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
Part 6: When To Sell
The Confidence Game
My goal as a value investor is to find companies trading at a significant discount to their fair value. Another way to look at this is that I am looking for situations in which my estimate of a company’s fair value is significantly different from the market’s assessment of fair value. As a value investor, I’m always taking the other side of the bet. And to do that with confidence and conviction requires a lot of research. I want to be damn sure there’s nothing I’m missing.
The two key components of my valuation calculation are my estimates of a company’s baseline earnings and its future growth prospects. Neither of these two data points comes handed to me on a plate. I can come up with a quick estimate of these two things within a few minutes and therefore a rough guess as to a company’s value, but it is only after several hours of exhaustive research and analysis that I can be truly confident in my assessment. Frequently my estimates will change and evolve as I gain more understanding of the situation I’m looking at. Beyond these two key factors, it’s the many details and nuances of a company’s story that frequently tip the balance one way or the other in favour of a potential investment or not. And to fully understand and appreciate those nuances requires developing a deep understanding of the business involved.
This is the key to successful value investing. It’s those hours spent poring over the financial statements, reading through the annual reports and conference call transcripts, visiting the company’s website, and scanning through the recent news releases, that give you the insights you need to outperform the market.
In this section I’m going to be diving into the nuts and bolts of how I research a company and the kinds of things I look out for.
The Financial Statements
Once I’ve found a company that I feel is worthy of further investigation, it’s time to roll up my sleeves and get to work. The first place I start is usually with a company’s most recent financial report.
It’s a 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, they are referred to as 10-Q’s and 10-K’s. In foreign countries these repots are often called interim reports and are issued biannually. The authorities maintain a website called EDGAR (in the US) and SEDAR (in Canada) that contain links to all the relevant files. In other countries, you sometimes have to go to a company’s website to find the appropriate filings.
In order to properly interpret these reports, you need to teach yourself some basic accounting. The Investopedia.com website is a great resource for this. I’ve covered some accounting terms in this series, but if you’re new to the investing game, there will likely be many other terms you come across that you’re not sure the meaning of. Fortunately, it’s easy enough to look them up. In the beginning, it can feel like learning a new language. There may be a lot of terms you’re unfamiliar with like “accrued liabilities” or “deferred revenue” but once you’ve taken the time to look them up, things will get clearer. It’s a relatively limited vocabulary and while it’s daunting at first, it doesn’t take that long to get up to speed.
In the middle of a company’s financial 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.
Your Share Of The Pie
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 a section which breaks down the share structure of the company and lists the different classes and types of shares that have been issued. In Canada, you can usually rely on there being a specific section in the notes dedicated to this topic. In the US, the information might be spread across a number of areas, and you have to piece it together. The number of common shares will be listed in small print on the first page of the 10-Q or 10-K and that’s a good place to start. You can then go looking in the back of the report for any additional share types. There may be a few different classes of shares (class A, class B, etc.) and if there are, it is important to add them all together. The total number of common shares is collectively referred to as the number of basic shares outstanding.
Especially with small and micro-cap stocks, there may also be quite a few warrants that have been issued. These warrants aren’t shares per se but they 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 the company. I typically add the number of warrants to my total share count.
In a similar vein, you’ll often have options. Since the excesses of the dot com era, companies have cleaned up the way they account for these things. Very similar to warrants, they give the holder the option to buy 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. 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. If I did include the options, I would refer to this as the fully diluted number of shares.
Companies will often issue various types of performance shares. An example would be restricted share units. These are special grants of additional shares that the company gives to employees as a type of bonus. Like options, the cost of issuing these shares is included in the stock-based compensation expense item and so I don’t include them in my share count.
It’s important to spend a bit of time on this. You want to get it right because all your other calculations are going to depend on having an accurate share count. Be careful not to get fooled by a number calling itself a “weighted average” share count. This is actually a good signal that the company may have issued a fair number of new shares recently. If they have, they will take an average of the number of shares before and after the new issuance and report that. But that’s going to be an underestimate. You want the most up to date tally so do your best to ferret out this number and don’t rely on the weighted average number.
Any time a new piece of information comes to light that is deemed to have a significant or “material” impact on the financial situation of a company they are required by law to issue a news release alerting shareholders to the change. So as a final check, I’ll scan the latest news releases to see if there have been any new shares issued since the latest annual or quarterly report. If so, I’ll want to include those in my share count as well. There have been a number of times where I have spent hours reviewing a stock and gotten excited about the possibility of adding it to the portfolio, only to realize that a month previously they had issued a bunch of additional shares. When I calculate a new earnings per share number using the correct number of shares, the p:e ratio moves out of my buying range.
Once you’ve got a number for your share count, it’s worthwhile double checking this number against the number reported by a financial website like Yahoo Finance. It may not be spot on, but it should be in the rough ballpark and that will help give you confidence that you’ve done the math correctly and haven’t missed out on any hidden classes of shares.
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. Knowing the market cap of a company helps you to conceptualise things.
Adjusted Earnings
You’re also going to use this share number to calculate a company’s earnings per share, but first, you need to calculate the earnings. Under no circumstance should you rely on the earnings “as reported” by the company. It’s not that the company is lying to you, it’s that the generally accepted accounting principles (GAAP) that companies are required to follow can include a lot of items which don’t necessarily reflect the ongoing day to day operation of their business. What I’m looking for is an adjusted earnings number that filters out all the noise and reflects what I think the company can earn on an ongoing, sustainable basis.
Likewise, I’d avoid any non-GAAP earnings number that might be presented by management or, for that matter by stock analysts. These non-GAAP numbers often swing too far in the opposite direction, excluding a bunch of inconvenient items which are nevertheless part of the legitimate ongoing expense of running a business (such as stock-based compensation or amortisation expenses) and can’t just be wished out of existence. Non-GAAP earnings are often designed to paint a particularly flattering picture of the company to investors.
Instead, I go straight to the source. I download a copy of the company’s financial statements and flip through to the 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.
Unfortunately, these income statements are not standardised. Companies have a lot of latitude over how they group different expense items and what they call them. You need to tackle each company on its own terms.
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. I need these adjusted earnings numbers 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 also exclude investment gains and losses or gains and losses on “fair market value adjustments”. An example of a fair market value adjustment would be if a company reported a gain from an increase in the appraised value of its headquarters. That might be fine from an accounting perspective 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 or instead reverse itself the following year. Best to just back it out.
You’ll also often see fair market value adjustments in relation to the current market value of a company’s debt instruments (bonds, debentures, etc.). I don’t include those in my earnings calculations either. One of the few times I will include fair market value gains in my earnings is with an agricultural company where their business model is predicated around planting a bunch of seeds and then watching these grow over time. If it’s a long-lived crop, they’ll be reporting periodic gains from the maturation of these crops, and I’ll include those gains as a legitimate part of their day to day operations. If instead a storm came along and wiped out their crop, they might take a large write down of their biological assets and record this as a loss. Do I include that? Maybe, maybe not. It depends on how frequently storms come along and wipe out their inventory. Was it a freak, one-time event or a regular ongoing cost of doing business?
Which raises a good point. There are no hard and fast rules in accounting. Every situation is unique and different and often you just have to make your own judgement call as to what to include in your earnings figures and what not to include. Just keep in mind that you are looking for a number that represents average, sustainable earnings and make your decisions accordingly.
As I go through the income statement, looking for exceptional items to exclude, it helps to compare these line items to the year before. If a company recorded a gain for something one year and a loss for it the next, or if this number bounces around a lot from one year to the next that could be a signal that it is not really part of the regular operations of the business and it is worth trying to figure out what exactly is going on. Looking back at previous year’s reports can help clarify the situation.
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. (In which case, I’ll average them out over several years.) 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 regularly repeating part of the business (as it might be with an equipment rental company).
Companies will often report big, lumpy expenses around acquisition activity. They may do a big acquisition and then fire a bunch of the redundant employees and take a one-time earnings hit for the severance costs. Or they may write down some of the goodwill they acquired in a previous acquisition if the business has not performed as well as they thought it would. It’s a judgement call as to whether to include these sorts of items, exclude them or average them out over a number of years. I’ve done all of the above depending on the situation.
In their news releases, companies will often report on their earnings before extraordinary or unusual items. That’s fine and sometimes that will agree with my own calculation of adjusted earnings and sometimes it won’t. My definition of what’s extraordinary is often different from what management feels is extraordinary. I always rely on my own calculations.
Death And Taxes
I’ll start all of these additions and subtractions not with the bottom line, the 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 numbers the IRS is using to base their tax assessments on, but year to year they can diverge quite a bit.
This has the unfortunate effect of distorting the picture I am 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 average corporate tax rate I would expect to see then I just apply a default average tax rate to my adjusted earnings figure to wind up with my final, fully adjusted and fully taxed earnings tally. The default corporate tax rate I use for the US is 25% and for Canada is 26.5%. You can find a breakdown of the taxes a company has paid to various jurisdictions in the “notes to financials” section.
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 those 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 many years of tax loss carryforwards built up, I just apply my default tax rate to their pre-tax earnings the same way I do for every other company.
Another situation you’ll come across from time to time is a company with a lot of foreign operations. Sometimes these companies can have average tax rates that are consistently above or below the expected default rate. If this looks sustainable, I’ll use the company-specific rate, not my more general default rate. Again, the section on income taxes in the “notes to financial statements” can help you make your decisions in this regard.
When you’re looking at US companies, keep in mind that in 2018, the federal corporate tax rate in the US was slashed from 35% down to 21%. Because of state taxes, companies often end up paying tax rates that are a few percentage points higher than that which is why I use 25% as my default. This abrupt drop in overall tax rates in 2018 can have a significant bearing on company results if you’re looking back and comparing results from before and after the tax cuts.
Minority Interest
Near the bottom of their income statement, companies will sometimes list an expense item called “minority interest” or “non-controlling interest”. I hate those line items. They are often impossibly difficult to deconstruct. They refer to that portion of a company’s profit that is earmarked for someone else. Often, it’s another company that owns a piece of them. It could be the government of a foreign nation where they do business that is demanding a share of their profits. It could be a previous owner of the company who still maintains a non-controlling stake. The difficulty is that the amount of profits siphoned off by these minority interests is often not consistent year to year and often is not calculated as a simple percentage of total profits. It may be a royalty based on total revenue or may be based on some far more convoluted formula. Frequently the exact means of calculating the minority interest is not disclosed. The best I can do in these circumstances is average out the minority interest amount over several years and subtract this from my estimate of earnings before the minority interest expense.
Adding It All Up
Once this process of calculating out my own adjusted earnings number is finished (and once you get the hang of it, it takes much longer to explain than it actually takes to do), I’ve got an earnings number which gives me a better picture of the ongoing, sustainable rate of earnings, and which excludes all the short-term noise and variability of the official “as reported” number. If the latest financial report was an annual report, then I can just use this number directly as my “trailing 12 month” earnings figure. If the most recent report was a quarterly statement, then I have to go back and look at the other three quarters, calculating adjusted earnings for those quarters as well, 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).
It’s often helpful to work out your own adjusted quarterly earnings for each of the four quarters, going back several years. This can give you very important clues as to the seasonality of the business. A lot of businesses do better at certain times of the year. Think retailers in the run up to Christmas or pool supply companies in the summer. If earnings are up sharply in the most recent quarter, how much of that is an improvement in the business and how much is due to normal seasonal effects? You won’t know unless you collect some historical quarterly data.
Common Sense
At its root, business is mostly just common sense. So is business analysis. 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 estimate of earnings do not be afraid to use your own judgment.
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 couple of years? 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. In this case, it is probably more appropriate to include these restructuring expenses in your earnings calculations, as they seem to be part of the ongoing cost of doing business at this particular company. 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 guide your decisions.
Putting Things In Perspective
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 all the way 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 does get 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 even? 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?
It’s here that I revisit my assumption for my baseline earnings estimate. By default, I’ll start with the assumption that the most recent 12 month period represents the best estimate of future, sustainable, ongoing earnings. But once I’ve got a full set of historical financial data to work with, I may reconsider that decision. It may be that the last 12 months were unusually lucrative for the company. Perhaps they scored a temporary but very profitable contract that is due to expire in another 6 months. Or maybe the company, or the economy, is in a temporary slump. In these cases, it might be more appropriate to go back a year or two and use an older set of earnings as your baseline estimate going forward.
Special Situations
The turnaround is a special situation that is a good example of this. I talked about this in the last chapter. These are formerly successful companies that have been hit hard by some internal or external headwind which, after careful examination, you feel to be temporary. It could be something as simple as a recession driving down the profits at a cyclical company to exceptionally low levels or it could be something more company specific like an advertising campaign gone horribly wrong that impacts earnings in the short term but whose effects will fade once the company repairs its reputation.
In these turnaround situations, I’ll go back and use an earnings figure from before the downturn began as my baseline earnings number. Investors refer to this number as the company’s “peak earnings”. As often as not, the company in question is losing money currently, so using trailing earnings as my baseline is not even an option. I’ll want to be pretty sure that the downturn is temporary, and I’ll pay extra close attention to the balance sheet (the amount of debt the company is carrying) in these situations. If the company is losing money, ideally I’d like it to be cash flow positive, which essentially means that if I add back in the depreciation and amortisation expenses, which don’t involve actual cash outlays, then the company isn’t actually hemorrhaging money and can hang on for awhile at least.
I’ll use the company’s earnings from before the downturn began as my baseline, but I’ll often “dumb down” these peak earnings to reflect the fact that I can’t really be sure that the company will completely regain its footing. As a rough rule of thumb, I’ll multiply the previous peak earnings by 0.75 (giving them a 25% haircut) to get my estimate of future expected baseline earnings.
Another situation in which my baseline earnings could differ from a straight-forward calculation of current, trailing 12 month earnings is with a highly cyclical company, one whose earnings go through frequent booms and busts. In this case, I’ll sometimes use an average earnings figure for my baseline, calculated by applying an average profit margin or return on equity (profit as a percent of sales or book value) to the current sales or book value of the company. The idea here being that if the company has grown significantly over the past 10 years, then simply taking an average of the last 10 years’ worth of earnings will underestimate the current earnings power of the company. Taking an average profit margin or ROE instead and applying that to the current sales or book value, which tend to be more stable than earnings, should give a better estimate. And if I’m really being obsessive about it (and of course I am), I’ll then multiply the average earnings number by 1.15 to mirror the typical cyclicality of the market and boost this average earnings number up to a level that is more directly comparable to the trailing earnings estimates I use for most companies (which do not factor in the temporary ravages of recessions).
As I’ve stressed, there’s no iron clad blueprint to follow here. Every company is unique and has its own unique set of circumstances and challenges to deal with. I’ve got some general guidelines and rules of thumb that I follow but I also feel free to break the rules if I think the situation warrants it. The number I want to use for my baseline earnings is a number that represents the ongoing, sustainable earnings power of the business during a typical, non-recessionary year. How I get there exactly can vary from company to company.
Sales, Earnings And Book Value: A Magical Trio
While I have been flogging the earnings side of the equation, there are a couple of ancillary data points that are also crucial to my full understanding of a company, namely sales and book value (shareholder’s equity). These two items are much less open to interpretation than earnings are, and you can probably just safely pluck them from one of a variety of online financial sites. If you’re not blessed with a subscription to a financial data provider, you can always resort to copying these numbers from the company’s own annual reports. As with earnings, you’d like to record these numbers going back 10 or 15 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 outside capital to grow. Similarly, a high profit margin (earnings divided by sales) means the company is very good at converting incremental sales into profits and this too could potentially point to higher growth.
If profit margins have changed over time then that can be an important clue as well. If they are increasing, that means the company is getting better at converting it’s sales into profits. It could be simply that the company is enjoying economies of scale as it grows, in which case profits may sustainably be growing faster than revenues. However, it could also be that the company has been cutting costs by firing staff and reducing research and development expenses. I’d be more concerned in this case that the boost in profits was not sustainable.
Both book value and sales tend to be more stable from one year to the next than profits and so can give you a better read on what the long-term trend is. Of the three, I’ll often put the most weight on the long-term sales growth trend when I make my growth rate estimates.
The Balance Sheet
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 (often reported as “marketable securities”) and then subtracting out the money it owes to its long-term creditors. Conceptually, what I’m trying to figure out is the amount of money the company owes that is not part of the day to day operation of the business. Bank loans, bonds, pension liabilities and notes payable are the main sources of debt I’ll factor into my calculations. I won’t include the current liabilities (money owing in the next 3 months) that are part of general working capital like accounts payable or accrued liabilities, but I will include the current portion of longer-term liabilities like bank loans and notes payable. Deferred income can be another large entry in the liabilities section for some companies and I’ll include this in my debt calculations as well. Many companies lease their equipment and buildings from third parties. I’ll ignore the money owed to financial leasing companies, provided that amount is roughly balanced by a corresponding financial leasing asset entry (sometimes called right of use assets). I’ll also ignore deferred income tax liabilities.
Once I’ve finished my debt calculations, I’ll be left with a number that tells 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 use it to make a 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 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. 5 if I’m really being generous.). 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 balance sheet. Companies will report their book value (they more typically call this “shareholder’s equity”) at the bottom of this page. 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.
On the other hand, when I’m assessing growth rates, I’ll focus more on shareholder’s equity, which includes the intangibles, not on the tangible book value. Many companies will grow through repeated acquisitions and so they’ll be trading their hard-earned tangible cash for intangible assets like customer lists and brand equity. In these cases, tracking the evolution of tangible book value over time will tend to underestimate the actual growth of the company.
While I’ve got the balance sheet in front of me, checking on a company’s net debt and book value, I’ll scan through the other line items. I’ll pay particular attention to the company’s inventory levels and accounts receivable. Inventory is fairly self explanatory. You never want to see inventory building up. That’s a sign that the company is not selling as much as it hoped to and this excess inventory may have to get liquidated at profit-sapping prices in the future. Likewise, you don’t want to see accounts receivable building up either. This is money that the company’s customers owe it but haven’t paid yet. If customers are delaying payments, it could be a sign that the customer base is in trouble. It could also be a sign that the company is “stuffing the channel” by aggressively shipping out product on loose financing terms to customers that may not be able to afford them. This can boost earnings in the short term if the company is booking these sales as soon as it makes them, but if it can’t actually collect the money, the whole scheme is likely to blow up in its face.
In both cases, I look at the evolution of inventory or accounts receivable over time as a percent of total sales. A growing company will naturally have growing needs for working capital (a term that includes accounts receivable and inventory and then subtracts accounts payable) but as long as these items aren’t growing faster than revenues, you should be alright.
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.
All of this builds on your understanding of the company. 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, don’t be afraid to rely on your own judgement. There are rules of thumb that I use but nothing in investing is black and white.
You’ll often come across a section in the financial report listing all the various risks the company faces. A lot of this is boilerplate stuff their legal department told them to put in there, but I still read it carefully because there are sometimes risks the company discloses that I hadn’t thought of and these can sometimes significantly change my opinion of the company.
Another important piece of data to focus on, if the company includes it, are the segmented results. Here, the company reports on the sales and earnings of its various divisions or gives you a geographical breakdown of its operations. There can be some important clues hiding in here. For example, you might see that one division accounts for only a small proportion of the company’s total sales. If management is touting the performance of this division, it’s not really going to move the needle much on the big picture. Or you might discover that while most of the company’s operations are solidly profitable, this is getting hidden by the fact that they have been losing large amounts of money from their Chinese subsidiary. If they announce that they are shutting down their Chinese operations this could have a very positive effect on overall profitability, something that other investors might not fully appreciate.
Connecting The Dots
When you finally finish your investigations, 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, if you’re researching a smaller company, I’d encourage you to do just that. Particularly in the micro-cap space where the company may only have a few hundred 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.
At this point, you’ve accumulated a good set of historical data going back 10 or 15 years, ideally to a time before the last big recession. You’ve calculated your own set of adjusted earnings numbers for each of those years and recorded the total sales and book value as well. You’ve read through the company reports and thoroughly familiarized yourself with the opportunities and challenges facing the company. You’ve gone over the recent set of financial statements line by line looking for anything out of the ordinary.
You’ve also read through the notes to financial statements from beginning to end.
Ideally, you’ve got access to a site that has transcripts of the company’s conference calls. (If not, you may be able to find them on the company’s website.) This is a bigger deal in the US where there is often some important information disclosed in these calls which is not necessarily included in the company reports.
You will have visited the company’s website to get some additional background colour. In the investor information section of this site, the company may have archived some investor presentations which might be worth taking a look at.
Start to end, this whole process can take hours. When I first started out, I would budget a full 8 hour day to review a company. I’ve got that down to about half a day now. It’s a big time commitment, but unfortunately I think it’s a non negotiable. This kind of in-depth research and analysis is something the computers can’t emulate (yet) and it’s what differentiates the most successful investors from the thundering herd.
After all this research, you’ll be much better able to interpret those historical earnings, sales and book value numbers that you recorded. You’ll have started this process with certain growth rate assumptions that led you to believe that the company was potentially undervalued, but now it is time to revisit those assumptions. With what you know now about how the company has grown and evolved over time you are in a much better position to make an educated guess as to where it will go over the next 5 years. You’ll also have a better sense of where it sits in its own business cycle. Is the industry it’s in in a boom or a bust? This too will inform your views on potential growth over the next few years. It will also help you come up with a more accurate estimate for baseline earnings.
After all this analysis you can have another stab at your valuation calculations, plugging in your refined baseline earnings and growth rate estimates. It may well be that your initial impressions were very wide of the mark and that once you have a deeper understanding of the company, you realise that there are more challenges facing it than you realised, and the company may no longer be quite the value you thought it was at the beginning.
Narrowing The Field
When I do my periodic reviews of the market, I start with a long list of stocks in the industries and sectors that I favour. I do a basic screen to weed out the companies with excessive debt or that just don’t make any money and then I get to work. I do subscribe to a data service that shows me a bunch of historical financial data at a glance. I don’t rely on this data, especially for my earnings estimates, but it is a great place to start to form your initial impressions. For more serious investors, the few hundred bucks a year it costs is probably worth the time savings. But it’s not essential. You can get all the data you need directly from the company reports. And you won’t fall into the trap of relying on inaccurate data because it’s a nice sunny day out and you’re too lazy to double check the numbers.
During my first pass through my list of companies, I spend a few minutes looking at each one and making a rough estimate of their baseline earnings and growth rate and then put this into my value calculation. I then rank and sort the list. After a few days of this I have a short list of 20 or 30 companies that I’ve flagged as being the most likely to be deeply undervalued.
I then go through this short list with a fine-toothed comb, doing all the heavy research that I outlined above. Most of these companies will fall by the wayside. There will be something about the company that justifies the low valuation. A class action lawsuit, a large number of warrants, a worrisome rise in accounts receivable. It could be as simple as lowering my growth estimates because I realised that this company’s best days are likely behind it.
Generally speaking, I’ve found that for every 10 companies that look good on the surface, I ultimately end up with only one that survives all my due diligence and makes it into the portfolio. Sometimes I’ll have a few companies that still look promising after I’ve done my research, but I remain undecided. There are things happening in the economy or at the company that could impact the future significantly and I can’t be sure which way the chips will fall. Perhaps the company has just done a big acquisition and I want to see how this will play out. Or perhaps they have launched a new product or are waiting for a major ruling on a legal issue. In those cases, I will put the company to the side. I’ll add it to my watchlist and just wait for further clarity. If things turn out in the company’s favour, then it is possible that the share price will move up out of my buying range before I can get in. So be it. If things don’t turn out well, I’ll be glad I held off making the investment.
I’m looking for the best of the best. I’m looking for companies that are very cheap compared to the rest of the market by my valuation standards. But I’m also looking for more than that. I look for opportunities and subtle signs that the company could end up surprising investors to the upside. That could be a pile of cash on the balance sheet that the company could use to make a big acquisition with. It could be the recent launch of a new product. It could be a new store concept that the company is trying out. It could be that the company is in an industry that has been out of favour and if the economic tides turn, this sector could rebound. I call opportunities like these “free plusses”. Free because I like to see them, but I don’t want to pay for them. After all, I’m a value investor. I’m cheap.
Company financial statements can seem a little daunting at first. There’s a bunch of lingo to absorb that is not part of most people’s everyday vocabulary. But it is not as hard to get a handle on as it appears. I didn’t come to investing from an accounting or business background and had no training or instruction. I read Peter Lynch’s book “One Up On Wall Street” and that got me excited by the possibilities. I then picked up a short little book called “Barron’s Guide to Reading an Annual Report” and with that in my back pocket I started researching and buying stocks.
The next challenge was figuring out when to sell them. That’s what I’ll be covering in the next chapter.
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.