Consider this the opening item in an ongoing discussion about how the Rule Maker is going to value companies.

As any of you who have kept up over the last few weeks have noted, we've thrown in a series of numerative evaluation steps into the Rule Maker mix. Matt Richey did a nice job finishing up our discussion on Return on Invested Capital (ROIC) in last week's edition. I'm really excited to have Matt back here in the mix.

If you spent any time on the Rule Maker Strategy discussion board this week, you also saw a discussion that highlights the danger of trying to use ROIC as some sort of exact science. The numbers that go in, while not in any way arbitrary, are certainly subject to interpretation. Once again, our hero and frequent contributor Andrew Chan has put together a nice explanation of how he calculates ROIC, as well as an Excel spreadsheet he uses to calculate it. Let it not be said that the Fool community doesn't provide value to one another.

The thing to remember with ROIC or any other calculation that you are doing here is that you are not looking for exactitude. Remember the words of Yogi Berra: "It's hard to make predictions, especially about the future." What we want to be able to determine is a gross imbalance between the current price of a stock and how much we believe it to actually be worth. I'm not going to ever fret about being a dollar off or missing the bottom of something. I am looking, with Rule Maker companies, to root out ones that have been penalized for short-term issues as if they are permanent impairments.

For me this means that I'd like to buy companies at somewhere below 60% of intrinsic value and sell them when they near 100%. In the past we Fools have missed opportunities to sell Yahoo! (Nasdaq: YHOO) and Cisco (Nasdaq: CSCO) when they sailed way beyond any reasonable value that would provide us a chance for a good return. I tend to believe that this missed inflection point had something to do with dogma rather than temporary (or permanent) stupidity. Well, no more. We're gonna sell stocks when we're convinced that they no longer provide much of a chance for appreciation. We will continue to be wrong on some things, and we are unlikely to ever, ever hit the top of a market. That's not our bag, baby.

You want to see a case in point of me making a complete misjudgment on the value of a company? Read yesterday's Fool on the Hill. It happens. We learn, but it still happens.

This is the framework I am going to propose for Rule Makers and valuation and selling. Each quarter at a minimum we will put together a report card of sorts for our existing holdings. We will do the same whenever we are analyzing other Rule Maker companies (remember, the portfolio owns only a few companies, but there are hundreds that actually meet the test of Makerdom). I don't think for a second that we would have caught the high, nor do I think that we would have been able to presuppose the burst of a bubble that seems all to clear in hindsight. But we DID look at what Cisco at a $400 billion market cap would have to do to justify its price plus build in room for growth. There was no room for error, just as there was no room for error when Qualcomm (Nasdaq: QCOM) exceeded $100 billion in market cap, which was one we got right. It's always harder to cast an objective eye on a company that one already owns.

Each quarter we will take a look at two things: the company's business prospects and its price and give a rating of A, B, C, or F for each. A company that rates an F for business is a sell no matter what, similarly one that is an F for valuation is a sell no matter what. Companies that rate two As are holds (or buys), ones that rate any combination of Bs and Cs are judgment calls. Now, the issue simply comes to trying to develop the criteria that will get us to this point.

From the business standpoint, we're going to want to look at companies in the following way:

A  =  Company has shown exceptional growth in revenues and steady profits and cash flows. Company has maintained or increased its competitive advantage period and no discernible threat to its dominant position has arisen since our last evaluation. The company has not added on debt, its inventories and receivables are stable or decreasing, and its executive compensation and full reporting policies are cogent, fair, and transparent.

B  =  Company has shown steady growth and has remained above its competition in terms of market share, gross and net profit margins, and cash flows. The company's debt, inventory, or receivables line items are not perfect, but there does not seem to be a big threat. The company's stock options program is generous but is clearly discussed, and its financials are easy to read.

C  =  Company has shown average growth in revenues, steady profits, and cash flows. There may be some imbalance between these three numbers (dropping margins, profits outstripping cash flows), but nothing that would set off an emergency alarm. Company has competition in its market, and this competition seems to be showing some strength. The company's Flow Ratio may have expanded, indicating that it has increased the level of receivables and/or inventories since the last review. The company is somewhat dependent on stock options for compensation and/or has recently repriced or cancelled and reissued options. Its reporting documents could use some improvement, but do not seem to obfuscate the actual position of the company.

F  =  Company has shown a significant worsening of the quality of its earnings as evidenced by lower gross and net margins and poorer cash flows. The company shows little differentiation of its performance in these areas vis-a-vis its competition, suggesting that its competitive advantage is either crumbling or was not as strong as we originally suspected. There is evidence of poor working capital management in the forms of high levels of debt, rapidly disintegrating Flow Ratio, significant increase in inventories and/or receivables, along with a major disconnect with allowance for doubtful accounts. Research and Development expenditures decreasing, the company insists upon maintaining high levels of management incentive programs through options and actually uses the words "to keep management interests aligned with shareholders." Corporate communications focus on different measures than they had in the past, and do not clearly communicate the true position of the business.

Many companies will fall somewhere in between, so you can feel free to shade your results with a "+" or a "-".

For valuation, the method will be the same:

A  =  Significant undervaluation. We're looking at a company that seems to maintain better-than-average economics than its peers but sits at a multiples to earnings or free cash flow that are equal to or less than other companies. It is possible that short-term considerations have conspired to knock the company's price down to levels that mean that we should consider it for a purchase.

B  =  Fairly valued. These companies do not leap off the page as screaming buys, as some of the worst-case scenarios would impact its performance in a way for which the share price may not have fully discounted. Still, with some luck and skill by the company, it could reward its shareowners with market-beating returns.

C  =  Fully valued. The company has some growth and some premium baked into its price, but as a Rule Maker with a competitive advantage it ought not be placed on the same level as the average company. This company should be looked at in conjunction with other factors, including a P/E or P/FCF ratio over the last five years or more to ensure that we are not overestimating its economic potential. If an investor sees better opportunities for his money, this might be a good source of those funds.

F  =  Grossly overvalued. Sometimes a cheery disposition can be quite expensive. This situation will arise if the company seems to have some real potential threats on the horizon, just as it will if the investment community seems to have nothing but good things to say about it. A company that shows degradation in its competitive advantage will become overvalued at a much lower multiple than one that still seems to dominate its market. However, any company, regardless of competitive strength or market potential, CAN reach the point where anything but the most rosy scenario possible has been priced in. In such cases, a company can be labeled overvalued regardless of the perceived promise of its market.

Next week we'll take a look at a few examples past and present in order to show how we are thinking on this issue. In the meantime, if there are questions, shoot 'em my way, or put 'em up on the Rule Maker Discussion Board!

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann is the Rule Maker Manager. At time of publishing, Bill had beneficial interest in Cisco. The Motley Fool has a disclosure policy.