When screening for new investment ideas, I want to be sure of two things:

  • There’s a sustainably growing and profitable business, and
  • Management are allocating capital appropriately for the best risk-adjusted returns

In an ideal world, all businesses would be self-funding of course and wouldn’t need either large dollops of debt or more equity from the market (and issuing more shares in the process). Of course, this is completely unrealistic and would mitigate the major reason why most private companies decide to ‘go public’ in the first place (i.e. the need for capital).

However, different companies manage their balance sheet differently depending on the industry they’re in and their maturity as a business.

Looking at a number of companies between 2005-06 and 2014-15, I can see how debt levels, net interest cover and share issuance have changed in that time, and here’s what I found:

2005-06 financial year
# of shares on issue (m) Debt/equity (%) Net interest cover Earnings per share (cents)
Wesfarmers Ltd (ASX: WES) 403.8 76.3 13.5 218.1
Transurban Group (ASX: TCL) 835.4 163.6 0.08 (7.4)
Santos Ltd (ASX: STO) 744.3 49.2 8.81 80.7
REA Group Limited (ASX: REA) 127.3 3.9 86.7 6.9
CSL Limited (ASX: CSL) 551.2 53.2 32.09 63.6
Reckon Limited (ASX: RKN) 132.5 0.0 (17.25) 6.1
2014-15 financial year
# of shares on issue (m) Debt/equity (%) Net interest cover Earnings per share (cents)
Wesfarmers Ltd (ASX: WES) 1,123.8 26.3 13.15 220.5
Transurban Group (ASX: TCL) 1,921.1 201.8 1.11 12.3
Santos Ltd (ASX: STO) 1,766.2 72.7 (24.25) (472.8)
REA Group Limited (ASX: REA) 131.7 0.0 (82.0) 152.0
CSL Limited (ASX: CSL) 464.8 83.0 39.45 374.5
Reckon Limited (ASX: RKN) 111.2 147.1 10.18 13.0

Source: Westpac

The key impressions I receive from the above table are:

  • It appears that Wesfarmers has reduced its debts levels at the expense of a much-enlarged share base providing almost flat earnings-per-share over this time period
  • Transurban Group’s very skinny net interest cover can perhaps be explained by its extremely reliable business model underpinned by CPI-linked toll revenue
  • Similarly to Transurban, Santos has massively increased its number of shares on issue and borrowed a whole lot more. Unlike Transurban though, Santos has found itself with high levels of debt at a time when its revenue has crashed (due to lower oil prices)
  • REA Group has demonstrated superior economics over the others in this list, with very little reliance on new debt or equity, but still nevertheless managed to increase its earnings-per-share by more than 22 times in the 10 years to 2014-15.
  • CSL Limited has been buying back its shares resulting in a reduced share-count, but perhaps at the expense of higher debt levels?
  • Reckon has managed to double its earnings in 10 years and reduced the number of shares on issue, but its debt/equity ratio has increased from zero to an uncomfortable 147. Despite this, it has a reasonable net interest cover of over 10 times.

Of course, the above figures can be obtained for any company, but I think the most important thing to look for is the relative change. Have things worsened, gotten better, or remained about the same?

Foolish takeaway

For my money, REA Group is the stand out candidate for a new investment from this list, despite its already-meteoric share price rise over the last decade.

There are six main reasons why I like REA Group Limited shares today:

  • its operating margins have increased almost three-fold since 2005-06, and the current operating margins look to be sustainable going forward,
  • it’s currently averaging a return-on-equity in the mid-30s,
  • it has a good history of keeping the share-count in-check,
  • there’s a solid history of above-average growth in revenue,
  • the company is debt-free, and
  • the company is forecast to increase its earnings again by at least 22% by 2016-17 from 2014-15 levels.

REA Group has also purchased the iProperty group of online property-portals in Asia, and more recently, Flatmates.com.au. It will be a very interesting read when the company’s annual results are announced this coming Tuesday.

More generally, using raw numbers like the ones presented above provides a useful starting point to your research, but the main point is, know your company’s results over a number of years, and don’t focus on any one single period. This will give you a good idea of which direction the company is headed.

Whilst REA Group looks expensive, it always has because of the quality of its results. With a couple of interesting acquisitions this year, there’s plenty of momentum behind this business that will continue to keep shareholders happy for the foreseeable future, even at today’s price of around $60.

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Motley Fool contributor Edward Vesely owns shares in CSL. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.