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The Science of Hitting
The Science of Hitting
Articles (432) 

How to Analyze a Company

A primer for new investors

January 10, 2017 | About:

A fellow GuruFocus reader recently sent me an email with the following question: “Which books would you recommend if I want to start investing in individual companies?”

I think there are two answers. You can find numerous articles and blogs discussing the “must-read” investment books as well as the books recommended by some of the great investors over the years (for example, see here, here and here). That’s clearly an important step in the process and a great way to build a foundation (in my opinion, you can’t do any better than Warren Buffett (Trades, Portfolio)’s shareholder letters). However, I find that most investment books are lacking in one critical area: outlining a usable process for analyzing a company. In my experience, there are few books that share a detailed framework of value investing in practice. Personally, when I first started, I stumbled along for a few years before I found a repeatable process that worked for me.

With that in mind, I thought it might be helpful to walk through my approach to analyzing an individual security (for the sake of brevity, this will be somewhat broad; as always, comment or send me a message if you would like to go into more detail). For this example, I’ll look at Costco (COST). Hopefully this step-by-step outline can help new investors hit the ground running.

The first step in my investment process is a broad overview of the financials. I’ll open a new Excel document and manually input financial data for the past 10 years (at a minimum).

The numbers I add at this point are the basics: revenues, cost of goods sold (COGS), gross profit, operating expenses, operating income (EBIT), net interest expense, taxes, net income, shares outstanding, diluted EPS, total assets, total shareholder’s equity, total debt, cash flow from operations, capital expenditures (CapEx), cash outflows for mergers and acquisitions (M&A), other returns to shareholders (dividends and share repurchases) and so on. My Excel sheet has been tweaked over time to take this data and calculate high-level financial metrics (margins, return on assets (ROA) and return on equity (ROE), revenue growth, etc.).

From here, I can answer several basic questions: What has happened with revenues over time? Has a lower tax rate juiced earnings growth? What has been the driver of EPS growth? How do cash flows compare to net income? How has the company spent its excess cash historically? The list goes on and on. At this point, I have a general idea of the financial picture. From this alone, you can get a broad view of how the company has evolved and performed over the past decade.

My next step is to read the most recent 10-K. To access this document, go to SEC.gov and search for the company’s ticker symbol on the right-hand side of the page; from there, scroll through the documents and open the most recent 10-K. Depending on the company/industry, this document can be anywhere from a few dozen to a few hundred pages. In the 10-K, you’ll find important pieces of information including an overview of the business and industry, the business model, the business risks, an in-depth discussion of the financial results in recent years and other items worth knowing about (segment results, funding status of the pension, etc.).

Bringing it back to Costco, you learn several important items in the early pages of the 10-K: the business model is based on high inventory turns on a limited number of SKUs. There’s a clear emphasis on moving products from manufacturers to store shelves as quickly – and with as few hands touching the product – as possible. If this strategy is effective, the company can pay its suppliers early (capitalizing on payment discounts) while simultaneously limiting the amount of inventory that needs to be financed out of the company’s working capital. In addition, the company strictly controls the entry (requires a membership card) and exit (receipt checked by an employee) of its warehouses, limiting shrinkage. Savings are largely passed through to customers as lower prices. Importantly, most of these ideas can be quantified and confirmed by analyzing the financials (for example, Costco’s inventory turns are much higher than its peers).

As I’m working my way through the 10-K, I’ll add additional company- and industry-specific items to my Excel document. For Costco, this includes the number of warehouses (now we can calculate sales and profits per unit), the number of members, comparable store sales, etc. When you work through this exercise for the company’s primary competitors – in this case, Walmart’s (WMT) Sam’s Club business – you’ll notice important competitive trends. For example, you would see that the average Costco sells ~85% more per unit in a year than the average Sam’s. In addition, the gap has held over time (an impressive feat). Costco is clearly doing something right.

When I’m finished reading the 10-K, I’ll think about what I’ve learned and ask some more questions. For example, how has Costco used its excess cash? We can see in the cash flow statement that Costco reinvests a large percentage of cash flow from operations back into capital expenditures (well ahead of depreciation expense) to build new warehouses. Is that an intelligent use of capital? Well, considering the attractive unit economics as well as continued comp store sales growth (both of which have been added to your Excel document by this point), it’s safe to say new units are an attractive use of excess cash.

After the 10-K, I’ll pull the shareholder letters for at least the past five years. These letters can usually be found on the company’s Investor Relations (IR) page. They will either be individually listed or in the introduction to the “annual report to shareholders” (the glossy book with pictures of smiling employees and immaculate facilities). Companies like Wells Fargo (WFC) and Walmart have decades of annual reports on their IR pages. In my experience, reading as many shareholder letters as possible is worth your time.

I’m looking for a few things in the letter: One, is there substance or pure fluff? I want a CEO that frankly discusses what has happened over the past year and what the company will do to increase per share intrinsic value over time. The beauty of years of shareholder letters is the benefit of hindsight: What was the CEO focused on five to 10 years ago? When investments or acquisitions didn’t work, did the CEO frankly discuss the mistake or sweep it under the rug? This is an opportunity for management to be forthright with investors; if they pass up the chance to do so, it's a big red flag. (I’ve previously discussed the example of a CEO that spent more time discussing a $900,000 donation than he did on a $1.6 billion loss in the business; see here).

After I finish the shareholder letters, I’ll pull up old investor presentations, CEO interviews, quarterly conference calls, analyst reports – pretty much anything I can find that relates to the company or the industry. These additional sources give you a chance to assess the management team and the strength/predictability of the underlying business. What problems have plagued the company in the past, and how serious were they? I’m constantly searching for additional information.

With 10-plus years of data, we can step back and think about what truly matters: How has the business model evolved over time? In the case of Costco, it has been astoundingly consistent. Do people enjoy dealing with the company? With Costco, consumers are clearly happy (look at the comps and unit sales relative to competitors). The work I’ve done suggests most employees are proud to be associated with Costco as well. As you work through this process, the important questions have a way of coming to the surface.

At this point, if I haven’t already, I like to work through a similar exercise for the company’s primary competitor(s). I mentioned Walmart previously. If you do the work, you’ll notice a stark difference between Costco and Sam’s Club. Simply put, Costco has consistently proven that it has the upper hand on its primary competitor (this is an example where on-the-ground research and speaking with customers is invaluable).

Finally, I’ll pull up the proxy statement (on SEC.gov, document DEF 14A). This is where you can find important information about executive compensation and equity ownership. How many shares do the named executive officers (NEOs) own? I'll look online at recent insider activity as well. If the CEO and chief financial officer have no interest in owning the stock, why should you? At the end of the day, actions speak louder than words.

It’s only at this stage that I’ll start thinking about valuation. I will build a simplistic model for the next few years that is based on historic results and management’s guidance. Costco has said it will build 31 (net) new units in fiscal 2017; how much will it spend on CapEx? Assuming anything is left over, what are they likely to do with the excess cash? How long will it take for new units to reach the productivity (average sales) of legacy units? Is there any reason to expect a change in margins over time? The answers to these questions are the basis for our valuation.

Conclusion

Considering the length of this article, it’s probably a good idea to stop. Hopefully I haven’t missed too many important points. For new investors that do a deep dive on Costco or Walmart, feel free to comment or send me a message if you would like to discuss any of this in more detail. Obviously this isn’t the only way to complete the task at hand; it’s simply what works for me. For the new value investor, hopefully this exercise will help you find what works for you.

Disclosure: Long WMT

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus.

As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.

Rating: 5.0/5 (15 votes)

Voters:

Comments

The Lion
The Lion - 3 months ago    Report SPAM

TSOH,

I enjoyed the write-up. Maybe to complete the circle you could do a post about what would make you want to gather all this info on a company in the first place? Building 15 years of financial data, doing the reading, asking the questions, etc., is exhaustive, not to mention exhausting. You need to have some kind of hunch that it's worth the exercise. What generally gets you to that point for a company?

Another thing I'd enjoy your further comments on is this: your criticism about the average investment book failing to teach people how to analyze companies is spot on! That being said, what you have laid out here is extremely complex, you may not fully appreciate how you arrived at your own level of sophistication. Proposing this approach to a newbie may be "correct" in theory, but it could be overwhelming. Putting on your empathy hat, how might you recommend to a neophyte a way to wade into these waters such that they can eventually swim laps in the deep end, but don't drown themselves in the process?

Maybe you could share a little bit about how you got to where you are in terms of your intellectual development with company analysis. If you looked back on it and could shortcut it somehow while still being sensitive to how big a challenge it would be to go from 0 to a comprehensive analysis like this, what might be the ideal steps for learning?

I struggle to answer this question myself for people I try to help teach, so that is why I am curious!

batbeer2
Batbeer2 premium member - 3 months ago

@SoH Thanks!

FWIW this is almost exactly how I go about it. One thing I would add (this is obviously subjective) is that as the very first step I take a minute just to think. I try to visualise what I expect to see/find before I look.

- What would be the most significant asset on the balance sheet? Intellectual property?, Goodwill?, Cash and bonds?, Land and Buildings?

- If I run my eyes down from revenue all the way to net profit at which point do I lose most? Would it be gross margin (a retailer might spend more than 80% of their revenue just for restocking) or do I expect to see them spend most on R&D (a company developping/selling drugs sells the product at very high gross margin but then turns around and spends it all on R&D).

Things like that. Then and only then do I look at the numbers. Sometimes they are exactly how I expect them to be in which case I feel confident that I correctly understand what the company does.

However, if they look different from what I was expectig then it gets really interesting. It could mean I (and perhaps others) am thinking about the company incorrectly. That might be very very good because the company is somehow better than people think (Lindsay and Nam Tai have more cash than you'd expect) or it is very very bad because the company is worse than people think.

Then of course it also helps me read the 10k more effectively. While reading, I am hunting for answers. To me at least it makes it easier to read.

If the answers are not in the10k then that's too bad. I'll have to find them somewhere else. Just reading a 10k is not an end in itself. I would hope one would be reading to get some questions answered.

In short, I have some company-specific questions before I get started. I don't mean general questions like "is this profitable?" or "how much is their revenue?". The questions need to be specific like "how much premium per customer does Progressive take and how does this compare to GEICO and Admiral group?" Of course I might get more questions along the way.

To the casual observer though my proces would be very much like you describe. The mere fact that I just sit for a minute with my eyes closed before I start is important though. At least to me.

Just some thoughts.

@ The Lion

The reason I start the proces in the first place is because I'm looking for answers. That simple.

Of course that too is subjective. I would pitty the guy who is doing this just to generate investment ideas. To them it would indeed be very tiresome. To me the proces itself is the reward. I have an advantage because I do for fun what they do for some hoped-for return.

Sometimes I get really interestimng answers and that might make it an interesting investment (or short). But the goal is to get answers to questions. As a side effect you get better at this over time. So as time goes by you generate more investment ideas per time spent. But again, that is just a secondary effect :-)

And yes, sometimes I sit for a minute and conclude that a particular company does not intrigue me. If that's the case, I simply move on and save myself many hours.

The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

Lion,

You make a number of good points, and my response is long enough that it deserves another article; let me try and at least hit the high level here.

On to your first point - how do you know if this company that's worthy of hours of work? I picked Costco for that reason. This company has a special connection with its customers. This insight doesn't require any understanding of the business model, the company's long-term success, etc. If you shop there, there's a very good chance you would agree with me (that's why their renewal rates are ~90%). If you're new to investing, why not start with a company that you know has happy customers? They also have a business model - selling beer, ketchup and TV's - that doesn't seem too hard to understand. It's a great way for a beginner to wade in.

As it relates to complexity / understanding, that's part of the learning process. When you dive into Costco's 10-K, you'll read about a comparable store sales (comps), diluted and basic shares outstanding, capital expenditures, etc. What the heck do those words mean? Pull up Google: the answer is at your finger tips. Even today, there are parts of the 10-K that trip me up from time to time (depending on the industry); over the years, I've slowly but surely chipped away at the concepts that were foreign to me. I'm not sure how you can do this any other way.

I wouldn't worry about going from 0 to 100; I'd simply try and get the ball rolling. Pick a company that's understandable that interests you and read the 10-K. Build the Excel document with 1-3 years of data instead of 10-15 years. For every number in the 10-K, add a new section to your sheet and input the data. Take notes. Use the internet to your advantage. Reach out to people on GuruFocus and ask questions.

I've been doing this for a decade; I bet I've put in more than 20,000 hours. Let me be the first to say that I still have PLENTY to learn. That was true 1, 3, 5, and 10 years ago as well. If you put in the time and have a passion for investing, I think most people will find a process that works for them.

I hope that's helpful; I'll see if I can put together an article answering these questions in more detail.

Thanks for the comment Lion!

The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

BatBeer,

That's a great recommendation - thanks for sharing. I really like the idea of walking down the P&L to get a sense for where revenues are ultimately ending up. It's stumbling across those surprising answers that makes investing truly exhilarating :)

Dr. Paul Price
Dr. Paul Price premium member - 3 months ago

Doing all that work (multi-year data collection) is fine but you are re-inventing the wheel.

Value Line provides subscribers with up to 15-years of data on over 1700 companies, all on one page which includes each year's share price action included as a bonus.

Standard & Poors reports give 10-years of backward-looking numbers, including most of the metrics you mentioned.

Good long-term company performance is always a positive. That said, every stock has a yearly high and low which are often far apart, representing very diverse risk/reward propositions. The same great company could be a sell at one valuation or a buy at a cheaper price point.

The statistical data you spoke about would be the pretty much the same at both the stock's nadir and its peak. That makes it mostly useless in buy-sell-hold decision making.

COST traded for as little as $138.57 and as high as $169.59 over the last 12-months. Those who paid the top print are not happy today while investors who bought near the bottom are feeling great. Most stocks exhibit much larger percentage intra-year swings than low-volatility Costco.

Valuation is by far the most important consideration.

The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

Dr. Paul,

I personally find there's a lot of value in digging through old 10-K's; you can see how disclosures have changed over time, determine when adjustments are appropriate (and when they're not), etc. I manually input the data for this reason, even though it takes more time. For me, this is a worthwhile exercise.

Thanks for the comment!

richday101
Richday101 premium member - 3 months ago

Wonderful article and great discussion. I'm sure Costco (COST) was chosen because it is a fabulous business with an easy to understand business and very predictable fundamentals with good growth. I find filling in all the fundamental values suggested could be a lot of unnecessary work and vert time consuming. I used to use this technique for over 100 stocks but found by the time I was done all the data was obsolete and I had to start over.

As a result, I look at valuation first using GuruFocus. It is easy to see COST is overvalued trading at a P/E of 29.5 (med of 24.6), P/B of 5.9 (med of 2.9), P/S of 0.6 (med of 0.4). COST has been overvalued for the last 3 years trading above median P/E, P/B, P/S. In fact most of the high quality stocks are overvalued.

I look at valuation first using several GuruFocus screens. I then study the summary page, 15 year Financials and the 15 year Interactive Charts. If the stock is trading above most valuation metrics e.g. Med P/E, Med P/B, Med P/S, Earning Power, Intrinsic Value, Enterprise Value, I fill in these values into a spreadsheet. I also fill in several quality metrics as we are always trading off between quality and value. I only buy stocks when P/Value < 0.75. Presently, I find 80% of my stock list overvalued, and <5% are in the "Buys" range, compared to 90% in March 2009.

I also find Valueline and Standard & Poors reports very useful.

The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

RIchday,

Thanks for sharing your approach. Out of curiosity, how do you position your portfolio (balance between cash / stock / bonds) when <5% of stocks on your list are in the "Buy" range? Does that mean you have a huge amount of your portfolio in cash or fixed income? Thanks for the comment!

richday101
Richday101 premium member - 3 months ago

The Science of Hitting

Thanks for the question. I run my Margin Acct and Tax-sheltered Accts differently. I haven't purchased bonds in 8 years. Yes, I have plenty of cash currently in my Margin Acct.

For my Margin Acct, I go from 100% stocks (e.g. 2009) to 80% cash (in mid-2008 and late-2015). In 2009 and 2010, I purchased JNJ, PG, WMT, ADT, BAX, GD, LMT, CSCO, MSFT, DTV, DST, EBAY, FISV, BBY, GME, HRB, etc., but sold all my US stocks in late 2015 as I had a 1-yr project and they were overvalued. I hold onto my Canadian dividend paying stocks (e.g. RY, TD, BNS, BMO, etc.) as we get a Dividend Tax Credit for owning these shares in Canada.

In my Tax-deferred Accts, I hold 100% stocks for the long-run (mostly blue-chip dividend paying, US and CDN).

I am now getting back into analysing stocks but I'm not finding many undervalued opportunities. It feels like 2000 and 2007 all over again. I'd rather sit and wait than take undue risk. I may look at opportunities in Europe, especially in the UK (looks undervalued and no tax on dividends).

My apologies for the long answer.

The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

Richday,

That makes sense to me; thanks for the reply.

"I'd rather sit and wait than take undue risk."

I couldn't agree more!!!

UrbanInvestments
UrbanInvestments premium member - 3 months ago

Yes, this market is not worth risking capital but it's a frustrating wait.

Bear03
Bear03 premium member - 3 months ago

I use the approach Dr. Paul W. Allen described in his book Choose Stocks Wisely. It is a relatively simple examination of the most recent balance sheet and earnings and projected earnings. It is a good approach for finding significantly undervalued stocks that have a solid balance sheet and future earnings prospects.

richday101
Richday101 premium member - 3 months ago

JayBird10

Could you expand on Dr. Paul Allen's 7 screening criteria. I could not find it on his website. I did however find his relaxed criteria of P/E<30, Insider Transactions >0, and Current ratio > 1.5

vgm
Vgm - 3 months ago    Report SPAM
Hi Science - thanks for a great article, as ever. You have an impressive process.

A few years ago, Mohnish Pabrai (Trades, Portfolio) gave an interview with Motley Fool, where he elaborated on advice that Charlie Munger (Trades, Portfolio) had imparted to him, in order to become a superior investor. Pabrai said Munger had never before been public with this advice.

Munger's advice is a guide to finding worthwhile companies, and is arguably complementary to your theme of 'valuation'. The question of uncovering worthy companies came up in the discussion above from The Lion and others.

Munger suggested:

1. Examine the holdings of outstanding investors - in other words, regularly study the 13F filings of bona fide superinvestors. (Parenthetically, this is very different from the huge number of so-called gurus who are covered on Gurufocus.)

2. Look for the Cannibals - those being companies which are buying in a lot of their own shares.

3. Study spin-offs, since they often present deep value for certain (illogical) reasons. This is of course something Joel Greenblatt (Trades, Portfolio) has written extensively about, and Seth Klarman (Trades, Portfolio) has lauded it too.

http://www.fool.com/investing/general/2013/01/15/charlie-mungers-three-rules-on-how-to-become-a-suc.aspx

I have found these suggestions to be quite fertile ground for uncovering interesting ideas, in my own humble and idiosyncratic approach. Intelligently implemented, they represent a shortcut to a shortlist of high caliber ideas. With respect to No 1 above, I'd add the observation that those superinvestors who run concentrated portfolios (Lou Simpson (Trades, Portfolio) would be a prime example) are particularly interesting, because their concentration reflects high conviction.

Thanks again for the stimulation.



The Science of Hitting
The Science of Hitting - 3 months ago    Report SPAM

Vgm - Those are great additional points; thanks for sharing your thoughts and the link to the article.

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