Below are some quick tips to analyzing a company fundamentally.
– Start by reading the business section in the quarterly or annual report so you get a strong overview of the industry business.
– Identify the business drives that lead to upside potential and those that can cause downside risks.
– What category does the business fall into? Is it a secular growth story, a cyclical business or declining?
– If the business has a revenue story, for example like Salesforce.com, is it due to units or pricing or bother?
– If it's a cost story, what specifically are they doing? It it a result of operating leverage or growing unit volumes?
– Ask yourself about causation. What factors drive what outcomes?
– Also investigate whether earnings are growing, declining, stagnant.
– Read the key risk factors and determine what is within management's control and outside their control. Once you ignore the generic ones you can think critically about what risk factors are very important. For example, are they price takers and subject to price hikes by suppliers?
– When examining the financial statements, start with the income statement and focus on drivers of operating income.
– For Free Cash Flow (FCF), a quick ballpark figure can be identified by adding up the changes in working capital as one line item and adding non-cash items as one line item too. Strip out the non-recurring items. Focus on earnings and FCF and identify if a huge gap exists. If so, investigate why? What accounting is leading to the discrepancy?
– Read the Management Discussion and Analysis (MD&A) section because it explains what drives the business. Identify if any tidbits of information such as units sold, ASPs or segment information (geography, products etc) can be helpful in building quick models by relating back to say macro themes, such as US growing at 2%, China at 5% and so forth.
– Create a simple model to begin to ‘estimate' earnings and free cash flows for the next couple of quarters. The inputs should be the key drivers of earnings and cash flows. Make sure to focus on 1-2 key inputs to run sensitivities (high, low).
– Examine the balance sheet as a source of value or risk. How will it evolve? Do they have debt? If so, evaluate the risk such as EBITDA/Debt ratio. If they produce excess cash what will they do with it to drive value? If they retain earnings, where will they invest it? Will it be in Mergers/Acquisitions? Do any buybacks or dividends exist? Can they sell any assets or divisions that may be undervalued? The balance sheet can tell you what you are buying as an owner. Is it brands, buildings, receivables? What is the mix?
– Calculate the current market value and enterprise value? What is it trading at from a multiple and yield perspective?
– To calculate the value you could use a DCF but it is very sensitive to WACC and treats valuation like a formula. Consider using projections and multiples to calculate investment returns. Pick a few comps and looks to Yahoo to check multiples. Use forward multiples for comps. For example, project next year's EPS and check out the S&P 500 multiple as a benchmark.
– Think about the current multiple relative to the future multiple. Is the multiple big (meaning expectations for growth) or low? Think about the multiple like an investor would in real estate or bonds, as a yield. If you have a multiple of 10, you earn 10% yield, which if it's a good company or project is being reinvested leading to compounded returns.
– Construct a thesis for high and low of both qualitative and quantitative factors. How do you pull this together to make an argument is critical.
– Finally, keep in mind that if you buy financial assets there are three ways to make money.
(1) Use the generated cash flows to pay dividends or pay down debts (this includes cash flows from operations or selling an asset)
(2) The multiple (or yield) at which you buy the business grows
(3) The cash flow at which you apply the multiple grows.
Which one drives your returns and does the market get it?
– Look to the market size and evaluate whether the market is growing.
– Does the company have a dominant share of the market?
– What the competitive advantages the company has?
– Does the company have an economic moat around it such as high switching costs, intangible assets, network effects, cost efficiencies or scale efficiencies? How do they translate into the business: recurring revenues, operating leverage, high barriers to entry? Think about it much like doing a Porter's Five Forces on a company.
– Is the Return on Invested Capital greater than the weighted average cost of capital? Will the two converge over time and how can the ROIC sustainably remain above the WACC? Keep in mind that you can have growth but if ROIC
– How can you forecast revenues accurately? Is it by looking at the market size, and the company's share of the market. How do you know the market size you calculated is accurate? You could look to sum all revenues of all companies in the industry, which by definition is the market size of the industry by revenues. You could also look to unit economics and multiply the price of the company's products by the volume of units sold to project forecasted revenues. If you're looking to a Sales & Marketing line item on the income statement, think about how many customers can still be sold to relative to total market size, will S&M decline over time as the company captures higher market share? What is the cost of acquisition of a customer? You could project out S&M by multiplying employee numbers and their projected growth by the average cost per employee.
– Develop a view exclusive of valuation. If you were talking to management what would you want to know.
– If a company makes an acquisition, determine if it is good not just by price paid, debt assumed, cash impact but also whether the acquired company has an ROIC>WACC.
– Are any accounting shenanigans taking place such as throwing CAPEX into R&D?
– How well is the company converting cash into returns?
– Is management aligned with shareholders? Look to the board composition, the HR structures and incentives, the focus on quarterly earnings versus creating long-term value, what minority shareholder protections exists, issuance of dividends, and share buybacks.
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