Learning stock analysis can be a daunting task for newbie investors. Here’s a complete step by step, do-it-yourself template for conducting in-depth stock analysis
- Analysing a Company- stock analysis basics, step-by-step
- Financial Health
- The Bear Case
- The Management
Learning to do an in-depth stock analysis is not rocket science. Here’s a step-by-step process that can be followed by any beginner stock enthusiast.
Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book –The Five Rules for Successful Stock Investing – suggests breaking down the process of evaluating the quality of a company into five areas -Growth, Profitability, Financial Health, Risks/Bear Case, and Management. These are the key areas to focus on when you are looking to do a stock analysis. His writings are the primary source for this article.
One word of caution, the following discussion is concerned only with evaluating the quality of the company. However, this is only half the story because even the best companies are poor investments if purchased at too high a price. Estimating the right price to pay for a company’s shares- or Stock Valuation is the other half of the story.
Anyone looking to do a stock analysis for a company is probably attracted to it because of its Growth. The allure of growth has probably led more investors into temptation than anything else. High growth rates are heady stuff – a company that manages to increase its earnings at 30% for five years will triple its profits, and who wouldn’t want to do that? Unfortunately a slew of academic research shows that strong earnings growth is not very persistent over a series of years; in other words a track record of high growth earnings growth does not necessarily lead to high earnings growth in the future.
Why is this? Because strong and rapidly growing profits attract intense competition. Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.
You can’t just look at a series of past growth rates and assume they’ll predict the future – if investing were that easy, money managers would be paid much less!. And this stock analysis much shorter. Its critical to investigate the sources of a company’s growth rate and assess the quality of the growth. High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that’s generated by merely cost-cutting or accounting tricks.
Investigating the sources of growth is an important element in any stock analysis framework. How to look for sources of growth? In the long run, sales growth drives earnings growth. Although profit growth can out pace sales growth for a while if the company is able to do an excellent job of cutting costs or fiddling with the financial statements, this kind of situation isn’t sustainable over the long haul – there’s a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottomline. In general, sales growth stems from one of four areas:1. Selling more goods or services2. Raising prices3. Selling new goods or services4. Buying another company
There are many ways of making growth look better than it really is, especially when we turn our attention to earnings growth rather than sales growth. (Sales growth is much more difficult to fake).
In general, when you are doing a stock analysis – any time that earnings growth outstrips sales growth by far, over a long period – for over 5-10 years – you need to dig into the numbers to see how the company keeps squeezing out more profits from lackluster sales growth. Stock analysis for sustainability of that growth becomes that much more critical. A big difference in the growth rate of net income and operating income or Cash flow from Operations can also hint at something unsustainable.
Any time you can’t pinpoint the sources of a company’s growth rate – or the reasons for a sharp divergence between the top and bottom lines, you should be wary of the quality of that growth rate.
Now we come to the second-and in many ways, most crucial-part of the stock analysis process. How much profit is the company generating relative to the amount of money invested in the business? This is the real key to separating great companies form average ones. The higher the return, the more attractive the business.
We know the first component of ROA. Its simply Net Margin, or Net Income divided by Sales. And it tells us how much of each dollar of sales a company keeps as earnings, after paying all the costs of doing business. The second component is Asset Turnover, or Sales divided by Assets, which tells us roughly how efficient the firm is at generating revenue from each dollar/rupee of Assets.
Multiply these two, and we have Return on Assets. Net Income/Sales =Net Margin and Sales/Assets =Asset Turnover
ROA = Net Margin x Asset Turnover
Think of ROA as a measure of efficiency. Companies with high ROAs are better at translating Assets into Profits. ROA helps us understand that there are two routes to excellent operational profitability. You can charge high prices for your products (high margins) or you can turn over your assets quickly.
Rough benchmarks for stock analysis – ROA
All things being equal, the more asset-intensive a business, the more money must be reinvested into it to continue generating earnings. This is a bad thing. If a company has a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything above 20% is asset-light [advertising firms, software companies].
Just using ROA would be fine, if all companies were big piles of Assets, but many firms are atleast partially financed with debt, which gives their returns a leverage component, which we need to take into account. ROE lets us do this.
Return on Equity is a great overall measure of a company’s profitability because it measures the efficiency with which a company uses shareholders’ equity. Think of it as measuring profits per dollar of shareholders’ capital.
Multiply ROA by the firm’s Financial Leverage ratio, and you have its Return on Equity.
Financial Leverage =Assets/Shareholders’ Equity and Return on Equity =Return on Assets x Financial Leverage. Because Return on Equity =Net Margin x Asset Turnover
ROE = Net Margin x Asset Turnover x Financial Leverage
Financial Leverage is essentially a measure of how much debt a company carries, relative to shareholders’ equity. Unlike Net Margins & Asset Turnover, for which higher ratios are almost unequivocally better, financial leverage is something you want to watch carefully. As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.
So, we have three levers that can boost ROE – net margins, asset turnover and financial leverage.
Rough benchmarks for stock analysis – ROE
In general, any non-financial firm that can generate consistent ROEs above 15 percent without excessive leverage is atleast worth investigating. As of mid 2008, only about 10% of the non-financial firms in ValuePickr database were able to post an ROE above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance. And if you can find a company with consistent ROEs over 30%, there’s a good chance you are really onto something.
Two Caveats when using ROE for stock analysis
First, Banks always have enormous financial leverage ratios, so don’t be scared off by a leverage ratio that looks high relative to a non-bank. Additionally, since banks’ leverage is always so high, you want to raise the bar for financial firms – look for consistent ROEs above 18% or so.
Second caveat is about firms with ROEs that look to good to be true, because they are usually just that. ROEs above 50% or so are often meaningless because they have probably been distorted by the firm’s financial structure. Firms that have been recently spun off from parent firms, companies that have bought back much of their shares, and companies that have taken massive charges of ten have very skewed ROEs because their Equity base is depressed. When you see an ROE over 50%, check to see if the company has any of these above-mentioned characteristics.
Cash Flow from Operations measures how much cash a company generates. It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year. As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business. To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.
Free Cash Flow =Cash Flow from Operations – Capital Expenditure
Free Cash Flow enables us to separate out businesses that are net users of Capital – ones that spend more than they take in- from businesses that are net producers of Capital, because its only that excess cash that really belongs to shareholders. Free Cash Flow is sometimes referred to as “Owners Earnings” because that’s exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company’s ongoing business.
Rough benchmarks for stock analysis – Free Cash Flow
As with ROE it’s tough to generalise how much free cash flow is enough. However its reasonable to say that any firm that is able to convert more than 10% of Sales to Free Cash Flow (just divide Free Cash Flow by Sales to get this percentage) is doing a solid job at generating excess Cash.
One good way to think about the returns a company is generating is to use the Profitability Matrix, which looks at a company’s ROE relative to the amount of free cash flow it’s generating. This Matrix can tell us a great deal about the kind of company we are analysing.
Companies such as Microsoft, Pfizer, and First Data Ltd all have consistently high ROEs. People write books about how to manage a business as well as these companies do, and its easy to see why – they are all money machines.
If you follow these companies at all, you’ll notice that they have another thing in common besides high ROEs -their stocks all had valuations that were very high during the bull market of the 1990s. Again its easy to see why. A company that can earn a high return on its shareholders money is worth more to those same shareholders.
Looking at the other axis, we see that these companies are also very good at generating free cash flow. Pfizer for example, generated more than $8 billion in free cash flow in 2002. That’s $8 billion Pfizer made after spending whatever it needed to invest in the business.
On the bottom half of the matrix we have companies like Amazon.com, Jet Blue, Comcast and Lowe’s which generate low or negative free cash flow. Companies like these aren’t generating much free cash because they are using all the cash their businesses generate -and then some- to invest in expansion. They are investing heavily because they hope that these expansion efforts will pay off in the form of fat profits in the future.
Jet Blue and Amazon are like young entrepreneurs. They have taken out loans and and maxed out their credit cards, and they are ploughing every cent that they have into building and expanding the business. Folks are investing in their business because they expect these businesses to be very profitable sometime in the future. Asian Paints on the other hand is more like a successful middle-aged businessman. He’s already proven he can earn a good return on shareholders money, so folks line up outside his door to for the privilege of investing in his ventures.
You would be taking a lot less risk investing with the older businessman than you would with the young entrepreneur -though that entrepreneur might just pay you back many, many times over. Just remember that for every Jeff Bozos or Steve Jobs, there are literally hundreds of entrepreneurs who never paid their investors a dime. There’s nothing wrong with investing in the entrepreneurs of the world, as long as you know what you are getting into. A profitability matrix can help you separate your long shots from your core holdings.
Return on Invested Capital is a sophisticated way of stock analysis for return on Capital that adjusts for some peculiarities of ROA and ROE. Its worth knowing how to interpret it because its overall a better measure of profitability than ROA and ROE. Essentially ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing. It removes the debt related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of Profits than ROE and ROA, both of which use Net Profits. ROIC uses Operating Profits after taxes, but before interest expenses.
Again, the goal is to remove any effects caused by a company’s financing decisions -does it use debt or equity?- so that we can focus as closely as possible on the profitability of the core business.
The true operating performance of a firm is best measured by ROIC, which measures the return on all capital invested in the firm regardless of the source of the capital. The formula for ROIC is deceptively simple
ROIC = Net Operating Profit after Taxes (NOPAT)/Invested Capital
Invested Capital =Total Assets – Non-Interest bearing Current Liabilities – Free Cash Flow
(Non-interest bearing current liabilities usually are Accounts Payable and other Current Assets)
You may also want to subtract Goodwill, if its a large percentage of Assets.
What does all this mean to you if you hear someone talking about ROIC? Simply that you should interpret ROIC just as you would ROA and ROE – a higher Return on Invested Capital is preferable to a lower one!
Rough benchmarks for stock analysis – ROIC
In general, any non-financial firm that can generate consistent ROICs above 15 percent is atleast worth investigating. As of mid 2008, only about 10% of the non-financial firms in SPH database were able to post an ROIC above 15% for each of the past 5 years, so you can see how tough it is to post this kind of performance. And if you can find a company with consistent ROICs over 30%, there’s a good chance you are really onto something.
Once we have figured out how fast (and why) a company has grown and how profitable it is, we need to look at its financial health. Even the most beautiful home needs a solid foundation, after all. Financial Health is the 3rd element in our stock analysis framework.
The bottom line about financial health is that when a company increases its debt, it increases its fixed cost as a percentage of total costs. In years when business is good, a company with high fixed costs can still be extremely profitable because once those costs are covered, any additional sales the company makes fall straight to the bottom line. When business is bad, however, the fixed costs of debt push earnings even lower.
For illustration, check out the volatility in Earnings for a fictitious company Acme, below
A common measure of leverage is simply the Financial Leverage ratio.
Financial Leverage = Assets/Shareholders’ Equity
Think of financial leverage like a Mortgage – a homebuyer who puts Rs. 200,000 down on a Rs. 1,000,000 house has a financial leverage ratio of 5. For every Rupee in Equity, the buyer has Rs. 5 in assets.
The same holds true for companies. In 2008, a retailer like Trent has a financial leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total assets. (It borrowed the other Rs. 1.1.)
Rough benchmarks for stock analysis – Financial Leverage
A financial leverage ratio of 2.1 is fairly conservative, even for a fast growing retailer. Its when we see ratios of 4, 5 or more that companies start to get really risky.
This is just what it sounds like – long-term debt divided by Shareholders’ equity. It’s a little like the financial leverage ratio, except that it is more narrowly focused on how much long-term debt the firm has per Rupee of Equity.
Debt to Equity = Long-Term Debt/Shareholders’ Equity
Rough benchmarks for stock analysis – Debt to Equity
The lower the better. Companies with Debt to equity less than 1 are conservatively financed.
Look up pretax earnings, and add back interest expense and taxes (EBIT). Divide EBIT by interest expense, and you will know how many times (hence the name) the company could have paid the interest expense on its debt. The more times the company can pay its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.
Interest Coverage = Earnings before Interest & Taxes (EBIT)/Interest Expense
Rough benchmarks stock analysis – Interest Coverage
It is tough to say how low this metric can go before you should be concerned -but higher is definitely better. You want to see higher Interest coverage for a company with a more volatile business than for a firm in a more stable industry. Be sure to look at the trend in Interest coverage over time as well. Calculate the ratio for the past 5 years, and you will be able to see the company is becoming riskier -Interest coverage is falling – or, whether its financial health is improving.
The current ratio simply tells you how much liquidity a firm has – in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities.
Current Ratio = Current Assets/Current Liabilities
Rough benchmarks for stock analysis – Current Ratio
As a very general rule, a current ratio of 1.5 or more means the firm should be able to meet operating needs without much trouble.
Unfortunately, some current assets – such as inventories – may be worth less than their value on the balance sheet. (Imagine trying to sell old PCs or last year’s fashions to generate cash – you would be unlikely to receive anything close to what you paid for them.)
So there’s an even more conservative test of a company’s liquidity, the Quick Ratio.
Current assets less inventories, divided by liabilities equals Quick Ratio.
Quick Ratio = (Current assets – Inventories)/Liabilities
This ratio is especially useful for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.
Rough benchmarks for stock analysis – Quick Ratio
In general, a quick ratio higher than 1.0 puts a company in fine shape, but always look to other firms in the same industry to be sure.
After assessing growth, profitability, and financial health, your next task is to look at the bear case for the stock you are analysing. Creating the Bear Case is the 4th element of our stock analysis framework.
1. Listing all of the potential negatives, from the most obvious to the least likely
2. What could go wrong with your investment thesis?
3. Why might someone prefer to be a seller of the stock than a buyer?
Constructing a convincing bear case is especially important for those who like to buy high-quality companies that have hit temporary speed bumps, because what looks like a speed bump may very well be a roadblock on closer inspection.
Equally important, your bear case will be a great reference point even if you do decide to buy the stock. You’ll know in advance what signs of trouble to watch for, which will help you make better decisions when bad news comes down the pike in the future. Having already investigated the negatives, you will have the confidence to hang on to the stock during a temporary rough patch as well as the savvy to know when the rough patch might really be a serious turn for the worse.
Excellent Management can make the difference between a mediocre business and an outstanding one, and poor management can run even a great business into the ground. Your goal is to find management teams that think like shareholders – executives that treat the business as if they owned a piece of it, rather than as hired hands. Evaluating Management is the fifth and final element of our stock analysis framework.
People buy stocks all the time without checking out the folks in the executive suite. There are many ways to get a feel for the folks running a company that have nothing to do with looking the CEO in the eye.
The Management assessment process can be broken down into 3 parts:
First and foremost, how much does management pay itself? Usually, it is preferable to see
* Big bonuses to big base salaries
* Restricted stock grants to generous option packages.
Bonuses mean that a good portion of the pay is at least theoretically at risk, and restricted stock means the executive loses money if the share price declines.
* CEO packages not more than 40x-50x that of average employee
* Look at competing firms to see what their CEOs are paid
* CEO pay tied to firms operational performance
In general the larger the firm and the better its financial performance, the more an executive should be paid. The bottom-line is Executive pay should rise and fall based on the performance of the company. After reviewing the company’s historical financials, read the past few years’ proxies to see whether this has truly been the case.
Some other Red Flags
* Does Management hog most of the stock options granted in a year, or do rank-and-file employees share in the wealth?
* Does Management use stock options excessively?
* If a founder or large owner still around, does he also get a big stock option grant each year?
* Do Executives have substantial holdings in the company, or they tend to sell shares right after they exercise options?
Compensation by itself is a often a good litmus test for character – anecdotally, there’s a pretty strong relationship between management teams that are in it for the money and management teams that treat shareholders poorly. However, there are some other important questions to ask to get a handle on whether a firm’s management deserves your trust.
* Does Management use its position to enrich Friends & Relatives?
* Is the Board of Directors stacked with Management’s family members?
* Is Management candid about its mistakes?
* How promotional is Management?
* Can the CEO retain high-quality talent?
* Does Management make tough decisions that hurt results but give a more honest picture of the company?
Running the Business
In addition to management who are paid reasonably and are honest, you also want folks who can run the business well.
The first stop is simply the financial performance of the company during the tenure of the current management team. Look for high and increasing ROEs and ROAs –don’t forget to check whether increasing ROE was driven by higher leverage as opposed to improved margins or asset efficiency.
Are there big jumps in revenue? If so, probably they did an acquisition. Was that reasonably priced and proved value accretive subsequently?
Finally look at stock analysis for its share count over a long period of time. If that has increased substantially because of aggressive options programs or frequent equity issuance, the firm is essentially giving away part of your stake without asking you. That’s not a great recipe for long term share performance.
When Management identifies a problem and promises a solution, does it actually implement the plan, or does it hope you forget about it? Same goes for any new strategic initiatives announced. One way to vet this is to look at past annual reports and see what new strategic initiatives were discussed 3-7 years ago. Where are they now? Or, have the initiatives just disappeared from the radar screen?
Does the firm provide enough information to properly analyse the business, or does it clam up about certain issues? Its entirely proper for firms not to report certain things, but selective reticence about problem areas is never a good sign.
Firms that do something markedly different from their peers or from conventional opinion, is to be generally applauded. Maintaining research and development spending during an industry downturn is another good example of self-confidence that shows management is more concerned with beating competitors over the long haul than beating quarterly earnings guidance.
Has management made decisions that will give the firm flexibility in the future? These include simple decisions such as not taking on too much debt to more strategic decisions such as issuing equity when the stock is high, retiring high-rate debt when the opportunity presents itself and buying back stock only when the price is low are also good examples of sound capital allocation decisions giving evidence of a strong operational hand on the tiller.
This brings us to the end of the Stock Analysis basics section-covering some essential elements of any stock market for beginners guide.