Analyzing a company
In this course, we have talked about investing in companies and we have seen how they reward their investors. We have also seen that it is important to perform a thorough analysis before investing in any company.
Well, here we will introduce how to analyze a company’s fundamental financial data to determine if they are a good investment or not.
The intrinsic value of an asset is its true, inherent value. It is a measure of an asset’s worth that is arrived at through the objective analysis of the underlying company’s financial standing and future expectations. The current price of a company’s stock and its intrinsic value may be different due to circumstances of the markets or the economy. However, intrinsic value helps us find great opportunities to buy stocks at a discount.
Imagine that you are looking to buy a car. You find the perfect one for you but, after doing a lot of research, you have found that its value is $30,000 (intrinsic value), which is too expensive for you. However, one day, a dealership is going out of business, it is trying to get rid of its inventory and it is offering that exact car for a massive discount at $20,000 (current price). Knowing the intrinsic value of the car is $30,000, you don’t hesitate to buy it for a 33% discount, you found a bargain.
Warren Buffett famously quoted “buy stocks like you are buying groceries, not like you are buying perfume.” This sentence provides a really powerful message to investors: be mindful of the price, the quality and the true value of what you are buying, regardless of how exciting or “hot” it may seem.
When you are buying meat at a farmers market, you may ask how much is a pound of steak and internally think about its perceived value and its utility, and you may look for deals and cheaper options. The same should be the case with buying securities, it is important to know the true value of things and shop around to find deals.
However, many people “buy stocks like they buy perfume.” Not paying attention to value and just focusing solely on hype and internet marketing displays.
In order to discover the intrinsic value of a company, we have to dig into its fundamentals and identify how good they are at making, keeping, and managing their cash, among other things.
Public companies (companies that trade their stock in exchanges, which you can buy and sell through brokers) have to go through rigorous regulatory procedures and have to make a lot of their financial information available to the public in order to offer the highest level of transparency possible to their shareholders (stock owners) and to the world.
Most professional athletes get drug-tested periodically to show that they are clean and not using any illegal performance-enhancing drugs while playing their sport.
Public companies go through something similar, although instead of testing for drugs, they get tested for financial fraud by third-party audit firms and by government entities such as the SEC (Securities & Exchange Commission) in the US.
Public companies make their financials public in the form of reports that are commonly known as earnings reports. These reports are packed with relevant information about the financial activity and health of a company and are published at least once a year (most big companies publish it once a quarter).
The earning reports include a lot of information that is presented in the form of financial statements, but three main statements provide a great summary of a company’s financial situation. Investors use these statements as a source to analyze the performance and prospects of a company’s financial situation.
The Balance Sheet
The balance sheet provides investors with a picture of what a company owns (assets such as cash, building, materials, etc.), what it owes (liabilities such as loans and debt) and what belongs to the investors (owner’s equity such as retained earnings).
This balance sheet is ruled by a very simple formula which explains that a company’s assets (what it owns) must equal its liabilities (what it owes) plus its owner’s equity (what belongs to the owners).
Assets = Liabilities + Equity
Each element in the above formula is formed by many different relevant pieces. For now, we will show a few of the most common items and in later segments, we will dig deeper to truly learn all about the balance sheet.
While the balance sheet shows information about a specific moment, the income statement covers a certain range of time (normally a quarter or a year depending on the period of the earnings report). The income statement is in charge of explaining what the company has earned (revenue) and what it has paid out (expenses) in a certain timeframe. It also shows what’s known as net income. The income statement is essentially based around this formula:
Net Income = Revenues + Expenses
As we can see, net income is a company’s profit after all expenses have been subtracted from revenues for a given period. This is also called net profit (if positive) or net loss (if negative). Net income is commonly known as the bottom line of a company’s financials because it is physically at the bottom of the income statement.
Both revenues and expenses can be divided into several differentiated parts depending on where they come from.
It is important to analyze the operating profitability and performance and some tools help us do that and more, which we will explain in future sections.
Cash Flow Statement
The cash flow statement is a true representation of what happened with a company’s cash during a certain period. It essentially tells us how efficiently a company generates its cash to fund its operations and investments and to finance its debts.
This statement is also called the statement of cash flows, draws information from the balance sheet and from the income statement to help us understand where the company’s money is coming from and how it is being used. So, as we can imagine, this is a very important part of the financial analysis of any company.
Operating Cash Flow
These are the activities related to the core business, any source (revenue) or use (expense) of cash that comes from selling or buying a company’s goods.
Investing Cash Flow
These activities include any source or use of cash intended for the long-term growth of the company. It covers the changes in assets that affect the cash of a company. Examples could be: buying a new warehouse, paying loans, etc.
Financing Cash Flow
These activities reflect how a company raises capital (cash) from its investors to finance all of its activities and how it pays it back to those investors. So, as we can imagine, cash dividends (paid out to investors) will be part of the financing activities. Other financing activities include issuing or selling stock, etc.
Net Cash Flow
This is the main result of combining all three sections of the cash flow statement. It measures the profitability of a company, as it shows the cash that a company generated or lost during a given period (a quarter, a year, etc.). It is essentially the difference between cash inflows and outflows. And it is calculated with the following simple formula:
Net Cash Flow = Operating CF + Investing CF + Financing CF
One of the keys to financial analysis is knowing how to dissecting these statements and understanding what things mean and how they affect the company’s financials. In future sections, we will dig into these statements individually so you can easily identify the financial health of a company.
Financial Ratio Analysis
We analyze the above statements in order to gain some meaningful information about a company’s financial situation. A great way to do that is through the use and interpretation of financial ratios.
These ratios are simple formulas that grab multiple related elements from the financial statements and compare them
- with each other (ratios),
- with those same elements from previous periods (historical analysis),
- and with those same elements from competitor companies (peer analysis)
in order to assess the state of a specific factor of the company’s financial health.
To understand the idea behind ratio analysis, you can think of it as a doctor that gets someone’s blood test results and analyzes their level of red blood cells, glucose, and other elements in order to identify any issues and to assess the health of that person.
In financial analysis, the investor or analyst uses elements from the financial statements to create ratios that will help identify potential financial issues and assess the overall financial health of the company.
Different financial ratios are used to assess different factors of financial health and they are grouped by these factors:
- Profitability ratios measure the ability of a company to generate income (profit) compared to its sales, assets, and equity.
- Efficiency ratios measure the ability of a company to use its resources (assets and liabilities) to generate profits.
- Liquidity ratios measure the ability of a company to pay off its short-term debt with its most liquid assets (such as cash and equivalents).
- Leverage ratios measure the level of debt a company has compared to other elements, such as assets or income.
- Market value ratios evaluate if the current price of a public company’s stock is undervalued or over-valued.
There are many ratios out there, which can make things very complicated and cumbersome. In future segments, we will focus on the most important ratios that you need to know to get a good feel for a company’s financial stability.
The sole purpose of fundamental analysis is to find companies that are underpriced relative to their “true” value (the intrinsic value), which can be derived from analyzing a company’s financial information and developing some estimates.
Investors and analysts use different techniques and models to arrive at the fundamental value of a company using its financial statements and observable, public data.
Here are some of the main methods used to value a company:
- Comparable analysis allows us to assess the current relative value of a company by comparing it to that of other similar companies (its peers) or its own overall sector.
- Dividend Discount Model (DDM) is a valuation method based on the idea that a stock’s value is worth as much as the sum of all of its future dividends discounted back to their present value.
- Discounted Cash Flows (DCF) Analysis is a common method that intends to identify a company’s intrinsic value by forecasting its future free cash flow (the company’s cash left after it spends everything it needs to operate well) and discounting it back to the present at the company’s Weighted Average Cost of Capital (WACC), which is the rate a company is expected to pay to its investors to finance its assets.
Don’t worry about the “weird” words or the confusing concepts for now. This is actually really simple once we get into it in future sections.
For now, just know that there are several ways investors use to value the true intrinsic value of a company, which is helpful to find good and bad investments.
In the next segment, we will dive right into the importance of macroeconomic and industry analysis in analyzing a company.