Part 5 in a series of tutorials on value investing: A step by step guide to the process I use to evaluate a new stock.
Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The Investor’s Toolkit
Part 4: Building a Valuation Framework
Part 5: Hitting The Books:
Understand What It Is You Are Buying
The key to successful value investing is understanding. In order to accurately assign a fair value estimate to a company, you have to get to know the company inside and out. You’ve got to pore over its financial statements, read through its annual reports, visit its website and scan through its news releases. In this section I’ll be giving you a detailed outline of the steps I follow when researching a new company.
Once I’ve found a stock that I feel is worthy of further investigation, it’s time to roll up my sleeves and get down to business. The first place I start is usually with a company’s p:e ratio.
To get an accurate number for this, you need to calculate the company’s earnings yourself. This means teaching yourself some basic accounting. The Investopedia.com website is a great resource for this. Once you know the lingo, it’s a fairly quick exercise to go online and download a company’s latest annual and quarterly reports. These are statements that public companies are required to file with the securities commission once every three months (quarterly reports) or once per year (annual reports). In the US, these are referred to as 10-Q’s and 10-K’s. (And in many foreign markets they file interim reports once every six months instead of using a quarterly schedule.)
The Financial Statements
In the middle of these reports, you’ll find three very important accounting summaries, known as the company’s financial statements. They consist of the income statement, the balance sheet and the cash flow statement. The income statement begins with the company’s total sales (the “top line”). It then lists all of the various expenses that subtract from these sales, things like overhead, depreciation, interest payments and taxes. At the bottom, once all the expenses have been accounted for, it will list the resulting net profit (the “bottom line”). The next section of the financial statements is the balance sheet which lists all of a company’s assets (cash, inventory, equipment, real estate, etc.) followed by all of its liabilities (amounts owed to suppliers, bank loans, bonds it has issued, etc.). If you take all of a company’s assets and subtract all of its liabilities the amount left over is known as the company’s book value or shareholder’s equity and this number appears in a section at the bottom of the balance sheet. Finally, we have the cash flow statement which shows all of the money flowing in to and out of the business.
Directly following the financial statements is an intimidating, but very important section called the “notes to financial statements”. There are some very valuable pieces of information in here and I usually start my investigation with one of them. Namely, the number of shares outstanding. Since I’ll be sharing the ownership of this company with many other investors, I need to know how big my piece of the pie is going to be. I’m looking for an item labelled “common” shares. There may be a few different classes of these (class A, class B, etc.) and if there are, it is important to add them all together. Especially with small cap stocks, there may also be quite a few warrants that have been issued. These warrants give the holders the right to buy more shares at a specified price. If the holders exercise their warrants it could increase the share count substantially, thus lowering the earnings per share and affecting the ultimate p:e ratio you calculate for this company. I’ll usually add the warrants to my share count unless the exercise price is more than double the current share price. Finally, you’ll have options. Since the excesses of the dot come era, companies have cleaned up the way they account for these things. Very similar to warrants, they give the holder the option of buying shares at a certain price. Unlike warrants, though, the cost of issuing these options is estimated and included as an expense (under “stock based compensation”) on the income statement. It would be double counting to both include the expense in your calculation of earnings and also include the number of options in your share count. So I’d suggest you do one or the other but not both. Personally, I accept the stock based compensation expense as given and do not include the options in my total share count.
Once you’ve got a number for your share count, it’s worthwhile double checking this number against the number reported by whatever financial website you are using. (globeinvestor, yahoo finance, etc.) It likely won’t be spot on (yours is more likely to be the correct one) but it should be in the ballpark. It is also a good idea to look at all the most recent news releases and make sure that there hasn’t been an issue of new stock since the last quarterly or annual report came out. This can affect your numbers significantly. There have been a number of times where I have spent hours reviewing a stock and believed it to be a good candidate for investment, only to realize that a month previously they had issued 10 million additional shares, lowering my EPS number significantly and thereby moving the p:e ratio out of my buying range.
With the share count in hand, you can use the current share price to calculate the company’s market capitalization (number of shares multiplied by the share price). While most of my figuring is done on a “per share” basis, the market cap still gives you an important insight into just how big the company is. Generally speaking, large companies trade at a bit of a premium to smaller ones so we need to know where our prospective company sits in this regard.
Once I have a line on the total number of shares, I can move on to calculate my adjusted earnings figure for the company. Once I have that, I can calculate the earnings per share and from that, finally, the p:e.
I’ll start my investigation of a stock with its most recent income statement, working my way methodically through from the top line (sales) to the bottom line (net earnings). As I work my way down the list, I consider each line item and see how it relates to the year before. (In the financial statements, the previous year’s numbers are always included for comparison purposes.) Have overhead expenses increased more than sales? Has marketing or R+D been cut drastically? (not a good sign for future profitability) Have interest expenses increased significantly? If so, the company has likely taken on a big slug of debt and I’ll need to look into this. There are sometimes little numbers listed beside the line items. These refer to footnotes found in the “notes to financial statements” section. It’s worth looking these up. For instance, there may be a line item called “other expenses” with a footnote beside it. If you flip through to the back and find the corresponding section it will break down what exactly those other expenses are. There could easily be something in there (like the sale of a division or a big restructuring charge) that will affect my adjusted earnings calculation.
As I work my way down the income statement, I factor out any items which do not seem to be part of the regular, day to day operation of the business. I want an adjusted earnings number that smooths out a lot of the noise and gives me a good sense of what average earnings are going to be like going forward. This is going to give me a clearer reading on the potential growth rate of this company as well. If earnings doubled in the past year but it was all because of a big one-time gain, that’s not likely to repeat and is not the kind of steady, sustainable growth that I am looking for.
An example of one of the things I factor out of my own earnings calculation is foreign currency exchange gains and losses. If a business does a lot of business in other countries, it will report gains and losses from the movement of exchange rates. Some years they may report a gain. Some years they may report a loss. In the long-term, these gains and losses are likely to even out and I am always buying with an eye to the long-term. I don’t try to make bets on the direction of currency exchange rates, so I just factor this variable out of the picture.
Likewise, I factor out gains and losses on derivatives. I exclude investment gains and losses or gains and losses on “fair market value adjustments”. If a company reports a gain from an increase in the value of its headquarters that’s a nice little windfall but it’s not part of the day to day operation of the business and I have no idea whether such a gain might occur again in the future. Occasionally, I’ll be looking at an investment company or real estate company whose main business is the business of making investment gains. In these cases, I’ll grudgingly include these in my earnings calculation, but it often leads to lumpy results and I’ll be particularly skeptical when making decisions based on these.
Pension adjustments get tossed aside. If a company reports a gain because the value of their pension increased, things could easily tip the other way during the next market drop. Again, this is not part of the core, day to day operation of the business. Restructuring expenses mostly get excluded unless they seem to be a regular occurrence. Legal settlements or insurance payouts won’t be included. Certainly, the gain on the sale of a division would get subtracted out. The company can’t keep selling off pieces of itself on a regular basis or there would quickly be nothing left! Even the gain on the sale of some old, unused equipment would get factored out unless this was a regular, repeating part of the business (as it might be with an equipment rental company).
I’ll start my additions and subtractions not with the bottom line, net earnings number but a little further up with the “earnings before income tax” figure. Taxes can be very lumpy. The company might pay a 20% tax rate one year and a 50% tax rate the next. The variation comes because taxes are based on a set of accounting rules that differ from the generally accepted accounting principles (GAAP) that companies use for their public filings. Over time, the GAAP numbers will typically average out to something close to the going corporate tax rate but year to year they can diverge quite a bit from this number. Again, this has the unfortunate effect of distorting the picture we are trying to build of the company. So I start with earnings before tax and then I look at the average tax rate over the last 5 or 10 years. If the average tax rate is within 5% or so of the official corporate tax rate (a number you can usually find in the notes to financial statements section) then I apply the official tax rate to my adjusted earnings figure to wind up with my final, fully adjusted and taxed earnings tally. (Note that some early stage companies won’t record any tax expense at all. They likely have tax losses built up from years of struggling to make a go of it and it will take a few years to use up these credits. Which is fine, but I don’t usually give companies any additional marks for this. They’ll have to pay tax at some point so unless they have years of tax loss carryforwards built up, I just apply the going corporate tax rate to their pre-tax earnings the same way I do for every other company.)
Once this process is finished (and it takes a lot longer to explain than it actually takes to do), I’ve got an adjusted earnings number which hopefully gives me a much clearer picture of the ongoing, sustainable rate of earnings for this company, minus all the short-term noise and variability. If the latest financial report was an annual report, then I can just use this number directly as the basis for my current p:e ratio. If the most recent report was a quarterly statement, then I have to go back and look at the other quarters to derive an earnings figure which encompasses the most recent 12 month period. This is known as “trailing earnings”, or, somewhat redundantly, “12 month trailing earnings”. Note that companies do not release separate fourth quarter results. To find out the fourth quarter results you have to calculate the annual results and then subtract out the results for the preceding 9 month period (found in the third quarter report).
At its root, business is mostly just common sense. When looking at an investment, you’ll need to use your common sense again and again. Every company is unique. It has its own unique set of issues and strengths. While there are generally accepted accounting principles that companies use when they put together their financial statements, there can not possibly be a one-size-fits-all set of rules. So when you calculate your own estimate of earnings do not be afraid to simply use your common sense. For example, a company might report a large restructuring expense if it needs to shut down a failing division. This can depress earnings significantly in the year in which it occurs. In calculating your earnings figure for this company, should you just ignore the restructuring expense? Possibly. If it was really a one-off event, maybe driven by the legitimately unforeseen obsolescence of a certain technology, then you might consider this to be water under the bridge. What you’re really concerned with is what earnings will be going forward and the business’s remaining operations may look very strong. But what if you look back at previous years and you see that the company is taking restructuring charges every year? Either management just really sucks at running the company (or the company is in a dying industry) or else maybe they are trying to pull the wool over investor’s eyes by categorizing regular, ongoing expenses as “restructuring” costs. There is no hard and fast rule to follow here. You simply have to dig a little, make the effort to understand the company and the environment it operates in and then use your common sense to make your decision.
Once you have a figure for your “adjusted” earnings, your job is not done. You need to put this number into context. A single year’s earnings figure doesn’t tell you very much about the company. To get the full picture, you have to go back further. You want to see how this company has grown and evolved over time. Using the same approach that you used to calculate the current earnings, go back and do the same thing for previous years. Ideally, you want to go back through the last recession so you can get a sense of how the company has performed over a complete business cycle.
I won’t lie to you; this takes time, especially when you’re first starting out and still learning the ropes. But it gets quicker. And seeing the full evolution of profits over time is invaluable in forming a deep understanding of the company you’re thinking of investing in.
When you’ve got your company’s adjusted earnings calculated, going back a number of years, you can take a step back and see what these numbers are telling you. Where are you in the business cycle? Is the company in recession? Is it just coming out of a recession? Or has it been years since the last downturn? How has the company grown over time? Going back to approximately the same time during the last business cycle, have earnings doubled, tripled? Or has the company just been treading water? Have earnings been smooth and consistent or have they been lumpy with big profits one year followed by a slump the next?
There are no right answers here. You’re not looking for a certain type of company. The goal here is simple understanding. To value the company properly, you have to know what kind of company it is and looking at the long-term evolution of the company’s earnings is one of the best ways to get that understanding.
While I have been flogging the earnings side of the equation, there are a couple of ancillary data points that are also crucial to our full understanding. Two of these are total sales and tangible book value. These two items are much less open to interpretation than earnings are and you can probably just safely copy them from one of a variety of online financial sites. As with earnings, you’d like to see these numbers going back a number of years to see how they have evolved over time. The interplay between these three key numbers can contain some important insights. Return on equity, for example is the earnings divided by the book value and it gives you some sense of how quickly the company might be able to grow. If it can earn a high return (ie a high profit) on its book value, then that implies that it doesn’t need big infusions of capital to grow. Similarly, a high profit margin (earnings divided by sales) means it is very good at converting incremental sales into profits and this too could potentially point to higher growth.
The growth record of a business is one of the key variables I assess when valuing a company. Sales, earnings and book value are very useful to cross reference in this regard. For instance, if earnings have doubled in the past 5 years but sales haven’t grown at all, that means that the earnings growth likely came from cutting costs and this won’t be as sustainable as if the growth had come from rising sales. Ideally, you’d like to see sales, earnings and book value all growing roughly in line with each other. If there are major discrepancies between the three numbers, it can be an important signal to do a little more digging to find out what exactly is going on.
The financial strength of the company is another very important factor to consider. You’ll want to look at the company’s most recent balance sheet where it lays out all of its assets and liabilities. For every company I look at, I do a quick calculation, starting with the cash the company has stashed away in its bank account, adding in any short term, liquid investments it might have and then subtracting out most of the debt it owes, whether that be to banks, bond holders, pensioners or financial leasing companies. (I don’t include accounts payable here, which is the money owed to suppliers, as this figure is typically balanced by the accounts receivable asset. I also give the company a pass on its deferred income tax liabilities.) This gives me the net cash or debt the company owns or owes. Cash is good and debt is bad.
Cash gives the company opportunities. They can invest this cash in their business or they can make a hopefully lucrative acquisition. They could even decide to just dividend out their extra cash to shareholders. Either way, cash is always a nice sweetener to any deal.
Debt, on the other hand, can be a millstone around a company’s neck. It limits their options in the same way that cash opens them up. A company with too much debt doesn’t have the flexibility to take advantage of a new business opportunity or buy a juicy acquisition target that unexpectedly presents itself. And if things go south, as they often do at various times, a big debt load can push the company into bankruptcy. A bankruptcy they might have otherwise been able to avoid.
I generally just avoid companies with too much debt (which I define as being more than 3 times their annual earnings). I’ll make exceptions from time to time and there are ways to approach this in a more sophisticated manner by combining the debt and the share price into one unified measuring stick (known as enterprise value) but it’s easier and probably just as useful to simply discard from consideration any company carrying too much debt.
Tangible book value is another important number that I harvest from the latest company filings. Companies will report their book value (they more typically call this “shareholder’s equity”) at the bottom of their balance sheet. The number they report, though, usually includes assets known as “goodwill” and “intangible assets”. These are somewhat artificial accounting constructs. When a company acquires another company, they will often end up paying more for it than the acquired company’s book value. Which is to be expected, assuming they’re not scooping up something from a bankruptcy sale. But the excess of the price they paid for the company over the company’s book value has to get reported somewhere and it ends up on the balance sheet under the goodwill or intangible asset heading. This is an asset that can’t be sold off in a bankruptcy sale. Like the name says, it has no tangible value. So I exclude it from my own calculation of book value. My goal in measuring book value is to look at the worst-case scenario. If the company I am thinking of buying goes south in a hurry, what hard, physical assets are there to provide support for the stock price? Tangible book value tells me that.
Moving Beyond the Numbers
Once you have all the numbers firmly in hand, the next step on your path to full enlightenment is to crack open the most recent annual or quarterly report and start reading all the wordy stuff at the beginning. The CEO or chairman will probably have a letter in there talking about their vision for the company and boasting about any noteworthy accomplishments the company might have made during the year. There will be a section that describes exactly what the company does and another that goes into excruciating detail on the ins and outs of the company’s financial performance. Here, you might find out that the company has filed a patent for a new piece of drilling technology that it thinks will give it a leg up on the competition. Or you might get told that while domestic sales were flat on the year, sales to Southeast Asia doubled. The important information that a big contract with the US military is due to be phased out over the next 2 years could be in here or that a single customer accounted for 70% of sales in the most recent period.
All of this builds on your understanding of the company. And again, there are no right answers. Sure, 70% of sales concentrated with a single customer is usually enough to scare me off, but if the share price is low enough then I might be persuaded otherwise, especially if there were other, mitigating factors. Maybe that single customer is the Canadian government and the company has had a stable relationship with them going back decades. Once again, rely on your common sense. There are valuation rules of thumb that I use but nothing in investing is black and white. I use my p:e guideposts as anchors and then adjust, as necessary, at the margins.
Once you’ve got all your numbers tabulated, have read through the annual and quarterly reports and sifted through the latest news releases, you can finally get down to brass tacks. At this point, you should have a thorough and comprehensive understanding of the business. You could have an in-depth, meaningful conversation with the CEO and not feel like an idiot. In fact, I’d encourage you to do just that. Particularly for smaller companies which may only have a few hundred or a few thousand shareholders, if you call up the company, you’ll often as not be put directly through to the CEO or CFO. If you’ve done your research, they’ll be more than happy to answer any questions you might have. They aren’t allowed to disclose any information that isn’t already publicly available, so I don’t do this much anymore but when you’re starting out it’s a great way to boost your confidence and comfort level.
The Final Verdict
With your thorough understanding of the business and the relevant numbers at your finger-tips you can now make a confidant ruling on this company. The purpose of all this arduous research and preparation is to steer you away from potential value traps. As I said earlier, most low-priced stocks are priced low for very good reasons. The goal of a value investor is to ferret out those reasons. Only after exhaustive study can you really be sure that there is nothing you’ve missed.
If the stock you’re looking at is trading at a big discount to its fair value and if, after a thorough investigation, you can truly find no obvious reason for the discount, then you’ve found a stock that has been seriously mispriced by the market. Snap that puppy up because it won’t stay mispriced forever! While there are no guarantees, I’ve found that a portfolio made up of these hidden gems can shine very brightly indeed.
It seems like there are so many details I’ve left out. I wish I could provide a template for every possible situation you might encounter but no such template exists. Remember to rely heavily on your own common sense and judgement. There are some basic rules of thumb and some broad guidelines that you can follow to start you on your journey but there is no precise formula for successful investing. Keep an open mind, stay skeptical but optimistic, give your curiosity free reign and may the best of luck be with you!
Buying is easy, selling is hard. In part 6 of this series I look at some strategies to take some of the uncertainty out of the selling decision.
Part 1: My Investment Philosophy
Part 2: The General Store
Part 3: The Investor’s Toolkit
Part 4: Building a Valuation Framework