There are a lot of things that you can check when investing in a company. In fact so many that you can probably spend years digging through reports to form an opinion. And in the end you can still get it wrong.
It’s always better to be 80% right and make a decision than to be 100% right but to miss the opportunity. That’s why we make decisions based on the best available information at the time of trading.
This article will address the issue of investment analysis. We’ll use a top down approach to achieve this. Bare in mind that the topic is vast and you are reading a brief overview. I did my best to make the article skimmable.
I could tell you that a company has good fundamentals based on a two minute peek at their financial ratios. However, this can’t be labelled as comprehensive fundamental analysis which is the subject of this article.
You can’t analyse a company without thinking about macroeconomics first.
The Macro Frame
What kind of a world do we live in and what will tomorrow look like?
When you buy a stock you buy the future not the past.
The left side shows the past performance of the SPY ETF very clearly.
On the right is the 55 day expected move of SPY as of the 18th of October 2020 calculated with a 70% probability. You see that the future is fuzzy, there are many paths to be taken. That’s the issue we all face when investing in a company.
Historical data only matters as the groundwork which helps us to imagine what the future may look like. This is the purpose of financial models, we take the past and try to create the most accurate version of tomorrow.
All models are flawed in one way or another but we have to start somewhere and the best place is macroeconomics.
The World matters when investing in a company
It’s 2020 and one thing that we know is that nobody expected a global pandemic back in 2018. There you have it, that’s how models fail, we just can’t predict the future with a decent level of accuracy.
Nevertheless, there are some things which can give us clues. Take interest rates for example. They are rock bottom, hence, we know that savings accounts, bonds and other fixed income securities will bring low returns.
Asset prices, like stock or houses for example, are high because everyone wants to make some money. If there is no profit in savings accounts investors will buy shares.
Stock is risky but we have the low interest rates which work to our advantage. It works like this:
The company you want to invest in has easy access to capital because central banks keep the rates low and use Quantitative easing to stimulate the economy. Consequently, banks lend money to businesses on favourable terms. The recipient firms can invest in profitable projects which bring growth and the shareholders make money.
The Financialized macro frame of business
Currently capital is more important than labour. Therefore, we have to distinguish between the productive and the financialized firm.
The latter relies on the performance of financial securities (like stock, futures, etc.) and often spends money on things like buying back its own shares. Share buy-backs can drive the price up but you need to consider the long term prospects too. Is it a real company or a wannabe hedge fund?
Your local farm can be a financialized company if it is making more money from speculation on the prices of corn futures rather than physical corn. We always need to know where the money is coming from if we are investing in a company. It sounds obvious but it may not be apparent at first glance.
I’ve heard smart people talk about the manufacturing cost of the iPhone relative to the store price. This is irrelevant as the competitive advantage of this product is derived from the network effect of the iOS platform.
The moral of the story is that you need to know the source of revenue. If the firm is financialized you have to be aware of the risk it’s taking on. Otherwise, you may end up like a shareholder who bought Bank of America in 2006 and is still waiting to make money.
They always matter to business. When you buy shares you are investing in a company but you are also investing in a country or a number of them. Are there any political conflicts, possibility of a war, sanctions or any other complications which may affect your return.
In terms of current affairs such questions may include: how is Brexit going to work out, is the US – China relationship going to deteriorate, what are the Russians planning, how long will it take for the economy to rebound from the coronavirus.
There are no clear answers, however, you can still collect some data. You’ll find it on the IMF, BIS and the World Bank websites. I’d avoid television because the information is superficial and often misrepresented or misinterpreted.
If you want to check the political commentary you can read the US point of view in the WSJ or Bloomberg, here in the UK you have the BBC and the Economist, Euronews covers the EU, Russia has RT and for Chinese news you can read China Daily or CGTN.
You’d be surprised by the differences of opinion on the same matters. Everyone has an angle that doesn’t include you making money. Therefore, check both sides of the political narrative.
You don’t have to know everything which is going on in the world but you need a basic understanding of the current state of affairs.
Do I need to have an opinion?
Is inflation good or bad or should central banks continue the quantitative easing program? It doesn’t matter, we perform the analysis with the purpose of making money.
All we need to do is to figure out how. What I think or what you think is not important. We aren’t doing this to change the world.
Just use the information to earn something. It’s fine to have an opinion but don’t lose sight of the main goal.
If the state of affairs changes we change our strategy but we also have to figure out why it did so to prevent losses.
Industry analysis when investing in a company
You can’t invest in a company if you don’t know anything about the industry. Well, you can but it will be slightly irresponsible considering we have the internet.
Industry analysis creates a benchmark for your investment. You already know what the average stock market return may be but what can you expect from the sector?
That’s simple, you just check the sector performance to get the average profit margin. If it is 10% you may choose not to invest in a company which returns 2.1%.
Sector specific information is important in a lot of ways. First you need to find out what is the main method of monetisation, how does the product work, what kind of substitute products are available. How easy or difficult is it to enter the industry. Is there a risk for the current leaders to get wiped out by newcomers.
You can start by finding out what is the industry model. The best case is if it is a monopoly, then you know you’ll make money. We won’t argue for or against monopolies as this is beside the point of this article.
Something may be right or wrong but it can still be a good investment. Therefore, make sure you are investing a company which works for you.
A regulated monopoly, a utility company for example, is different because you can’t expect stellar growth. An oligopoly on the other hand can be a very good investment. This is an industry where a handful of firms have a large chunk (like 90%) of the market share.
Think of aircraft manufacturers, UK coffee chains, cereal manufacturers, online advertising, computer and mobile phone operating systems, etc.
The few big companies make it difficult for the small guy to enter which sustains the profit. Another advantage for shareholders is that firms can charge high prices without triggering any anti-trust laws.
The high prices occur spontaneously, hence, the firms don’t have to collude. Unfortunately sometimes they do to charge even more which triggers anti-trust litigation. The outcomes of past lawsuits are somewhat mixed.
Another bonus is that oligopolies can be analysed by using game theoretic frameworks. You can find out what is the dominant strategy of each firm in various scenarios, you can also anticipate when the end of a price war may be.
We won’t be beaten on price
You must have seen a price promise advert: tell us if you found it cheaper. That’s actually a threat, although it can be seen as a guarantee but not to you. The company you are investing in is assuring its competitors that it is going to wipe them out if they reduce the prices.
That’s how game theory works as long as the threat is credible. No one benefits from a price war so the price promise can be translated in the following way:
You dare lower the price, we’ll engage in aggressive dumping and we can go on until you go broke. Then we’ll make sure you won’t re-enter the industry.
Rivalry and Cartels
Should you be investing in a company if it is part of a cartel? It depends, if we’re talking about something like OPEC, say Saudi Aramco, maybe or maybe not. We have the commodity problem there, lots of politics and defectors.
Don’t take the word cartel literally. Sometimes a company may have a few brands but keep it on the down low to offer customers choice. I’ve seen cases where the consumers think that the two brands are in some kind of a rivalry even though both are owned by the same parent firm.
You can find information about the firm’s product lines in annual reports.
I remember that there was some kind of perceived rivalry between Google Maps and Apple Maps years ago. It never made any sense, it’s not the same thing, these are 2 different ecosystems. I thought that consumers will use the app which has native integration to the platform.
There is competition between iOS and Android but even these are not the same thing, not exactly. Why else would Eric Schmidt be on the board of directors of Apple and Google’s CEO simultaneously back in the 2000s? That ended due to the Federal Trade Commission’s interest in potential anti-trust issues.
Success in some industries is dependant on economies of scale. You can’t be competitive unless you offer the cheapest product. The firm which can manufacture the largest quantity can secure the lowest production cost.
Let’s go back to our local farmer turned futures speculator. He or she can’t produce the cheapest corn but knows all there is to know about growing it, distribution and so on. The sector specific knowledge allows them to make money from futures.
A big farm will produce cheap corn and supply it to a lot of customers. I mean, let’s be honest are you going to pay double the price to get your corn from our friendly local farmer? You may do so but big customers won’t. They’ll go to the cost leader.
This is applicable to any commodity product such as silver, steel, coffee, soya beans, oil, even milk.
Niche or specialisation
Some firms just find a product or service that appeals to a limited number of customers but they do it really well and make money. That’s great, the question is is it worth investing in such a company.
They may be, I’d argue that Tesla was a niche company in 2006, look at it now. Aston Martin has not been as fortunate and is currently trading for 50p. The difference is that Tesla is now seen as a technology company rather than a small volume car manufacturer.
This example is important because change is one of the few constant things in the business cycle. Niche companies require additional research in terms of growth, sustainability and competitive advantage.
Tesla may have worked fine so far but Hornby plc didn’t.
You can always perform an industry analysis freestyle, just think about it and form an opinion. If you want a more structured way of doing it you can use strategic management tools.
SWOT stands for Strengths, Weaknesses, Opportunities and Threats. It is the most widely used because it is simple, quick and includes intrinsic and extrinsic factors. This comes with the shortcoming that it is pretty basic.
VRIO (Value, Rarity, Imitability, Organisation) is a bit more advanced but it is firm-centric so you have to combine it with the Institutional based view to get a grasp of the extrinsic factors. You get a more cohesive picture but the results can remain a bit unclear.
I prefer to use Porter’s 5 forces for the above reasons. It’s not the most popular but it is comprehensive and includes all the extrinsic and intrinsic factors you may need.
You have to know that Porter’s framework is based on firm position so if the result is poor the recommendation is to move on to a more profitable industry. That’s not that bad as we’re talking about buying shares.
We can buy anything we want it doesn’t need to be in a particular industry. Conversely, you’d be in trouble if you present it to your boss to explain how their new project has to be scrapped because it is going to deliver less than the S&P 500. Below is a diagram showing how it works:
It takes some getting used to but I find it good and I hope you’d enjoy it too.
Profitability is important when investing in a company
After the industry analysis is complete we’ll get the average profit margins. It is always a good idea to invest in an industry with high profits. This secures free cash flow which has a certain degree of causality with share price increase.
For example, you may like aviation, but airlines are capital intensive and bring in low profit margins. Therefore, you may decide look into manufacturers, service companies, etc. to find shares with good profit potential.
Another important finding is the location of the competitive advantage. We’re always looking for economies of scale. Are they on the supply-side or on the demand-side?
Demand-side economies of scale
Demand-side economies of scale and network effects are roughly the same thing. They are known to deliver sustainable competitive advantage because they lock customers in an ecosystem. Such products are operating systems, social networks and software like Microsoft office.
A network product delivers value because others are using it, like the fax machine. The product reaches critical mass when a certain number of customers get onboard and you end up with an oligopoly market model.
Consequently, the network effect itself is a barrier to entry for newcomers. It will be extremely difficult for a new firm to dethrone Facebook, Google or Amazon. Someone probably will but it may not happen in the next few years. This is all that matters when you buy shares: is the company going to make it and if so how much money is there.
An easy way to spot a company seeking demand-side economies of scale is to look out for bundling. The firm will offer multiple products for a single fee, think of Amazon Prime or Microsoft Office, with the purpose of locking customers in an ecosystem.
Supply-side economies of scale
This is simple, for example a paper towel manufacturer. Whoever makes it the cheapest wins the crown. The problem is that cost leadership is not always sustainable. Furthermore, commodities can be involved which drags international relations in the equation only to make things harder.
China was blamed for dumping in the steel industry some time ago. I don’t know if this is true or not. However, the rumour alone can send the shares of a UK or US steel manufacturer going towards zero. Therefore, you have to be careful with oil companies, miners and so on as these are prone to various issues. If in doubt check out the performance of US Steel Corp:
Cobalt was hot a few years ago. Luckily we have loads of data so we can check the share price of Glencore, the world’s largest producer. It’s gone down from £4 to £1.70. That’s the kind of investment no one wants.
The economies of scale can be economies of learning typical for airplane manufacturers. Lockheed Martin sold the first F-35 for a flyaway cost of $223 million which has now gone down to $77.9 million because they learned how to make them cheaper.
Supply-side economies of scale can move to the demand-side. An easy example is Nokia which was a top mobile phone manufacturer before Android and iOS came around. The latter ones are ecosystems so as soon as they reached critical mass Nokia started to struggle as it lost its competitive advantage.
Business model and monetization
The business model may be fairly standard across the board. An airline is straightforward, passengers pay to travel form point A to point B. The company buys planes and pays staff, whatever’s left is profit.
Other industries can be hard to understand. There are a lot of fintech start-ups which are not necessarily trying to replace banks but they find new clever ways to monetize their products. A lot of them sound really interesting but if you are investing in a company you need to have a very good knowledge of who is paying and for what.
New companies, especially technology ones, struggle to figure out how to monetize their business. This can be a serious problem as a lot of them start as free services. I love that as a consumer but if I’m going to buy shares I want them to make money.
The hot new start-up will definitely go bankrupt if it doesn’t figure that part out like Quibi did while losing over $1 billion of investors’ money.
Hooray! We finally drilled down to the company we are investing in. I will split this in two parts: quantitative analysis and qualitative analysis. It is always a good idea to start with the quantitative part.
This is the first and most basic thing on our list. If the math doesn’t make any sense then there is no reason to proceed to the qualitative part, we are not investing in the company.
The qualitative analysis, as the name suggests, is concerned with stuff that can’t be measured with numbers. Some examples are the quality of the top management team, the organisational structure, the company culture and other things that can make or break our profits as shareholders.
We want hard working managers not greedy ones who’d take the shirts off our backs to board a private jet. There is much to be done so without further ado we’ll dive into the math.
The company’s financials are the go to place for this. We have to address accounting and finance.
An accountant is a historian or a photographer as he or she will give us snapshots of the company’s past on a quarterly and yearly basis. It’s a bit like a family’s Christmas photo album, they may look completely different this year.
A finance professional on the other hand is a fortune teller as he or she will need to tell us what may or may not happen with the future. Therefore, figuring out what the family may look like on their Christmas 2026 photos is within the scope of finance.
I assume that you are just starting your investing journey. Therefore, you have to understand what accounting does and what it can’t do.
There are three documents you need to check: the income statement, the balance sheet and the cash flow statement.
The income statement
The income statement shows a company’s revenue, expenses and profits. What you need to look for are things like: is the revenue increasing, decreasing or flat; what is going on with the net profit and the expenses.
If the company’s revenue is growing are the expenses growing too and if so how much. You don’t want a large increase in the expenses based on a small increase in revenue.
The income statement is relatively intuitive and the easiest to understand. Imagine that you are painting your friend’s house.
You got £1,000 for the job (revenue) and bought supplies for £200 (expenses). Therefore, your gross profit is £800 and assuming you’d pay 20% tax your net profit is £640. This is how every company works, however, the big ones have more revenue and expenses compared to a painter.
The Balance sheet
The balance sheet gives you information about the things that the company owns (assets) and the ones that it owes (liabilities). These are split in current and non-current assets and liabilities.
The current ones are short-term, no more than a year, while the non-current can span for many years. Your credit card bill is a current liability while your mortgage is a non-current one. Both of these go on your personal balance sheet as you owe them to your lender.
Your house and car are non-current assets, more specifically fixed assets, unlike the food in your fridge which is a non-current one.
In terms of investing in a company you can see the amount of debt that it has. It is important as you can determine what is the capital structure and then a profit target.
You can also check the company’s assets and shareholder equity. The assets are the stuff that you own so you need to know if they are tangible (buildings, cars, etc.) or intangible (intellectual property, goodwill, etc.). Both tangible and intangible assets can be valuable or worthless.
The cash flow statement
When you go to a supermarket you’ll see a lot of customers buying things and paying for them. However, you don’t see the manager sat in the back office ordering all the tomatoes that are gone from the shelves.
You have money going in and money going out of the company you are investing in. Did you ever wonder how can a firm which is making losses year after year remain solvent? It’s because the customer cash enters the firm before the owed cash goes out.
An ideal situation is if the company you plan to invest in receives cash from customers immediately while liabilities are due in a later period (30-60) days. The reverse can render an otherwise potentially profitable firm bankrupt as the debt collectors will show up. Of course the management team can negotiate the payments but this is not an optimal situation.
Even if a company is loss making it can survive if it has a positive cash flow or if the economic cost of liquidation is higher than the cost to run it. Again be careful.
The cash flow statement also shows non-cash expenses, such as depreciation and amortisation.
The cost of a new plant or machinery is spread over a few years to prevent distortions in the accounts. Therefore, you need to take these into account. They will reduce the cash available, however, they were not paid for during the period of the statement, hence the name ‘non-cash’.
Remember that all of these statements are historical and they will be different if taken the following week. You cannot rely on them blindly.
Some companies commit fraud, it happens, even to Tesco. This is none of our concern as there are relevant authorities, however, as shareholders we are only interested in reputable companies.
The problem with fraud is that it is difficult to detect. I could never hope to analyse a grey economy business because there’s no suitable data. This is why we can’t use quantitative analysis in isolation.
There are various methods to conduct financial analysis. The simplest one is to check the financial ratios of the company. These are various accounting metrics multiplied or divided by each other to give you an idea of the current state of the firm.
You can find a summary of these on various websites so pick your favourite one. The main things I want to know are in the following sections.
What is this company I am investing in worth, are the shares expensive
I’ve said before that the market price of a stock is the fair price. This is true but it doesn’t mean that it reflects the fair value of the firm. The market is prone to bubbles, therefore, we have to do the math.
There are various methods to value a company: the discounted cashflow model and the comparables method are two popular ones. I don’t use the dividend discount model because some companies don’t pay dividends and that’s not necessarily a bad thing.
Discounted cash flow
The discounted cash flow model consists of predicting the future cash available to shareholders and then discounting it to today’s value called net present value. We divide it by the number of shares to get a price.
It is very comprehensive but flawed as any other model, however, it reflects the time value of money. A pound today is worth more than a pound tomorrow.
The disadvantage is that the output is only as good as the assumptions you make. You are trying to create an accurate version of the reality of 2030 which is extremely difficult. It is unlikely to be correct but as long as you get the trend right you should be fine.
Otherwise, mathematically it’s straightforward, you can set up your own for a few hours if you want it to look pretty. Don’t forget to include a sensitivity analysis. It will allow you to find out what will happen if the revenue drops unexpectedly.
This method is useful for mature companies, it won’t work on a start-up.
This is the method that I use whenever I buy or sell shares or options. It is quick and easy but also flawed.
You take some financial ratios and compare them to other companies. It is important to compare similar companies, AMD and Intel for example. You can’t compare Ford and Tesla or Apple and Intel.
Normally, I’d use the Price-to-Earnings (P/E) ratio. This is the share price divided by the earnings per share. The value is high if the earnings are low or if the share price has gone through the roof.
A high P/E is not always a bad thing but it shows that the market is pricing in substantial future earnings or that investors are willing to pay a lot for the shares. Sometimes, the earnings may be lagging behind as the company is reinvesting in the business as is the case of Amazon.
Amazon’s P/E was about 80 (high) on the 31st Dec 2019 and the share price is up 73% year to date. On this occasion you would have earned a lot despite the high P/E. Other times it just means that the stock is overvalued.
AMD’s P/E is 154, while Intel’s is 9.9, does that mean that you are better off investing in a company like Intel? I don’t know, it just means that AMD’s shares are more expensive relative to Intel’s. Either or both could be good or bad investments, you need to dig deeper.
Sometimes cheap stock is low-priced for a reason, therefore, a low P/E of 1 or 5 doesn’t mean you should be investing in the company.
What other ratios are out there
The world doesn’t end with the P/E, we can look at other things too. I find that debt, return and liquidity are important so we’ll cover a few related ratios. There are many more, you can analyse as much as you want.
Debt to Equity ratio
Debt-to-equity ratio is calculated by dividing total liabilities by shareholder equity. A value of 1 means a 50:50 distribution and if it is below 1 then the company has more equity than debt.
We live in a financialized world so companies have to use debt to increase returns meaning that you’ll see numbers higher than one. The optimal value is between 1 and 2, however, you have to consider that it can be distorted.
5 million divided by 1 million is 5 and 1 bn divided by 200 million is also 5. Which is more risky? It also varies between industries as some are more capital intensive than others.
This is a liquidity measure calculated by dividing current assets by current liabilities and the optimal value is between 1.5 and 3.
It shows if the company has enough cash to pay its suppliers and short term debtors. A value below 1 means that it has less assets than liabilities. This is not good and you need to examine the liquidity further.
You are investing in a company so you want to know how much money it makes. I start with the net profit margin, it’s simple and easy. If you remember from the industry analysis section you have to put it in the context of the industry profitability.
Next we continue with return on assets. How much cash does the firm make from the available machinery. A low value may mean that the company is not very productive and you don’t want that.
Return on capital employed gives you information about the efficiency of the company. It has millions of debt, fine but is the money being put to good use or not.
We finish this with the most important for us as future shareholders: return on equity, net income divided by the average shareholders’ equity. This is our money so we want it to be as high as possible. However, not too high as this may mean volatile earnings, excess debt or even negative net income!
You can see that we cannot use any financial metric independently. We have to look at the company from multiple angles to build the most accurate version of reality.
What does the share price tell us
The share price itself can be a source of information. I assume that you are looking at a long term investment in a company so we’ll ignore candlesticks. Nevertheless, have a look at BP’s chart:
You can see various peaks and troughs which are caused by different company related or macroeconomic events. It is normal to expect that the price will go down during the financial crisis of 2007 – 2008. But what happened in April 2010?
All you need to do is to search the news for your date of interest. This time it was the Deepwater Horizon oil spill, very bad time for BP. The latest one is the general drop in demand. Whatever the company you can always check the news to find out what caused the price action.
Never forget to check the share price chart for abnormalities. If the price of the stock has gone parabolic like Tesla below you have to consider how much upside is left there for you to make money. It may be a little or a lot.
You may have figured out that I am more mathematically inclined when it comes to analysis. However, it cannot be complete without some digging on the qualitative side too. It would just be wrong.
You can start with the annual report to find the firm’s value proposition and the goals and aspirations of the top management team. Check the news too for any bad publicity, lawsuits, regulatory or firm-specific macroeconomic issues.
You don’t want to read something like we are very concerned with the performance of our financial securities on page 2 of the annual report if you are investing in a manufacturing company. This is an indication of a financialized firm.
Other important issues include existing and future product lines, competitors, marketing strategy, dedication to research and development, geographical location of the firm’s markets, executive compensation and more. Compare that to the competition, is it the same across the board or is this company somewhat different in a positive or negative way.
The top management team
It is a subject of debate whether a few people can steer the future in your favour. However, you can at least check their track record.
Who’s on the board, who’s in the C-suite, what have these people achieved in the past. You have to take the data with a pinch of salt as sometimes there is random chance involved. They may have been lucky or the CEO may be more charismatic than capable.
Either way that’s alright as long as your profit and loss is in the green.
Organisation and culture
That’s not my favourite topic but it matters. A more bureaucratic company will be slower to respond when market conditions change and can become a thing of the past like Kodak.
Think of a national government, that is the definition of bureaucracy. How quickly does a government complete a project, like HS2 or the 3rd runway of Heathrow for example?
The culture is not easy to figure out but you can still check former employee reviews. There must be something wrong if all of them were unhappy. People don’t always work for money alone, everyone would take a 5% pay cut to work in a nice friendly office.
And we’re done, that’s it! Now you know what to look for when investing in a company. Unfortunately this was just a brief overview and I had to omit quite a bit to fit it in an article.
There are many books which cover each of the sections and some may claim that one thing is more important than another. I see it a bit like a car. You need tyres, engine, suspension, steering wheel, etc to drive. It will be short sighted to say that any major component is more important than another.
If you want to learn more about each of these subjects I’d suggest to use the top down approach. Start with macroeconomics, then move on to industries and then firms.
Look a bit into finance, it may be just math but it is not always intuitive. Every now and again you either know how something works or you don’t. It’s always easier to know.
Finally, I support the semi-strong efficient market hypothesis and I don’t think that fundamental or technical analysis will give you any edge in the market.
That doesn’t mean that it is pointless but you have to consider that millions of capable people perform it on a daily basis. Consequently, it is priced in the market. There is never a sure way to secure profits.