10 Things to Look at When Analyzing a Company
Performing a complete financial analysis of a company takes time as you run through all the financial statements, calculate dozens of financial ratios, and study the industry, just to name a few things. Following are ten types of fundamental analysis you should always make time for.
Measuring how much of a company’s earnings are “real”
If you’re not a full-time fundamental analyst, and you own more than a handful of stocks, it would be a full-time job to constantly monitor in real-time every bit of financial data you’ll want to be aware of.
The one form of fundamental analysis you should never skip is the measurement of a company’s quality of earnings. As soon as you can get your hands on a company’s income statement and statement of cash flows, you want to make sure a company’s cash from operations is greater than or equal to its net income. When a company is generating cash flow, you have some proof the earnings are real, not just smoke and mirrors allowed by accounting.
Considering how much cash the company has
It would be pretty rude to ask strangers you meet at a cocktail party how much money they have in their savings accounts. But you don’t have to worry about such etiquette when it comes to companies. Before you invest a dime in a company, you want to make sure you not only know how much companies have, but also what they owe. You should know:
- How much cash a company has on the balance sheet.
- How much the company owes to lenders in the short term and long term.
- How much cash a company generates.
Paying close attention to these three variables will help you avoid plunking your money down in a company that may not survive.
Making sure you don’t overpay
There are countless forces at work to determine a stock’s price. Remember, stock prices are set by the constant tug of war between buyers and sellers trading shares back and forth until settling on a price everyone can agree upon. That’s why it’s critical for you to not only evaluate how solid a company is, but also how profitable it is and whether it has staying power. But above all: It’s imperative to not pay too much for the company.
Evaluating the management team and board members
As an investor in a company’s common stock, or the shares issued to the public representing standard ownership in the company, you’re at the mercy of the management team to make the correct decisions with your money. You’re counting on the board of directors to keep a watchful eye on the management team. If you can’t trust the management team and board of directors, you shouldn’t trust them with your investment.
If you don’t look at anything else in the proxy statement, always be sure to look for related party transactions between executives or board members and the company. These are side business dealings with the potential to corrupt the ability of executives or board members to represent the interests of investors like you. Even if a CEO is doing an excellent job, also be watchful of excessive pay packages.
Examining the company’s track record of paying dividends
Day traders used to scoff at investors who paid attention to dividends. During stock market booms, these small cash payments some companies pay to their shareholders seem almost insignificant.
But fundamental analysts know better. For one thing, dividend payments account for a big portion, roughly 30 percent, of the returns generated by stocks over time. Miss out on those payments, and you’re leaving quite a bit of cash on the table. Also, steady dividends can make sure you’re earning something on your money even if a stock is flat. Dividend payments can also be helpful in helping you decide how much a stock is worth.
Comparing the company’s promises with what it delivers
It is up to you to verify claims made by a CEO. If a company’s CEO says a new product is selling like crazy, take the time to look at its revenue growth and also the accounts receivable turnover in days to ensure customers are buying and actually paying for the goods. If a company claims to have posted record profits, it’s up to you to not only verify the claim, but also make sure it wasn’t the result of accounting puffery.
Always compare the promises made by a CEO in one year’s annual report to shareholders with the reality delivered in the following year’s financial statements. Professional fundamental analysts often read a company’s latest 10-K with the previous one, side by side.
Keeping a close eye on industry changes
Fundamental analysis is powerful, but there is a great deal of emphasis placed on financial statements. The big weakness of financial statements is that they’re historical documents telling you how a company did, not how it will do.
Trend analysis is one way fundamental analysts look beyond historical numbers to assess the future. But you need to be especially mindful of game-changing technologies or new ways of doing things in business that can render a company’s way of making money, or business model, obsolete.
The constant danger that a new technology may wipe out a company is one reason why some fundamental analysts stick with easy-to-understand and basic businesses, where consumers keep coming back. Consumer products companies, for instance, don’t have to worry that people will stop buying deodorant (at least your nose hopes so).
Understanding saturation: knowing when a company gets too big
When a company expands rapidly, it becomes more difficult to grow further. These growing pains and maturity present great challenges to both management teams and fundamental analysts. Companies often struggle with the transition from a fast-growth company to a slower growth one, and sometimes need to change their entire strategies. Fundamental analysts, too, much change the way they evaluate a company and measure its valuation.
Keep a close eye on a company’s operating profit margin, or how much of revenue the company keeps in profit after paying direct and indirect costs. When you see the operating profit margin deteriorate, that can be a heads-up that the business’s glory days are fading. A falling operating profit margin is a tipoff that the company can’t charge such a rich premium for its product.
Avoiding blinders: watching the competition
It’s often tempting to buy stock in a company you think is the best in a business, and assume that your work is done. But companies are constantly changing and evolving. Sometimes a company’s rival might rise up from near death with a killer product and pose a huge threat. Meanwhile, the valuations of so-called leading stocks are often driven up so high that its future returns are often disappointing.
When looking to invest in a company, take the time to read statements and documents released by a rival company you might consider to be weaker –maybe not even a serious threat. Paying attention to statements made by the CEO of a rival company in a letter to shareholders, for instance, might tip you off to industry trends the CEO of the leading company may not have noticed yet.
Watching out when a company gets overly confident
Companies can sometimes get full of themselves. Figuring that their fat days will never end, some companies build opulent headquarters, send employees on overly lavish business trips or even spend cash on vanity promotions.