Tuesday, July 14, 2015

Stock Investing: Fun with Financials

Let’s say you’ve been doing your qualitative research and have found several companies whose stock looks very interesting to you. These are businesses you understand at a basic level. They make a high quality product or service—and hopefully you’ve experienced that firsthand as a customer. You’ve decided that these companies have a wide moat, or a sustainable advantage, against their competitors. You’ve read up on their executive management and find them to be smart, capable, and relatively transparent leaders whose moves and choices make sense to you even as an outsider. Finally, you can see that these companies are growing both in size and popularity, or at least you see no obvious red flags pertaining to their potential.

Fantastic. You’re ready for some basic arithmetic. You may have been putting this off, or you may have been looking forward to some hard numbers. Different strokes. So let’s have a look at the companies’ financials to see how they’re doing on their ultimate purpose: making money for their shareholders.

First up, visit Yahoo Finance, enter the name or stock ticker of a company you want to look at and pull up their summary page. Down the left column is a list of 3 types of financial reports the company puts out quarterly: the Income Statement, the Balance Sheet, and the Cash Flow Statement. I find it easiest to copy these into an Excel spreadsheet to simplify and speed my analysis.

First let’s have a look at Return on Assets, which is simply the Net Income figure on the Income Statement divided by the Total Assets figure on the Balance Sheet. It represents the efficiency of the company in utilizing its assets to make a profit. You’d like to see upwards of 10%.

Return on Equity, another marker of efficiency, this time the company’s ability to use the combined equity of all current shareholders to make money, is Net Income divided by Total Shareholder Equity, another Balance Sheet item. Again, you’re looking for something above 10%.

Debt is a measure of all substantial borrowed money held by the company (to buy equipment or raw materials, to finance hiring or marketing or research) should equal less than 25% of Total Revenue. If a company is ringing up sales 3 or 4 times its total debt, that’s a good sign (though some capital-intensive industries, like heavy manufacturing or airlines, require more borrowed money). Ideally, Debt should be close to zero.

Debt-to-Equity Ratio, which is Long Term Debt divided by Retained Earnings and Total Shareholder Equity added together, measures the same debt against ownership equity in the company. For obvious reasons, this number should be as low as possible, but let’s be on the lookout for companies with a Debt-to-Equity ratio of 40% or less.

The Current Ratio is a simple one—it’s the measure of a company’s ability to pay off its most immediately-due debt with cash on hand. Using the Income Statement, just divide Cash and Equivalents (usually stocks or bonds or other asset which are effectively liquid) by Total Current Liabilities. You should see something higher than 2, or more than twice as much cash as current debt. This is important if those current lenders (many of whom may be vendors selling materials or labor to the company on payment terms) call the debt: in other words, if those lenders need the money immediately, can your company just pay them or is it going to mean trouble? A good indicator of the quality of financial management.

Next up is Accounts Receivables Growth: Is the amount owed the company by its customers—credit extended by the company—rising over time? On the Income Statement, locate the Accounts Receivables line and check to makes sure each successive year is higher than the previous. On Yahoo Finance you can click around to locate the quarterly reports from the company as well as the annual ones, and make sure the number rises quarter by quarter as well.

Next we’ll visit an area in Yahoo Finance’s company coverage called Key Statistics, a link on the left of the company summary page. Here you can find other very interesting data, some of which you could calculate but is easier just to look up.

52- week Price Change is in a block on the right margin. It’s simply an indicator of how far the stock price has moved up (or down) in the past year. You’d like to see the stock price rising over that time, of course, even if you’re considering buying on what you expect is a temporary price drop.

Also on the Key Statistics page you’ll find the PEG Ratio, in the middle-top section. This is an indicator of the Price-to-Earnings Ratio divided by a company’s expected growth rate.  The P/E Ratio (Price per share divided by earnings or profits per share) is a common old-school measure of a company’s profitability, a less useful marker now in the tech and information economy than it was in the days of manufacturing, but it’s still a good benchmark. The PEG ratio looks at that figure in light of the company’s growth rate. In general, the lower the number the better, as it indicates that the company is possibly undervalued by the market.

In my next post, I’ll detail some additional metrics I’ve found useful in choosing companies with the potential to completely upend the marketplace they operate in, changing the rules  of their industries or even inventing entirely new ways of doing business, and leaving others in their wake.

Drifting to Fifty | Random unrelated nugget of the week
The single most useful tool in your kitchen is a good, generally expensive, 9-inch chef's knife. If you never drag the blade edge sideways on a cutting board and you hone it briefly after every use it will stay sharp 4 times as long. 

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