high-quality company: We try to avoid paying more than 10 years' worth of EBITDA per share when we buy a business.

We measure the cash earnings against the enterprise value of the business (the value of all the shares and all the debt, minus the cash in the business). But you don't need to do all this work yourself. You can find this multiple for any given stock on the key statistics page of most financial websites.

Valuing businesses is a lot more difficult than evaluating their performance. You should be willing to pay more for a high-quality business that's growing.

So the Four-Step Test of Greatness is...

1. Cash operating profit margin: cash from operations divided by revenue – should be greater than 20%.

2. Shareholder payout ratio: capital returned to shareholders divided by capital expenditures – should be greater than 1.

3. Return on invested capital: net income divided by (long-term debt plus shareholder equity) – should be greater than 20%.

4. Returns on net tangible assets: net income divided by net tangible assets – should be greater than 20%.

Bonus Step:

5. Share price multiple: enterprise value divided by EBITDA – ideally less than 10.

Editor's note: We've spent the past few days celebrating our 20th anniversary...

And as part of the celebration, Porter recently sat down at our headquarters to reflect on the past two decades with some of the most influential folks in our company's history.

They gathered to relive their fondest memories... and to share stories about subscribers like you, who tell them time and time again how our financial research has impacted your lives.

During this rare "look behind the curtain," they also made two important announcements... These moves could forever change how you enjoy our research. Get all the details here.

New 52-week highs (as of 10/29/19): Celgene (CELG), Americold Realty Trust (COLD), Equinox Gold (EQX), Nuveen Preferred Securities Income Fund (JPS), Masco (MAS), Polymetal International (LSE: POLY), ResMed (RMD), and ProShares Ultra Financials Fund (UYG).

Do you use the Four-Step Test of Greatness when evaluating businesses? Tell us about some of the great investments you've uncovered through the years by sending an e-mail to feedback@stansberryresearch.com.

"Wanted to just drop you a line and say thank you for all you do. I just signed up for the 20th anniversary promo, your customer service was great, and I can't wait to get started. It just so happens that the money it cost me to sign up was equal to the profit I made on one of your recommendations that just hit my stop loss. Thanks!" – Paid-up subscriber David W.