The ultimate look at how to analyse companies for investments

Fundamentals 18: Fundamental investors need to analyze companies to determine whether they are candidates for investment. This article looks at the various ways to carry out such an analysis.
 
The ultimate look at how to analyse companies for investments
"Know what you own, and know why you own it."  Peter Lynch

There are 2 key questions when value investors try to find companies to invest in:
  • Is this a good company?
  • Is this a good investment?

A good company is one that is fundamentally sound while a good investment is one that can enable you to make money.  They are different questions as they address different aspects of the value investing process.
  • A company can be fundamentally strong but not a good investment. This is when its price is significantly higher than the intrinsic value. 
  • A company can be a good investment but not sound from a fundamental perspective. The company could be facing some problems. But the price of the stock is so low that there is a significant margin of safety even if liquidated.

Most of the time, to see whether it is a good investment you have to first find out whether it is a good company.  This is because:
  • To determine whether it is a good investment you have to compare price with the intrinsic value.
  • To determine the intrinsic value, you need to understand the company. Intrinsic value is not determined by simply following some formula. There are assumptions on the company’s prospects that you have to make. To ensure that these are realistic, you have to first analyze the company.

This post focus on how to analyze a company from the value investment perspective.

Contents

1. What is a company analysis

2. My approach

3. What to analyze

4. Relative fundamentals

5. Getting to the answer

6. Pulling it all together

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What is a company analysis?

1. What is a company analysis

Company analysis involves collecting info related to the company’s profile and performance. It incorporates basic info about the company. This could be its history focusing on events that have contributed to shaping the company.

Apart from specific information about the company, the analysis will also cover external data. Examples are the industry performance, threats, and opportunities affecting the company's prospects. You are looking beyond the company to its competitors and industry. 

Company analysis generally involves both qualitative and quantitative information. 

The quantitative side involves looking at factors that can be measured, such as the company’s assets and profits. The limitation here is that it does not capture the company’s performance that cannot be measured by a number. A good example is the R&D efforts or the quality of management. 

Financial statement analysis is an important aspect of numerical analysis. By analyzing reported financial info, you can get a picture of the profitability and risks of a company. This generally involves studying the accounting ratios. These include asset utilization, profitability, leverage, liquidity, and valuation ratios.

The analysis of the non-numerical items is the other side of company analysis - the qualitative side. The qualitative analysis involves studying the other part of the annual reports. This generally covers the Chairman's statements and the Management Discussion and Analysis. It covers even the Corporate Governance and Sustainability reports. I also look at market research reports, trade journals, and government reports. 

Techniques used here include the various MBA type of analysis. Examples are the SWOT analysis, Porter 5 Forces, PESTLE Analysis, Value-Chain, and Ansoff-Matrix.

Given that a company analysis can vary in terms of depth and breadth, how do you decide what is enough?
  • Before you perform any analysis, you have first to figure out the purpose of the analysis. Analyzing companies for investments is different from analyzing them to determine their creditworthiness.
  • Analyzing companies for takeover also look at different things. It also differs if you are an insider trying to figure out the business direction of the company.

In the context of value investing, you are trying to determine the prospects of the company to determine its intrinsic value. The focus is not on what the company had achieved but rather on what it will achieve.

You should not be surprised by this perspective.  When you value a company, you are looking at its future earnings. An assessment of its prospects will go a long way to establish its future earnings.

My approach in analyzing companies

2. My approach 

I have 2 decades of experience running public companies. These companies produce 5 years plan which involves projecting the business performances over the next 5 years.  I would say that I have been involved in developing several 5 years plans in several sectors.

Despite the experience and knowledge, it is very challenging to forecast business performance. When I look back at the actual results and compare them against the various 5 years projections, the track record is nothing to shout about.

I would say that the best was achieving about 70 % to 80 % of the next 1 to 2 years’ forecast. This is because there are many factors affecting performance such as:
  • Competitors' actions.
  • Uncertainty in the company product development timeline and the market reception of the new products.
  • Changes in government policies and unforeseen economic situations.

The list could go on. The reality is that I have doubts about the accuracy of any forecast beyond the next 2 to 3 years.

The worst part is that these projections were for established businesses. They were not start-ups. 

Management as insiders have problems forecasting the company performance.  What makes you think that an outsider would be able to do better?

That is why it is not realistic to have financial models that extrapolated business performance decades into the future.

2.1 Don’t be too clever

Because of my experiences, when it comes to company analysis and valuation, I try not to be too clever.

Rather I frame my analysis and the corresponding valuation in the following context:
  • I know the historical performance. The depth and breadth of the analysis will determine the accuracy of the assessment as an outsider.
  • I use the historical performance as the base. I then judge the business prospects relative to the historical performance. I categorize the future performance into 3 - same, better, or worse than the past.

The focus of the company analysis is the future. You are trying to understand the future prospects and it is easier to do this in a relative sense. 

This presupposes that you have analyzed the current and/or historical performance. It is much easier to analyze the current and historical situation because all the data are available. 

Once you have a bearing on the current situation, it is much easier to assess the future relatively.

In analyzing the current/historical performance, I look at several areas:
  • Operations. I focus on profitability and growth. 
  • Capital allocation. The focus is on those elements that impact shareholders' value creation. This covers reinvestments, dividends, and capital structure.
  • Financial strengths. This impacts both financial risks and the cost of funds which in turn affects the valuation. 
  • Market potential. I looked at projected industry growth, whether it is in a sunset sector, and the likelihood of the business being disrupted.
  • Management. Comparing the company's performance with its peers will provide a good picture of how well management performed. I also look at the continuity of staff.

The real challenge is how you decide that the historical performance is good, bad, or average.
  • One way is to compare it with peers on a number of metrics - returns, growth, and market share.
  • For a more objective measure, I compared the returns with the cost of funds. In a competitive environment, returns would be equal to the cost of funds. Poor performance is when the returns are lower than the cost of funds. The best is for returns to exceed the cost of funds.
  • If the company has laid out some business plans or directions, I also compared its performance relative to the plans.
Retail investors should focus on desk research

2.2 Scuttlebutt

Scuttlebutt is a term associated with Fisher.  He referred to this as fieldwork to gather information about the company. 

The goal of the scuttlebutt approach is to get a better understanding of a particular industry/company beyond desk research.

If you are already knowledgeable eg you spent many decades working in the industry, then the scuttlebutt may not add any value.

For an individual investor, I would think that your first step is to read the past decade of the company’s annual reports. And if you are not familiar with the industry, there are lots of info that you can get online.

I am sure this would be a more cost and time-effective way to get a good understanding than the scuttlebutt approach involving fieldwork.

Think in terms of the cost-benefit. Besides, unless you are a trained investigator, you may not be seeing the correct things with fieldwork.

The moral of the story - you are better off with desk research as an individual investor.

2.3 Link to valuation

The rationale of my approach for company analysis applies to valuation.

I know with certainty what has transpired. If I value the company based on its historical performance, I am very certain that it is a realistic picture of its historical value.

But for investing, we are looking at the future prospects. I believe that if I have a realistic value of this past, I can use this to judge the future value.

I can determine based on my company analysis whether:
  • The future is better and correspondingly, the future value is better than the historical value.
  • If the future performance is expected to be similar, then it is safe to assume that the future value would be the same as the historical value.
  • If the future is worse, then you can expect a lower value for the future.
What to analyze

3. What to analyze

I have been involved at the senior management level in running companies. I have also done a few hundred analyses and valuations over the past 2 decades. 

I realized that there is not much difference in analyzing the business in the context of running it compared to investment analyses.   

But, the focus is different. When investing, you are trying to formulate your investment thesis.  You want the outlook of the business and its valuation assumptions to be realistic. 

The basic steps involved in a company analysis can be summarized as:
  • Identifying the company and industry’s economic characteristics.
  • Identifying the products and/or services.
  • Assessing management.
  • Understanding the risks and concerns about the company.

Accordingly, I frame my analysis to answer the following:
  • Where is it now?
  • How did it get here?
  • How does it make money?
  • Where is it heading?

3.1 Financial statement analysis

The investment industry is today very competitive. Many platforms provide both financial statements and standard analyses of companies. These typically included liquidity, profitability, activity, leverage, and DuPont ratios.

There are also many investment sites that provide detailed descriptions of the use of each of these ratios. They would do a much better job than I would so please refer to them if you are not familiar with these ratios. Investopedia is a good place to start. 

For my financial statement analysis, I refer to the following sources (in alphabetical order).  You can use them or subscribe to other services. 
  • Finbox
  • Macrotrends
  • TIKR.com
  • Yahoo Finance

3.2 Management

While knowing the importance of management in driving the business, the challenge is how to evaluate them.  This is because you are not able to meet with them as a retail investor.  

I try to get a picture of management by looking at the following;
  • Are they owner-managers?
  • How long have they been with the company?
  • How have they performed relative to their peers?
  • How have they allocated capital?

The goal is to ensure that management does not do things that benefit them rather than the company or shareholders.  Examples of red flags are giving themselves bonuses even though the company is making a loss, or using company assets for their benefits.

Secondly, business performance needs a long-term perspective. You do not want management to forgo investments that only show results after several years.

How can you achieve this?
  • The best way is for the major shareholders to be part of management. This is common in family-controlled companies.
  • The second is to tie performance bonuses to long-term returns on capital with clawbacks for losses. Performance payment should be made years later and even after the person has retired to send the message that the company wants long-term results.

3.3 Risk

When it comes to risk, my analyses and valuation are based on a long-term view of the business. I try to identify and assess those factors that will affect the long-term prospects of the business.  You can consider these as strategic risks. 

My view is that as a minority shareholder, you are not management.  Hence you leave all the operational and other short-term risks to management to resolve.  You focus on those risks that will change the nature of the business. 

I cover risks in more detail in other articles. Refer to

At this stage, remember that looking at the business risk is only one component of the risks you face in investing.

Relative fundamental analysis

4. Relative fundamentals

My analysis covers both qualitative and quantitative analysis.  But the quantitative analysis is not standardized.  Depending on the subject matter, I sometimes compared:
  • The target metrics with the industry. The industry will involve more companies than the benchmark.
  • The target current performance with its own historical performance.
  • The target metrics with the benchmark ones.

For want of a better word, I describe these as the conventional company analysis or conventional fundamental analysis.

The relative fundamental analysis compares a company's fundamentals with those of its peers. It is a structured numerical peer comparison. Think of relative fundamental analysis as a sub-set of the conventional company analysis. 

The focus is on numerical analysis usually based on data extracted from the company’s financial statements. While there are many factors and metrics to consider, I focussed on those that affect the intrinsic value of a company.

For further details to do such an analysis, refer to “Expanding your company analysis toolbox with relative fundamental analysis.”

Getting to the answers

5. Getting to the answer

You have completed your financial statement analysis. You have made notes of all the key points from reading the various reports. How do you pull them all together?

Remember that the goal of company analysis is to determine whether it is a good company for investment. 

To help reach the conclusion, I organized the results of my analysis under the following headings.
  • Expertise. This is to identify whether there is anything special about the company.  It provides insights into its competitive edge or moat. This tends to be a qualitative analysis.
  • Sources and Uses of Funds. While quantitative in nature, the goal is to see how effective it has deployed its funds. It provides an insight into management capital allocation capabilities. 
  • Current Performance. I assessed the company's current performance relative to its historical performance. This can throw light into how it will perform in the immediate future. This is usually a numerical analysis.
  • History. This is to provide a picture of how the company got to be where it is today. It covers both qualitative and numerical analyses.
  • Future. I also performed an industry analysis and assessed the challenges faced by the company. There is a lot of market research data here and is both quantitative and quantitative in nature. 
  • Management.  This is to assess its track record as an operator and capital allocator. I also assessed whether management interests were aligned with those of the shareholders. I used both qualitative and quantitative analysis. 
  • Growth in Shareholders’ Value. This is a quantitative look at the company performance from a shareholders’ value creation perspective. 
  • Risks. I covered the key investment risk as well as the key business risks. This is mainly a qualitative view. 

If you want to see examples of what I have done, look at the following case studies

Concurrent with the above, I also have a spreadsheet with the key metrics from the financial statement analysis.

It is now time to judge the performance in the context of good, average or bad. For these, I focus on the following areas:
  • Profitability. Did the company achieve a return greater than the cost of funds?
  • Growth. Did it grow faster than the GDP growth rate? Would it be able to sustain the growth in the future?
  • Reinvestment. This assesses how it funded its growth. Was this a sustainable reinvestment rate? 
  • Financial health. It is financially sound?
  • Other risks. Is there foreseeable disruption and how has the company handled it?

A good performance is one where the company performed positively in all of them. Conversely, a bad performance is one where it failed in most of them. 

You will note that the above metrics are the ones that affect the intrinsic value based on the Free cash flow model as per Damodaran.

Summary of company analysis

6. Pulling it all together

There are 2 key questions when value investors try to find companies to invest in:
  • Is this a good company?
  • Is this a good investment?

A company analysis will provide the answer to the former. To answer the latter you have to compare price with the intrinsic value. This requires you to value the company. But all valuations are based on assumptions. To ensure that the assumptions are realistic, you have to first analyze the company.

Company analysis involves quantitative and qualitative analysis. You not only study the financial statements, but also the Chairman's letter and the Management Discussions and Analysis.

Also, you should also review the competitors' annual reports, the industry as well as government reports.

I recommend that you analyze the company in a relative sense. You first study the historical data and assess whether the performance is good, average, or bad. You then judge whether the future would be the same, better or worse than the historical performance.

I also value the company with the same approach. I know for certain the historical value as all the data is available.  I then judged whether the prospects are going to be the same, better, or worse than the historical one.  I then use this to determine whether the value would be the same, better, or worse than the historical value.

As you can see, a company analysis is more than just some quantitative analysis. You need to dig through the past Annual Reports to get insights. You also have to look at industry reports and competitors' Annual Reports.

Of course, you may decide that it is too troublesome to do all of them. One way out is to then rely on third parties to do the fundamental analysis for you.

There are several financial advisers who provide such analyses. 

Those who do this well include people like The Motley Fool. Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.


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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you.





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