By Matthew Goldfuss
It is important to be independent in our decisions to invest, and be able to evaluate and understand the companies that we are considering for potential investment. In this article, I want to share with you some of the things that I look at when deciding if a stock is a good investment or not.
Revenue
To pick out a stock that will create good long-term value for its shareholders, investors need to look at the sales figure to see if it is growing at a healthy rate long-term.
Investors should, however, make sure that the company is not over-aggressive in its expansion and taking on too much debt; spreading itself too thin. Investors should also make sure that the company is not in the habit of regularly issuing new stock to fund its growth, as this kind of activities will dilute the holdings of shareholders. The best companies are usually the ones that can mostly or fully fund their expansion from internally generated funds.
Investors also shouldn’t overpay for stocks with high growth rates, as this will put investors in a situation where they find themselves with big losses because a high-growth company they bought shares in missed earnings estimates by 0.1% or something.
It is important to figure out if the growth rate of the company is sustainable by reading the annual report for information on growth and looking at the industry the company is in, as well as the size of the company in relation to the size of its largest competitors. A company doing $8 billion dollars in sales in a mature industry where its biggest competitor is only doing $10 billion dollars in sales generally can’t grow much and shouldn’t have too high a rate of growth.
Most important, however, is that an increase in sales is only a good thing if there is an equivalent growth rate or a higher growth rate (due to scale) in income over the long-term. We will look into income a little later in this article.
While I do believe that investors can get good profits from investing in large-cap stocks, I also believe that if investors are looking for stocks that have the potential to go up 20-30 times in value that they have to look for this kind of gains in small-cap to medium-cap stocks. It’s much easier for a $20 million dollar company to grow ten times its size than it is for a $100 billion dollar company to even double its size.
Operating Income
Investors should look for companies with operating incomes that are rising. There don’t have to be an increase in income every quarter or even every year, but there should be healthy growth in profits over the long-term.
The operating margin is the percentage of revenue a company translates to profit before paying interest and taxes, and before taking into account non-operating profits and losses. A company earning higher margins is able to expand faster and better fund its expansion from funds generated internally, while relying less on debt or issuing new shares that will dilute the holdings of its shareholders.
Many companies make losses during recessions as demand for their products drop. Companies with high operating margins are, to a certain extent, somewhat protected from adverse economic conditions and may still make at least some money during bad times. Additionally, when there is an increase in the costs of materials, companies with higher margins are able to delay passing on the increased costs to the customer and gain market share from their competitors that have no choice but to raise prices early.
While it’s true that investors should generally look for companies with high profit margins, in industries with high profit margins, investors should also take into account things like business models, return on equity, and expansion plans. Wal-Mart for example thrives on a business model that entails low margins, because it is its business model that permits it to earn a high rate of return on equity and experience great growth that turned it into the largest retailer in the world. All this has translated to very impressive profits for shareholders over the long-term.
Companies spending aggressively on expansion will temporarily experience lower profit margins (It is important that each dollar a company retains to expand its business, returns to shareholders in the future as more than a dollar plus whatever return shareholders could acceptably have earned had the company instead paid out dividends with the money used for expansion).
Net Income
While operating income allows us to have a better idea of the efficiency and growth of the company, net income is a more accurate measure of the current profitability of a company, as net income takes into account taxes and interest expense.
The Price/Earnings ratio can help investors tell if a stock is cheap. Generally, a low P/E ratio indicates that the stock is cheap. Investors should, however, take into account that a low P/E ratio could also be a sign of bad things to come. The P/E ratio could also be low because of big one-time gains (which should be taken out when evaluating profits). Companies can manipulate earnings, or accounting rules can give temporary boosts to earnings, and these things will also result in the P/E ratio being unreliable.
Investors should add the latest annual net income figure available with net income figures from the past few years and average them out. This will somewhat give investors a more normalized view of profits. The same goes for operating income and return on equity.
Return on Equity
It isn’t difficult for companies to increase earnings. Companies can for example, take on more debt or retain earnings to deploy in profit generating projects. What’s important is the return on equity, as that is the rate of return earned on shareholders’ money.
Here are some questions investors need to ask themselves with regard to return on equity: “Does the increase in assets and liabilities due to the company taking on more debt translate to an increase in return on equity that’s significant enough to compensate shareholders for the increased risks inherent in holding stock in a company that has become more leveraged?”
“Can the company continue to achieve an above average return on its equity that’s constantly rising (due to retained earnings)?”
Investors should always look for companies with high returns on equity (and if possible, rising return on equity), but should also beware of companies earning high returns on equity solely due to the fact that they are taking on lots of debt and operating on very low levels of equity in comparison to their assets.
When analyzing stocks, it is important to see if the return on equity is consistent over the long-term, even if equity has been gradually rising over the years. If the amount of debt has been rising over the years, investors need to make sure that the increase in assets paid for with money the company borrowed resulted in an increase in return on equity that is acceptable.
These are some other things that investors can factor in when evaluating a company’s return on equity:
As an organization grows bigger, it might not be able to sustain its growth without adding new products to their product line, expanding into different lines of business, or entering new markets. The company’s expanded operations might not be able to generate a return on equity that’s similar to that of its past operations (This assumes that the company uses mostly retained earnings and little or no debt to fund its growth). In this kind of situations, investors need to ensure that if the company is not able to achieve a return on equity that is as high as the past, the company has to at least achieve a return on equity that’s above average.
Increased competition is another factor that can reduce a company’s profits and ultimately the company’s return on equity.
Balance Sheet Strength
Investors should generally look for companies with as little debt as possible and as much cash as possible. I usually look for companies with cash and short term investments equaling at least 40% of total liabilities and 150% of current liabilities.
For me the more cash the company has the better, as cash allows a company to weather downturns and even take opportunities during downturns to acquire assets at depressed prices. While on the surface I think it is a good thing for a company to have lots of excess cash, I also would need the company to have a great track record in terms of using its cash wisely, whether it has been known to make great acquisitions at reasonable prices, launching share buyback programs when the company’s stock is undervalued, or etc.
Companies shouldn’t have excess cash for a long period of time as not only will inflation erode the value of the company’s cash holdings, but the shareholders will be much better off if the company paid out its excess cash in dividends.
I can’t remember the exact quote, but Warren Buffett once said something along the lines of “If you’re smart you don’t need debt, and if you’re dumb you shouldn’t get involved with debt in the first place.” I try to recall this quote every time I think about personally taking on debt to invest or buying stock in a company that have a little bit too much debt for my liking.
I generally dislike debt, but I do understand that companies can benefit from taking on debt when the cost of debt is very low. However, I find it important that the company don’t take on more debt than it can very comfortably manage, no matter how low the company’s cost of debt is. When evaluating if a company has taken on too much debt, I generally look at book value to total liabilities, cash to total liabilities, and owner earnings to total liabilities.
Another thing I look at when investing in a company that has debt is the maturities of the company’s debts in the short to medium term, and if the company is able to build up enough cash to repay any maturing debt in the near to medium term. I also look at the company’s cost of debt and will tend to exclude the stock from my list of potential investments if the cost of debt is too high, as not only will it be harder for the company to service its debt, but it is a sign that there could be something fundamentally wrong with the company that justifies it having to pay higher interest rates on its debts.
This segment of the article describes very generally some of the things I look at when evaluating companies’ balance sheets. There are of course other things that investors should take into consideration when evaluating a balance sheet.
Owner earnings
Warren Buffett wrote about a concept he called “owner earnings” in Berkshire’s 1986 letter to shareholders. While it has been quite some time since I read about owner earnings, this is how I calculate owner’s earnings:
Net profit (I try and take out one-time gains or losses) + depreciation and amortization +/- certain non-cash items – average capital expenditure needed to maintain current profitability and competitive advantage – increase in working capital (if there is).
Some companies might be building up cash, and this might result in a significant increase in working capital. I try to take this into account by factoring out the cash portion of the working capital increase once the company’s total cash reaches a certain percentage of current liabilities(depending on the industry the company is in and what you believe is enough cash for the company to run smoothly).
After calculating the owner earnings figure, I will discount the company’s owner earnings for the next 20 years (I use 20 years as I feel that this is the minimum timeframe for long-term investing, investors can of course use their own timeframes) to the present at a discount rate of 6-7%. I suggest applying a 6-7% discount rate, as I feel these are the returns investors can very reasonably earn over the long-term by dollar cost averaging into a low-cost index fund. The value I get from discounting all the owner earnings to the present will be the base from which I will determine the company’s intrinsic value.
After I’m confident that I’ve roughly arrived at the intrinsic value of the company, and I believe that the stock of the company will make a good investment, I make sure that there’s a margin of safety before buying the stock. I generally look for the market price of the stock to be at least 40% below my estimate of the stock’s intrinsic value but may require less of a margin depending on factors like high profit margins, strong cash position, and etc. No matter how sure an investor is in his or her calculation of the intrinsic value of a stock, the investor, to be prudent, should still have a significant margin of safety when investing, as this will give the investor some protection if things at the company don’t go well, if there are adverse economic conditions in the future, if the investor’s valuation of the company is off, and etc.
Investors should note that different people may come up with a different value for owner earnings, as well as a different intrinsic value for the same company.
(I read a little bit about the margin of safety before, and I know that Benjamin Graham wrote about it in the “Intelligent Investor” (which for some dumb reason I haven’t read), but I currently don’t have a good understanding about the margin of safety, and I’m not sure if I’m applying the concept correctly (even though I think what I’m doing makes sense). I am of course going to make reading the “Intelligent Investor” a top priority, but until then, I would greatly appreciate it if anyone could share some information about the margin of safety).
Competitive advantage
Companies need to have some sort of a competitive advantage if they are to produce good returns for shareholders over the long-term. A great brand or a great reputation, an effective distribution system, an exceptionally strong focus on the customer, being the low-cost producer, having a product that’s the de facto standard, and having a great business model that is incredibly difficult to profitably copy can all be a source of competitive advantage.
Economies of scale can be said to be a source of competitive advantage, but I wouldn’t, in most cases, count on it being a lasting competitive advantage over the long-term as some competitors can gain scale with time. There are also an increasing number of smaller companies that are able to effectively compete against their larger counterparts due to the fact that they are able to successfully integrate technology into their business models. Don’t get me wrong, economies of scale is great and can contribute to a company being a low-cost producer, I just don’t think it’s a very substantial competitive advantage on its own.
I do, however, believe that having a near monopoly over a market is an excellent source of competitive advantage. Companies that have achieved almost monopoly status not only get all the possible advantages of scale in their markets, but also pricing power as a result of their huge market share, as well as significantly higher margins than they normally would due to a lack of meaningful competition which would most certainly put pressure on prices.
Usually, there is a reason why some companies are able reach a point where they’re almost monopolizing their respective markets. The reason could for example be a license that makes the company the sole distributor of a certain product, or the company has a product or line of products that have become the de facto standard in their product category (example: Windows engine). These reasons are the things that make these companies able to somewhat sustain their near monopolies over their markets.
Intellectual property, especially in industries like the pharmaceutical industry, can be a great source of competitive advantage assuming that the company has a great R&D department that works closely with the production and marketing departments to consistently come up with feasible and profitable products that have a big enough market potential for the company to enjoy really huge returns (needed to compensate for the risk that the new products won’t be successful) on R&D costs and the costs needed to bring the new products to market.
There are also competitive advantages that are unique to their industries. In the banking industry for example, a large cheap deposits base is a source of competitive advantage.
Great management is also a very good source of competitive advantage. Here are a few things to look for to tell if management is good:
Management is committed to enhancing long-term shareholder value. Management that aims to enhance shareholder value will do things like buyback shares when the stock is undervalued, pay out dividends when the company can no longer reinvest earnings at higher returns than shareholders can, and focus on activities that will result in long-term profits.
Management has a good track record of doing what they say, whether it is to cut costs, reduce debt, increase revenue contribution from a certain division, or etc.
Management is committed to keeping costs low. This can be seen in terms of the company’s selling/general/administrative expenses being significant lower than that of similar size competitors.
Management is conservative. A company that is run by conservative management will have low debt levels and hold enough cash on its balance sheet to ensure that the company doesn’t find itself in financial trouble. The company will also distance itself from risky activities.
The executives own shares in the company worth significantly more than their total annual compensation. The shares these executives own should come not only from stock options, but also from them investing their own money on their own account. While this doesn’t indicate that management is good, it ensures investors that management’s interests are aligned with the shareholders.
Management should be honest and open with shareholders, whether it’s about the current performance of the company, the company’s goals and the progress made towards those goals, the slip ups of the company, or etc.
Price & Understanding your investments
Companies in different industries are valued differently. For example: book value and cost of funds are important in determining the value of a bank, while a lot of weight is put on same-store sales figures in the evaluation of the investment appeal of retailers.
Not knowing what to look for in a particular industry, can lead to investors not being able to properly value companies in that industry. Because of this, investors should put their efforts into analyzing stocks in industries they understand, as this will increase their chances of properly identifying and valuing a truly great company. It is also important to note that great companies can be found over many different industries, and investors will be better off specializing in and really understanding a few industries (even one will do) as opposed to knowing just a bit about many different industries.
Investors should always try to avoid overpaying for stocks, and should instead just build up cash and wait for the stocks they like to become undervalued. This is one of the most basic rules in investment, and everyone knows this, but there will always be people who will still do it anyway, whether they realize it or not. A 50% loss on overpaying for a “hot stock” that has come back to ground will require the stock to go up by a 100% (which could be years) from its no longer irrational price just for you to breakeven. So, even if you are confident that you’ve found a really great stock, you should wait till the price of the stock drop to a point where if bought, could turn out to be a very great investment.