Before buying a stock, you should always conduct a thorough analysis of the company to see if it’s actually worth investing in it.
A thorough analysis will also serve as a foundation for you to stand on in times of turmoil.
To analyze a stock, you begin by conducting a quantitative analysis, looking at the three financial statements:
- Income Statement
- Balance Sheet
- Cash Flow Statement.
Once you have a general idea of the financial health, you continue by conducting a qualitative analysis, looking at the business model, management, and the competitive advantage.
In this article we’ll look at everything you need, don’t worry if it seems complicated, I’ll explain everything as we go.
Before we dive in, I understand it might seem like a lot of work, but to get above-average results, you have to do things that the average person isn’t willing to do.
“Hey! What if I don’t want above-average results?” you say.
Don’t worry, just buy whatever the newspapers tell you to.
Now, let’s get going. We’ll start by looking at what a fundamental analysis is and how to conduct one.
Fundamental analysis is a method used to determine a stock’s intrinsic value or true value, not to be mistaken for the market value.
The market value is the current stock price. It’s what the market collectively deems the stock to be worth.
Fundamental analysis consists of two parts:
- Quantitative analysis involves analyzing the numerical data, i.e., the data measured and spoken about in numbers. Most often the numbers in the income statement, balance sheet, and cash flow statement.
- Qualitative analysis is the analysis of data that can’t directly be translated into numbers. Things like the quality of the product or service the company provides, competitive advantage, market share, management, and so on.
Let’s continue by going deeper into what a quantitative analysis is and what to look for in the financial statements.
As we just talked about, quantitative analysis is the analysis of information shown in numbers. When talking about stocks, this primarily means analyzing the income statement, balance sheet, and cash flow statement.
Using the numbers from those statements, you calculate different financial ratios to uncover any potential weak points, and also to see if the company is undervalued or overvalued.
You also compare ratios from different periods to see how they have changed, or to those of other companies.
We’ll look at the most common ones for each statement below. Now, let’s dive into the income statement.
Analyzing the Income Statement
The income statement is one of the key financial statements to look at when analyzing stocks. It shows the company’s profit or loss over a period of time by taking the company’s revenue and subtracting the expenses.
If the company’s expenses exceed its revenues, it’s operating at a loss and vice versa.
The income statement will usually show:
- Revenue / Sales
- Cost of goods sold
- Gross profit
- Operating income
- Net earnings
A simple example of what it could look like:
|Cost of goods sold||-$35,000|
|Earnings before tax||$53,500|
Income Statement Financial Ratios
Earnings per share (EPS.) You get the EPS by dividing the company’s net earnings by the number of outstanding shares. Let’s say the fictional company in the income statement example above has 25,000 outstanding shares, you simply take the net earnings of $50,000 and divide by 25,000 to get an EPS of $2.
P/E ratio. The Price-to-earnings ratio is a metric used to determine if a stock is undervalued or overvalued. You calculate it by taking the share price and dividing it by EPS.
Let’s assume the share price is $17. To get the P/E ratio you divide the share price ($17) by the EPS ($2) to get a ratio of 8.5. This number can then be used to compare to that of similar companies.
The gross margin shows you how much of the revenue the company gets to keep after paying the direct costs of producing the product or service they provide.
You get it by dividing the gross profit ($65,000) by the revenue ($100,000) to get a gross margin of 65%. This means the company gets to keep 65 cents for every dollar they make. But then there are other expenses like salaries, rent, etc.
The operating margin is like the gross margin but it takes it one step further by also subtracting the expenses.
You get the operating margin by dividing the earnings before tax ($53,500) by the revenue ($100,000) to get an operating margin of 53%. So for every dollar the company makes, they get to keep 53 cents. But then there are also taxes to pay.
The profit margin takes the final step by also subtracting taxes.
You get it by dividing the net earnings ($50,000) by the revenue ($100,000) to get a profit margin of 50%. The company gets to keep 50 cents for every dollar it makes in revenue.
Now that you have a general view of the income statement as well as being equipped with some useful ratios, we can continue to the balance sheet.
Analyzing the Balance Sheet
The balance sheet is one of the three most important financial statements when it comes to analyzing stocks. Here you can see whether the company’s assets are mainly financed through debt or equity.
The balance sheet consists of liabilities (what the company owes) and assets (the company’s resources, i.e., cash, inventory, machinery, vehicles.)
The liabilities and assets in their turn consist of current and non-current assets and liabilities.
- Current assets are things that the company is expected to use, consume, or sell within a year.
- Non-current assets are the company’s long-term assets, things like property, equipment, machinery, etc.
- Current liabilities are short-term financial obligations that the company often has to pay within a year.
- Non-current liabilities are long-term debt not due for more than a year.
To get the shareholders’ equity, you take the assets and subtract the liabilities.
Below, you will find an oversimplified example of a balance sheet I made so we can better look at the financial ratios used when analyzing a balance sheet.
|Current Assets||Current Liabilities|
|Accounts Receivable||$45,000||Taxes Payable||$5,000|
|Total Current Assets||$80,000||Total Current Liabilities||$40,000|
|Non-current Assets||Non-current Liabilities|
|Total Non-current Assets||$350,000||Total Non-current Liabilities||$160,000|
|Total Shareholders' Equity||$230,000|
|Total Assets||$430,000||Total Liabilities and Shareholders' Equity||$430,000|
Balance Sheet Financial Ratios
Current ratio. The current ratio shows you how well-equipped a company is to pay its short-term debt.
You calculate it by dividing current assets ($80,000) by current liabilities ($40,000) to get a current ratio of 2 in this case.
A current ratio of less than 1 typically means that the company doesn’t have enough money on hand to pay for the short-term debt.
A high current ratio shows that the company is well equipped to pay its short-term obligations. But if the ratio is too high, it might mean that the company is not using resources efficiently.
(Personally, I prefer a current ratio of around 1.5-2.)
Quick ratio. The quick ratio is like the current ratio but a bit more conservative as it removes inventory from the current assets.
To calculate it, you take the current assets ($80,000) and subtract the inventory ($25,000) to get $55,000. You then divide that by the current liabilities to get a quick ratio of 1.37.
It basically shows you how well the company is equipped to pay its short-term debt without having to sell inventory or take on more debt. For every $1 the company has in short-term debt, it has $1.37 in liquid assets.
Debt/Equity (D/E). The debt-to-equity ratio is probably one of the most common ratios used when analyzing the balance sheet. It shows you how the company is mainly financed, through either debt or equity.
To get the D/E ratio, you simply divide the total liabilities ($200,000) by the total shareholders’ equity ($230,000) to get a D/E ratio of 0.87.
So, for every $1 the company has in equity, it has $0.87 in debt, which can be considered safe. It depends on what industry the company operates in.
Now you’re done with two out of the three financial statements. Good job! Let’s continue with the cash flow statement.
Analyzing the Cash Flow Statement
The cash flow statement is one of the three key financial statements analysts look at. Out of the three, it’s probably the one most overlooked, especially by beginners.
A cash flow statement shows you how cash has moved in and out of the company during a period, where it’s coming from, and where it’s going.
Now that might sound similar to the income statement, but it’s important to distinguish the two.
- The income statement shows the company’s financial performance during a period.
- The cash flow statement shows all the cash and cash equivalents going in and out of the company during a period.
Here you can read more about the differences between the two.
There are three components to the cash flow statement:
- Cash from operating activities shows how much cash the business generates.
- Cash from investing activities is usually “cash out” from buying an asset, but it can also be “cash in” from selling an asset.
- Cash from financing activities is either cash in, from taking on debt or cash out, from paying off debt.
Below is an oversimplified example of what that could look like.
|Cash Flow From Operations|
|Additions to Cash:|
|Net Cash From Operations||$55,000|
|Cash Flow From Investing|
|Cash Flow From Financing|
|Cash Flow For Period||$50,000|
Cash Flow Statement Financial Ratios
The Price-to-Cash Flow ratio (P/CF) is like the P/E ratio, but instead of earnings, the price is related to the operating cash flow. And like the P/E ratio, it is used as a measurement to see if a stock is undervalued or overvalued.
Again, let’s say that the fictional company used in the examples above has 25,000 outstanding shares. You then divide the operating cash flow ($55,000) by the number of shares (25,000) to get a Cash Flow per Share of $2.2.
Let’s again say that the company’s shares are currently trading at $17.
To get the P/CF, you divide the price ($17) by the cash flow per share ($2.2) to get a ratio of 7.7.
The Cash Flow-to-Debt ratio measures how long it would take a company to repay its debt if it used all of its cash flow to pay back the debt.
You calculate it by dividing the operating cash flow ($55,000) by the total liabilities ($200,000) to get a ratio of 27.5%.
So the company could potentially be able to repay 27.5% of its debt in a year. It would then take approximately four years for the company to repay all its debt.
The Operating Cash Flow Margin tells you how good the company is at converting sales to cash.
To get the operating cash flow margin, you divide the operating cash flow ($55,000) by sales ($100,000) to get a 55% margin. For every 1$ worth of product the company sells, they convert 55 cents to cash.
Quantitative Analysis Summary
Now we’re done with a basic overview of the three financial statements and their most common ratios.
Now you might be thinking, “Woah, this is so much information. There’s no way I’m going to remember it all.”
I wouldn’t expect you to. Like with all new things, you have to do them again and again for them to stick. And if you don’t understand everything the first time, don’t worry, I didn’t either.
When I got started, I often read the same things over and over again in order to fully get them, and every time I understood a little more.
With the pep-talk done, let’s look at what Qualitative Analysis is and why it is important.
If you remember, qualitative analysis means analyzing information that can’t put into numbers.
It’s far less precise than quantitative analysis since if you can’t put the data into numbers, you can’t make different ratios and compare them to others. And if you can’t make comparable ratios, you have to use subjective judgment.
A qualitative analysis relies much more on gut feeling. I don’t know how to explain it in another way.
The three parts to qualitative analysis:
- The Business Model
- The Company’s Management
- The Competitive Advantage
Analyzing the Business Model
It’s the number one rule to investing, before investing in something you need to fully understand how the business works. The business model should be simple and understandable.
If you can’t understand how it works, you won’t know how it’s doing, and if you don’t know how it’s doing, you won’t know when to buy and sell or what it’s worth.
In his book, The Personal MBA, Josh Kaufman names five processes that make up every business. All of them are very useful to know when analyzing a business model.
- Creating value. The business has to find out what people need or want and then create it. Usually, it’s a problem that needs to be solved.
- Marketing it. After the business has found out what people need or want, they have to market it. The people need to know that the product or service exists. Maybe some of them didn’t even know they had a problem until someone showed them the solution.
- Selling it. This one should be obvious. The business has to sell the product or service they’re providing.
- Delivering it. Then they have to deliver it, in the way they promised, making sure their customers are satisfied.
- Finance. It has to make sense business-wise. The cost of the combined steps can’t exceed what the business is bringing in, otherwise, they can’t keep going
When looking into how a business model works, here are some questions you can ask:
- What type of product or service is the company providing?
- How much are they charging for it?
- What’s the quality like? (What do the customers think about it?)
- How are they marketing it?
- Who are the customers?
- What does it cost for the business to keep going?
With a long list of things to look at when analyzing a business model, we’ll continue with what to look for in the company’s management.
Analyzing the Company’s Management
When analyzing management, I like to use the Warren Buffett way, which also is the name of a book written about him and his investment strategy. The book dedicates a whole chapter to his twelve immutable tenets to follow when buying a business, which of three is about management. I’ll give you the whole list as well as an affiliate link to Amazon below, should you decide you want to get it.
Here are Warren Buffet’s twelve immutable tenets to follow when buying a business:
- Is the business simple and understandable?
- Does the business have a consistent operating history?
- Does the business have favorable long-term prospects?
- Is management rational?
- Is management candid with its shareholders?
- Does management resist the institutional imperative?
- Focus on return on equity, not earnings per share.
- Calculate “owner earnings.”
- Look for companies with high-profit margins.
- For every dollar retained, make sure the company has created at least one dollar of market value.
- What is the value of the business?
- Can the business be purchased at a significant discount to its value?
And here is the link to the Amazon page I promised.
Let’s continue with what we were doing. In the list above, under management tenets are the three questions Warren Buffett asks himself about management before investing in a business.
1. Is the management rational?
There’s often a link between how the management allocates capital and how rational they are. And, over time, the allocation of the company’s resources is what will determine if an investment turns out profitable or not.
Where the management should allocate the capital largely depends on what stage of its life the company currently is in. If the company is in an early stage, it’s often rational to reinvest the money into the business to further boost the growth.
If it’s at a more mature stage when growth has stagnated and the business is generating an excess of cash, the rational thing to do is most likely distributing it to the shareholders.
Yet, there are plenty of irrational and stubborn managers who keep reinvesting money into a business without being able to grow it at a satisfactory rate.
2. Is the management candid with its shareholders?
Honesty is the fastest way to prevent a mistake from turning into a failure.
This one might be self-explanatory. If the management isn’t honest, how can you trust the things they’re telling you? A financial report should present the company’s performance fully and genuinely, even if it’s grim.
Management shouldn’t hide anything behind accounting principles. Sugarcoating useful information can severely hurt you as an investor, and it’s not something you should take lightly.
Buffett says financial reports should help the reader answer three questions:
- Approximately how much is the business worth?
- What is the likelihood that it can meet its future obligations?
- How good are the managers doing, given the hand they have been dealt?
He also goes so far as to say that most annual reports are shams and that way too many managers are overly optimistic in their reports. Most likely to serve their own short-term interests.
So when analyzing a business’s management, any sign of lying or twisting the truth should be taken very seriously.
Another thing you might want to consider is the management’s track records. Where have they worked before, and how good of a job did they do?
3. Does the management resist the institutional imperative?
The company’s management should not blindly base their decisions on what other companies operating in the same industry are doing.
The management should base decisions on what is best for the company, independently of what everyone else is doing.
But as Buffett noted, it’s far from uncommon for the management to mindlessly imitate each other, showing lemming-like tendencies.
Another thing you might want to consider when analyzing management is their track records. Where have they worked before, and how good of a job did they do?
Analyzing the Company’s Competitive Advantage
A competitive advantage is something that’s inherently hard to duplicate, otherwise, it wouldn’t be an advantage. Three different competitive advantages might be that the company:
- provides a product or service of higher quality than the competition.
- provides a product or service at a lower price than the competition.
- provides a product or service no one else is providing.
Those are three different strategies a business can incorporate. They are often called:
- Cost Leadership
The differentiation strategy focuses on setting the business’s products or services apart from the competitors’. This often means providing a higher quality product and charging a premium price. Apple is a good example of this.
The cost leadership strategy is about becoming the lowest cost producer of the product or service. The company does this by continuously improving operational efficiency and cutting costs.
Often, they have to pay their worker less, which is why China is a good example of this. They can pay their workers less since the living conditions in China are lower. A business example would be Walmart.
In a focus, or niche strategy, the company identifies a narrow market, a small segment in the total market, and provides products or services for it. (It can be age or sex-focused, geographical, special product, etc.)
An example might be an insurance company that just deals with car insurance. Or Porsche, focusing on the upper-middle class.
That’s it! I’ll leave you with some final advice I have learned by experience.
Don’t get hung up on a specific stock. When you’re analyzing stocks, it’s easy to feel like you have spent too much time to just discard them. But if you find something wrong with it that’s what you have to do.
Don’t become obsessed with short-term prices. Short-term volatility is the result of the stock market’s erratic behavior. The price fluctuations don’t necessarily have anything to do with the fundamentals of your stock.
Trying to time the market is, in my opinion, a fool’s game. Jumping in and out of your investments is probably only going to lead to you racking up transaction fees. In the long run, they will significantly impact your result.
If you’re set on becoming a trader, although not something I encourage, ignore this advice.
This leads me to my next advice.
Beware the charlatans. Seriously. All these courses and services promising to teach you how to make money quickly are all hoaxes. And many investing blogs will encourage trading because that’s where they make the most money. Not by trading, but by selling you products and services related to trading. Or by giving you a link to sign up at some brokerage firm so they get a cut.
Don’t blindly take advice from people, whether it’s an uncle, father-in-law, or just a friend. They probably have the best intentions, but you should be careful who you listen to. Especially when it comes to things that can have a major impact on your future.
I hope you enjoyed this article, and that you learned something new. I’ll leave you to start analyzing stocks now, good luck!