In business analysis we look at the big picture. We need to know what the company does. How it makes its money. What risks are associated with it? What do we like about it? Is it a business we’d be happy to buy? Let’s look at business analysis…
What does the company do?
The easiest way to build a profile of a company is to use the Web. Publicly listed companies usually have a website. And typically have an investor’s section where you can download annual reports.
Annual reports are a great place to start your in-depth analysis. But if you just want a quick run down on a company you might find it more timely to read the company’s profile on your favorite finance website. Sites such as Yahoo Finance, MSN Money, or stock exchange websites, will have a few paragraphs describing the company and what they do.
You’ll want to develop some awareness of:
- What the company does
- What industry it operates in, and
- Where the industry is in its cycle (top, middle, or bottom)
Note: Industry Analysis is a separate lesson. But for now we are just interested in making some general observations about the industry while we examine the business.
Does the company have a history of making money?
Has the company’s Return on Equity (ROE) been consistently above 15% in the last five or ten years?
Return on Equity = Net Income / Shareholder’s Equity
Shareholder’s Equity = Total Assets – Total Liabilities
ROE is a good profitability metric. It shows you what sort of return management have been able to achieve on shareholder’s equity.
ROE is not perfect but it’s still useful (an increase in borrowings can inflate returns on equity. We’ll look at some better metrics in the next lesson – Profitability Analysis)
Has the company’s Return on Assets (ROA) been consistently above 7%?
Return on Assets = Net Income / Total Assets
ROA is an efficiency measure. It tells you how successfully management has been able to utilize the company’s assets.
Asking questions and searching for answers
It’s a good idea to download the company’s annual report. Get a feel for the company by trying to answer the following questions:
- What products or services does the company sell?
- Is now a good time to sell those products or services?
- Is it diversified or does it only sell one item?
If the company only sells one item (as in a commodity), there could be significant risks involved with this investment.
- How many customers does it have? One, or many?
If the company only has one customer the investment risk is higher. An example that comes to mind is automotive parts manufacturers that make parts for a single car manufacturer.
- When does the company make most of its money (summer, winter, during a housing boom etc)? Is it seasonal? Is it cyclical?
- What economic conditions favor a company of this type?
- What makes this company better than its competition?
- Looking at the company’s 10 year fundamental data, when did it have its best year? What contributed to its success at that time? When did it have its worst year? What contributed to its decline in fortunes?
Educators tell us that the more questions we ask, the more we learn. While that’s probably true, you can easily reach a point of information overload where more data isn’t going to help you make an informed investment decision.
You could spend the next three months analyzing a company. But is that a good use of your time? Probably not (unless you’re Warren Buffett and you really are intent on buying the whole company).
All we really want to know is:
- Is this a good company?
- Is now a time to buy a company like this?
- What risks and rewards are involved?
- Do I understand this company well enough to buy it?
What is the “value catalyst”?
A value catalyst is something that will cause the value of a company to be realized. As a value investor, interested in purchasing a company that might not be travelling very well. It’s important to identify the catalyst that will return the company to an upward trajectory.
Examples of catalysts include:
- Divestitures of non-core assets.
This involves selling a business asset that hasn’t been producing sufficient returns. The proceeds of the sale are then reinvested into an area of the business that will produce a higher return on the invested capital.
- Share buybacks.
This is where a company purchases its own shares as a shareholder reward. It makes sense to do this only when the shares are cheap.
- New management.
Quite often, fresh management will introduce new ideas and initiatives that drive value.
- New products.
Innovative new products can drive sales.
- Operational efficiencies.
Actions that improve operating margins can be effective catalysts.
- A reduction in working capital
Tightening accounts receivable policies and reducing inventories can free up cash flows that can be used elsewhere – in the higher return areas of the business.
- Before buying a business – you need to understand it
- Look at the “big picture” before getting into the details.
- Consider the industry the company operates in. Is it a good time to invest in this industry?
- Ensure that the company has a history of making money
- Continue on to Lesson 6: Profitability Analysis