Back of the Napkin Valuation Tools
Simple is Usually Best
Investment, at its core, is an undertaking of valuation. The market assigns a price to every asset at any point in time, reflecting the consensus view of market participants. The source of superior market returns for an investor emerges when your personal valuation differs from the market’s, and you are more correct than the market in these instances of difference. Being different isn’t enough; being different and correct is the source of superior returns. But how does one actually value a company or asset?
Despite the multitude of valuation approaches, one concept stands as the rational foundation over time: the intrinsic value of a company or asset is the cash it can generate for shareholders over its lifetime, discounted to the present. This encompasses both present and future cash flows, with the discount applied to account for the time value of money (opportunity cost). This definition is rational for a fundamental reason: regardless of what markets and other investors might be willing to pay for an asset, if you hold it, you will experience ownership of the underlying cash flows and thus have ownership over tangible returns. Discounted cash flow (DCF) models attempt to capture this reality, but they can become unwieldy and overly complex. Sophisticated models promise precision, with countless variables feeding into elaborate spreadsheets that project decades into the future. Yet history has repeatedly demonstrated that such precision is often illusory. The human world is simply too complex, too dynamic, and too unpredictable for any model to capture perfectly. A single unexpected change, whether it be a regulatory shift, a technological disruption, a new competitor or a countless range of other factors, can render an entire model obsolete overnight. This reality suggests that investing is more art than science.
As Einstein reportedly once said, “everything should be made as simple as possible, but not simpler.” In a world where many pursue the mirage of perfect accuracy, there is a genuine advantage in being generally correct rather than precisely incorrect. Back of the napkin mathematics and checklists, rather than being unsophisticated, can actually serve as a powerful shortcut that distils core ideas and often proves more accurate than the complex precision of financial modelling. This is what this article is for, to briefly go through some of the simple quantitative and qualitative back of the napkin mental models and tools that while easy to do, provide invaluable help in analysing an investment.
The Quantitative Valuation Toolkit
Price-to-Earnings Ratio (P/E)
The P/E ratio is perhaps the most intuitive and common valuation metric. It is normally calculated as the price per share divided by the earnings per share (after preferred dividends). Commonly it is interpreted as for every dollar of earnings, how much are you paying for it? However, it can also be interpreted as how many years would it take to earn back your investment if current earnings were sustained?
A company trading at a P/E of 15 requires fifteen years of current earnings to earn back the money you have paid for it in accumulated earnings. Whether this represents good value depends on the company’s growth prospects, competitive position, and the returns available elsewhere. A mature, slow-growing business might deserve a P/E of 10, whilst a rapidly expanding company in a growing market might justify a P/E of 30 or higher. The key is understanding what you’re paying for. To give some context, the S&P 500 P/E ratio historically is around 15-20, however in recent decades, it has normally sat around the 20-25 range.
Another mental trick I find useful at times, but not common to my knowledge is that the P/E ratio can be used as a rough yardstick for cumulative earnings relative to the purchase price: under a sustained earnings assumption, a P/E of 10 implies annual earnings equal to 10% of the purchase price, cumulative earnings equal to the purchase price after ten years, and cumulative earnings equal to 200% of the purchase price after twenty years.
Price/Earnings-to-Growth Ratio (PEG)
The PEG ratio refines the P/E metric by incorporating growth expectations, providing a more nuanced valuation framework as much of a company’s value comes from its future ability to generate cash. It is calculated by dividing the P/E ratio by the expected annual earnings growth rate. A PEG ratio of 1.0 is often considered fair value, suggesting you’re paying proportionally for the growth you’re receiving.
For example, a company trading at a P/E of 30 with expected earnings growth of 30% annually has a PEG of 1.0 (30 ÷ 30). This same company might appear expensive on a P/E basis alone, but when growth is factored in, the valuation appears more reasonable. Conversely, a company with a P/E of 15 but only 5% growth has a PEG of 3.0, suggesting overvaluation to the growth on offer.
The PEG ratio is particularly useful when comparing companies with different growth profiles. It helps answer the question: “Am I paying a reasonable price for this growth?” However, it comes with important caveats. The metric is only as good as the growth estimate used, and growth estimates are notoriously unreliable, especially beyond a few years. Additionally, PEG ratios don’t account for differences in business quality, for example, a company with a sustainable moat growing at 20% is usually worth more than a commodity business growing at the same rate in the long run.
Despite these limitations, the PEG ratio serves as a useful quick-reference tool for initial screening and for contextualising what might otherwise appear to be an expensive P/E multiple. It reminds us that growth has value and that a high P/E isn’t necessarily problematic if it’s accompanied by commensurately high growth. The key is understanding whether that growth is sustainable, profitable, and achievable.
Earnings Yield (E/P)
The inverse of the P/E ratio, the earnings yield expresses valuation as a percentage return. A company with a P/E of 20 has an earnings yield of 5%. This framing allows for direct comparison with alternative investments and provides an intuitive sense of what you’re actually receiving for your investment.
The earnings yield represents the annual earnings generated relative to what you’re paying for the asset. More precisely, it shows what percentage of your purchase price the company earns back each year. Think of it like a bond yield in concept: if you buy a bond yielding 5%, you receive 5% of your investment back in interest. Similarly, a 5% earnings yield means the company generates earnings equivalent to 5% of its market capitalisation annually, though the company may retain some or all of those earnings rather than paying them out as cash.
This metric becomes particularly powerful when comparing stocks to other investment opportunities. If ten-year government bonds yield 4% with virtually no risk, and a stock offers an earnings yield of 5%, you must ask whether that additional 1% adequately compensates you for the equity risk, lack of guaranteed payments, and business uncertainties involved. Conversely, if that same stock has strong competitive advantages, consistent earnings growth, and operates in a favourable industry, the 5% earnings yield might represent exceptional value compared to the risk-free rate.
The earnings yield also helps frame the opportunity cost of investment decisions. A company with a 10% earnings yield (P/E of 10) is returning earnings at double the rate of one with a 5% earnings yield (P/E of 20). Whether the latter justifies its lower yield depends entirely on its growth prospects, quality, and sustainability of earnings. High-quality compounders often trade at low earnings yields because investors recognise that today’s earnings will grow substantially over time, making the effective yield on today’s purchase price increasingly attractive in future years. Thus the earnings yield should be considered alongside the quality and sustainability of those earnings. A 15% earnings yield on a deteriorating business in a dying industry may be far less attractive than a 3% earnings yield on a high-quality compounder with decades of runway ahead. The yield tells you what you’re getting today; your analysis must determine what you’re likely to get tomorrow.
Return on Invested Capital (ROIC)
ROIC measures how efficiently a company generates profits from its total capital base, both debt and equity combined. It answers the question: for every dollar of capital deployed, how much profit does the business generate? The metric is usually calculated by dividing Net Operating Profit After Tax (NOPAT) by Invested Capital, where Invested Capital equals Total Assets minus Current Liabilities, or alternatively, Debt plus Equity. This calculation reveals how efficiently a company converts deployed capital into operating profits, and it is capital structure neutral, meaning it examines returns before considering how the business is financed.
High ROIC businesses tends to be a good sign as it indicates a business has found a way to generate substantial returns without needing to deploy vast amounts of capital. This allows for a far lower reinvestment rate of their income to achieve the same amount of growth compared to a lower ROIC business, and this tends to create far better outcomes for shareholders, especially if compounded over time. This often signals competitive advantages, whether through brand strength, network effects, or operational excellence. A company consistently generating 20%+ returns on invested capital is doing something right. Think of ROIC as the company’s return on every dollar invested in the business, regardless of whether that capital came from debt or equity. A ROIC above 15% generally indicates a strong business, whilst above 20% suggests meaningful competitive advantages. However, you must remember that for high ROIC to translate into real strong growth, the company must also possess the internal or external opportunity to reinvest its earnings at those same high rates going forward.
Reinvestment Rate × ROIC
The fundamental relationship between earnings growth, reinvestment, and returns on capital is elegantly captured in a simple formula: Earnings Growth = Reinvestment Rate × ROIC. Rearranged, this becomes Reinvestment Rate = Earnings Growth ÷ ROIC, which reveals why ROIC matters so profoundly. Consider two companies both targeting 6% earnings growth: Company A with 20% ROIC needs to reinvest only 30% of its profits (6% ÷ 20% = 30%), whilst Company B with 8% ROIC must reinvest 75% (6% ÷ 8% = 75%). Company A achieves identical growth whilst retaining 70% of earnings for dividends or buybacks, whereas Company B must plough back nearly all profits just to keep pace. This formula explains why high-return businesses can be so attractive to investors as they can grow rapidly, return cash generously, or do both simultaneously.
Return on Equity (ROE)
Similar to ROIC but focusing specifically on shareholders’ equity, ROE measures the return generated on the owners’ investment. The calculation is straightforward: Net Income divided by Shareholders’ Equity. This shows the return generated specifically on shareholders’ money—what equity investors actually earn on their stake in the business. ROE above 15% is generally considered strong, whilst 20%+ is exceptional. However, ROE can be misleading if a company is highly leveraged, as debt magnifies returns (and losses). It should therefore be considered alongside debt levels.
ROE’s critical weakness is that leverage amplifies it as a mediocre business with substantial debt can show impressive ROE simply through financial engineering. This is why you must examine ROE alongside debt levels.
Debt-to-Equity Ratio
This simple metric reveals how a company finances its operations and is calculated by dividing Total Debt by Total Shareholders’ Equity. The ratio reveals the proportion of debt versus equity financing. Essentially, it is how much the company has borrowed relative to what shareholders have invested. A ratio of 1.0 means equal parts debt and equity; below 0.5 suggests conservative financing; above 2.0 indicates aggressive leverage. However, appropriate levels vary dramatically by industry as capital-intensive businesses like utilities may operate comfortably at 1.5-2.0, whilst software companies typically carry minimal debt.
High debt levels can amplify returns during good times but create existential risks during downturns. Understanding capital structure is essential to understanding risk. A company with minimal debt has far more flexibility and resilience than one loaded up on a mountain of borrowings. When analysing debt, also examine interest coverage (EBIT divided by interest expense) to ensure the company can comfortably service its borrowings even if profits decline.
Price-to-Sales Combined with Gross Margins
For high-growth businesses that are reinvesting heavily and may not yet be profitable, price-to-sales offers a useful alternative metric. Price-to-Sales can be calculated by dividing Market Capitalisation by Annual Revenue, showing how much investors pay for each dollar of revenue. However, it should be considered alongside gross margins, which are calculated as Revenue minus Cost of Goods Sold, divided by Revenue. Gross margin reveals what percentage of each sale remains after direct production costs. A company with 80% gross margins trading at 10× sales is fundamentally different from one with 20% gross margins at the same multiple. The former usually, but not always, has more economic potential once it reaches maturity and can potentially harvest those margins.
This combination is particularly valuable for analysing reinvestment-stage businesses where current profitability is suppressed by deliberate growth investments. A SaaS company with 80% gross margins trading at 8× sales may be considerably cheaper than a retailer with 30% gross margins at 2× sales once you consider their respective profit potential.
Free Cash Flow Yield
The logic of free cash flow yield is largely the same as E/P ratio, but is useful because earnings can be manipulated through accounting choices, but cash is harder to fake. Free cash flow yield, which can be roughly calculated as free cash flow divided by market capitalisation, reveals what percentage return you’re receiving in actual cash generated by the business. Free Cash Flow itself is usually calculated as Operating Cash Flow minus Capital Expenditures, representing the cash available for shareholders and debtholders a business generates after maintaining and growing its asset base.
Operating Leverage
Operating leverage describes how profits respond to changes in revenue and can be calculated as the percentage change in operating profit divided by the percentage change in revenue. This measures how sensitive profits are to changes in revenue, it shows how much of each additional dollar of sales flows through to profit. Businesses with high fixed costs and low variable costs exhibit high operating leverage. Once they cover their fixed costs, additional revenue flows predominantly to profit. The inverse holds true as businesses with low fixed costs and high variable costs exhibit low operating leverage.
Understanding a company’s operating leverage helps predict how profitability will evolve as the business scales. A company with high operating leverage can see dramatic profit expansion from modest revenue growth, making it particularly attractive if you can identify inflection points in revenue trajectory. Software companies exemplify this: once the software is built (fixed cost), serving additional customers costs almost nothing (minimal variable cost). A SaaS business might see a 10% revenue increase translate to a 40% profit increase. This creates dramatic profit acceleration once revenue inflection occurs but works equally powerfully in reverse as revenue declines hit profits disproportionately hard. Traditionally, manufacturing and airlines show high operating leverage; consulting businesses show low leverage since costs (people) scale directly with revenue. When analysing companies, high operating leverage often increases both potential returns and risks, making it crucial to assess revenue and stability alongside the leverage itself.
Owner Earnings (Buffett’s Measure)
Warren Buffett refined the concept of free cash flow into what he calls “owner earnings,” calculated as Net Income plus Depreciation and Amortisation, minus Capital Expenditures required to maintain competitive position, minus any increases in Working Capital requirements. This metric attempts to answer the question: how much cash could the owners actually extract from the business annually without harming its competitive position? Owner earnings tries to provide a more realistic picture of economic reality than accounting earnings, which may include non-cash charges or exclude necessary reinvestment. It attempts to represent the true economic benefit flowing to owners.
The Qualitative Valuation Toolkit
Moat Analysis: Hamilton Helmer’s 7 Powers
Beyond the numbers, sustainable competitive advantages or “moats” play a large role in determining whether a company can maintain attractive economics over time. Hamilton Helmer’s “7 Powers” framework provides a structured approach to identifying genuine competitive advantages:
Scale Economies: Cost advantages that arise from size. The larger the company, the lower the per-unit cost. This creates a self-reinforcing cycle where the biggest player can underprice competitors whilst maintaining superior margins.
Network Effects: The value of the product or service increases with each additional user. Social networks, marketplaces, and payment platforms all benefit from network effects. Each new participant makes the network more valuable for all existing participants.
Counter-Positioning: A new business model that incumbents cannot adopt without cannibalising their existing, profitable business. Netflix’s streaming model counter-positioned Blockbuster’s rental stores; the incumbent couldn’t respond effectively without destroying its own economics.
Switching Costs: Customers face significant costs—financial, time-based, or psychological—to change providers. Enterprise software often exhibits high switching costs due to integration complexity and employee training requirements.
Branding: Affective associations that increase willingness to pay. True brand power means customers will pay more for your product than for an identical generic alternative, purely because of the brand.
Cornered Resources: Preferential access to valuable assets that competitors cannot easily replicate. This might include patents, exclusive contracts, unique mineral deposits, or irreplaceable talent.
Process Power: Embedded company processes and organisational knowledge that cannot be easily replicated, even when visible to competitors. Toyota’s manufacturing excellence exemplifies process power.
A company possessing one or more of these powers may have a genuine moat. Without such advantages, attractive returns will eventually be competed away as you must assume, unless you have special advantages that allow you to be superior in your process and product, competent and well-backed competition will always emerge if there is an area of high margin profitability. The durability of excess returns depends entirely on the strength and sustainability of these competitive advantages.
Psychological Analysis: Robert Cialdini’s 7 Principles of Influence
Understanding the psychological forces at play both in consumer behaviour and investor behaviour often provides an additional dimension of insight. Robert Cialdini’s seven principles of influence reveal how human psychology impacts business success and market pricing.
Liking: People prefer to say yes to those they like. We are more easily influenced by people who are similar to us, who compliment us, who are physically attractive, or with whom we cooperate towards mutual goals. This principle operates automatically and often unconsciously; we naturally favour those we find likeable, even when that likeability is irrelevant to the decision at hand. The feeling of affection or positive regard creates a bias towards compliance and favourable treatment.
Reciprocity: People feel obligated to return favours. When someone gives us something, whether a gift, a concession, or an act of kindness, we experience psychological pressure to reciprocate. This obligation is deeply embedded in human nature and exists across all cultures. The reciprocity impulse is so strong that it can override our normal decision-making processes, causing us to say yes to requests we would otherwise refuse. Notably, we often feel compelled to return favours that are larger than what we originally received.
Scarcity: People value things more when they perceive them as scarce or decreasing in availability. The possibility of losing something or missing an opportunity creates psychological tension and urgency. Scarcity works through two mechanisms: rare items are often more valuable, and scarcity signals that other people want the item (social proof). Importantly, the perception of potential loss is typically more motivating than the prospect of equivalent gain. Time limits, limited quantities, and exclusive access all trigger scarcity responses.
Authority: People defer to and follow the guidance of credible experts and authority figures. From childhood, we’re conditioned to respect and obey legitimate authorities whether it be doctors, professors, law enforcement, credentials, titles, and even superficial symbols like uniforms or impressive settings. This deference to authority is often automatic and operates even when the authority’s expertise isn’t directly relevant to the situation. We use authority as a decision-making shortcut, assuming that experts know best and following their lead reduces our risk of error.
Social Proof: People look to the actions and behaviours of others to determine their own, especially in situations of uncertainty. When we’re unsure what to do, we assume that others possess more knowledge about the situation and that their actions reflect the correct behaviour. This tendency is particularly strong when we observe people similar to ourselves, when we see large numbers of people acting the same way, or when we’re in ambiguous situations. Social proof operates automatically and we often don’t consciously realise we’re being influenced by what others are doing.
Commitment and Consistency: People have a deep desire to be consistent with things they have previously said or done. Once we make a choice or take a stand, we encounter personal and interpersonal pressure to behave in ways that align with that commitment. This drive for consistency is so powerful that we’ll often persist with commitments even when they no longer serve our interests. The consistency principle is strongest when commitments are active (we took action), public (others know about it), effortful (we invested resources), and voluntary (we weren’t coerced). We modify our attitudes and beliefs to align with our past actions.
Unity: People are influenced by appeals to shared identity and belonging. Unity is about being part of an “us”, sharing an identity with others. This goes beyond mere liking or familiarity; it’s about kinship, whether defined by family, geography, ethnicity, nationality, political affiliation, or shared beliefs and experiences. We’re more receptive to requests from those who are part of our in-group and less receptive to those outside it. The unity principle taps into our fundamental need for belonging and our tendency to favour those with whom we share identity markers. Creating a sense of “we” rather than “you and me” dramatically increases influence.
These principles operate on two levels for investors. First, they reveal hidden business strengths: companies effectively leveraging multiple psychological principles may possess stronger customer economics and more durable moats than financial statements alone suggest. Secondly, these same forces can distort prices in investment markets. Scarcity drives bubbles, social proof creates momentum cascades, authority figures move markets beyond fundamentals, and commitment bias keeps investors trapped in losing positions
Conclusion
None of these metrics tells the complete story in isolation. A low P/E might indicate value or a dying business. High ROIC could reflect a genuine competitive advantage or unsustainable conditions. Strong psychological influence might mask deteriorating fundamentals, or it might represent an underappreciated moat. The art lies in combining these tools, understanding their limitations, and developing a holistic picture of a company’s economics, competitive position, and the psychological forces at play. There is certainly room for DCF’s and complex valuations in this world, and sometimes it may truly be useful, however, many times, using back of the napkin tools can serve just as well, if not better in analysing and valuing.
Simple tools don’t just save time, they often enable deeper insight. When you can initially assess a business with a few key ratios, a competitive latticework, an understanding of psychological moats, or whatever other frameworks you have in your head, you can hold more ideas in your head simultaneously. It became easier to spot patterns, make comparisons, connect the dots and reach better conclusions. The ability to cut through complexity and focus on what truly matters is a rare and valuable skill. Yet again, as Einstein is once reported to have said, “everything should be made as simple as possible, but not simpler.”
*Disclaimer: This information is for general informational purposes only and does not constitute financial, investment, or professional advice. The author may hold positions in the assets or companies discussed.
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