Also see:
How to Think about Stock Ownership
How to Analyze a Business Qualitatively
Value Line
Value Line is a great resource for looking through a lot of companies’ financials. Your local library’s website should grant you free access. There is also roic.ai.
My eyes go straight to the revenue to see whether they have doubled over the last 7 years. Using the Rule of 72, I know that if a company’s sales have doubled in 7 years, that comes out to about a 10% growth rate. Why 10%? Because it’s a nice round number. I’m probably not going to be interested if growth has been stagnant. But there are other things to consider. Have there been any acquisitions, divestitures, product cycles, or recessions? You can’t just look at financial statements in a vacuum. Consider where these numbers come from if you want to have any idea where they’re going.
Are margins expanding, declining, or flat? Are the margins good? You can find good companies with bad margins. That can be because the company has a lot of turnover like Walmart or is still growing like Amazon. If you find a company with consistently good margins, then it’s probably a good business. (Whether or not it’s a good stock to own, is another story. We’re going to get to valuation in the next episode.)
Balance sheet. Check the company’s net debt position. Take the company’s total debt and then subtract cash and investments. I’m probably going to pass if net debt is over 5-10 times earnings. This is an arbitrary rule of thumb.
Value Line also does a good job of normalizing numbers and giving you footnotes for their major adjustments. I don’t recommend relying on Value Line’s numbers for making investment decisions, but I do find them useful for screening.
10Ks
Our objective is a valuation and we just need three things: the company’s look through earnings, a vague notion of a growth rate, and their net cash position. Look through earnings, aka core earnings or owner’s earnings, are a normalized number to base our valuation on. Imagine a bank wanted to know your monthly income before approving your loan. You wouldn’t include a stimulus check. You’d give your average monthly income. It’s the same principle here.
Revenue may seem like a pure number that doesn’t require adjustment, but a lot of things can throw it off: acquisitions, divestitures, product cycles, and recessions. You need to adjust for those things. Then you’ll want to break out revenue by product segment/geography. Understand each segment. What are the key drivers of growth for each segment? Typically, it’s going to be price and volume. For example, for Netflix it’s the price per subscription and the number of subscribers. And those things will be different across geographies.
Cost changes will be explained in the reports. Head count is a common one. Sometimes there will be one-time events that will require your adjustment. For example, perhaps the company just paid a huge one-time fee to the FTC. Or maybe you don’t believe that fine is a one time thing, and you want to adjust for legal fees in your earnings estimates. Or during COVID a lot of companies reduced their travel and ad spend. Read through all the expenses and figure out if anything requires an adjustment.
Other Income includes interest on cash and investments. I remove this interest, but leave the interest on the company’s debt. Long story short, I don’t consider the cash and investments to be part of the company’s core business. But I do consider making interest payments to be part of the core business. Feel free to disagree with me, this is just how I do it. Then there’s Forex which usually isn’t going to have a huge impact, but it’s something to always look out for. Also, you will come across write-offs or write-ups. My favorite example is Disney’s 2019 fiscal year. They had bought more Hulu at a higher valuation than they had previously paid, so their investment in Hulu increased in value. This caused nearly $5B to be added to their bottom line. Something like that is just accounting gimmickry and not part of the company’s core earnings.
Taxes. Be inquisitive if the tax rate is wildly different than previous years. Tax laws change. For example, a few years ago the Trump Tax Cut impacted a lot of tax rates. I believe the UK just passed a tax law thats had a major impact on some US companies. In Microsoft’s latest 10Q, they got a $3.3 billion tax refund because they moved some intangible properties from a Puerto Rican subsidiary to the US. These things sometimes throw off your numbers if you’re not careful.
Earnings. I add back depreciation and subtract maintenance CapEx and Financial Lease Repayments. All of this can be found on the Cash Flow Statement. But notice how I said maintenance Capex. I don’t like to penalize a company for growth Cap Ex. Companies aren’t going to breakout capital expenditures by maintenance and growth. It’s up to you to decide. Basically, earnings can either be returned to the shareholders as dividends and stock buybacks, they can be retained and just sit on the balance sheet earning low interest, or they can be reinvested back into the company as capital expenditures.
Ideally, the money reinvested back into the business will grow at a satisfactory rate for you. You’d rather the company reinvest the money at 20% growth, then pay it out to you as a dividend. But if cap ex isn’t going to generate a satisfactory return, then it makes sense to deduct it from future earnings. For example, the reason Facebook fell recently is because investors are worried that Mark Zuckerberg is going to invest tens of billions of dollars into virtual reality. Subtract those capital expenditures if you think they’re a complete waste.
Forecasting. I don’t put a lot of stock in forecasts. ‘Well sales have grown at 20% over the last 5 years, therefore sales are going to grow at 20% over the next 5 years.’ That’s called a naive forecast. Instead try to find a reasonable basis for your estimates. What is the total addressable market in terms of customers/dollars? Is it growing? Pay attention to similar companies to help paint a picture. Any forecast you do is going to be complete dog shit, but you at least want an idea.
Also, think about operating leverage. Sometimes a company can have shitty margins, but their costs are largely fixed. If their sales continue to grow, then a lot of money will start falling to the bottom line. Though, be careful because operating leverage can cut both ways. Or take a company like Netflix. Several years ago, they were spending a lot of money on international expansion and the sales weren’t there yet. But those sales numbers kept growing, and the costs started to plateau, so you started to see operating income. Don’t just think about where the company has been, but think about where it’s going. Though sometimes costs will stay around a certain percentage of revenue. Finally, don’t get crazy with your forecasts. A rough estimate is better than a precise guess.
Alright, I think that’s been more than enough. Next episode we’re going to talk about valuation. Have a great day.