Unfortunately stocks aren’t basic, and they are the single most important and predictable way to expand your net worth. So here is our take:
We are fundamental investors, we believe that to determine the value of something you have to look almost exclusively at a company’s balance sheet and related economic factors. This can be a long and detailed process, and without a passion for this type of due diligence many will see their interest wane. But it’s important to remember that owning a stock is simply owning the upside of a company’s aggregate success. So instead of falling in love with a company’s story, believe me there are many to admire, we look at a company’s or industry’s financial health (if we like the story all the better). But, if I’m going to do a quick inquiry into a companies health, this is where I start:
Is the company making a profit? This is cash flow, at the end of the day this is the most important. Revenue – CoGS = Profit/Loss. I want to know about this first. If the company is profitable at what rate, this is the P/E ratio. If the company is not yet profitable, what does the timeline look like to get there? This is more speculative and can cause us concern as investors.
Is the revenue increasing? A fantastic leading indicator for a company’s success. Profitable or not, a company seeing the topline number on the grow quarter over quarter can answer a lot of other questions like “how will it get to profitability?” “when will it pay down debt?” “can it pay a dividend or increase its current dividend?”. This is how companies tell us their potential.
What does the company have for cash on hand? Cash on hand tells us two things. 1) how good are they at creating cash from operations and what is their intrinsic value (see above for cash flow). And 2) how much can the company expand options, either by reinvestment or acquisition and what multiple can we give that. The amount of cash a company has on hand is a vital sign that lets investors know if the company can grow further, and with the help of answering the below “How does a company behave?” What is the company going to do with that cash?
Can the company service its debts? A good company can bury itself in debt. As quickly and easily as a person can. If you consider debt as a company borrowing from its future profits, then if your participation in its upside is impacted by money it borrows. So knowing the rate it pays on its debt, and the amount of its income it sends out the door in debt is important. It is important to remember that not all debt is created equal, debt to buy a new factory or a competitor could be expensive to a company’s revenue and ultimately profit lines. Debt to service current operations, and debt to service dividends are troublesome for an investor. Tracking the reason a company accrues debt takes time.
What do its nearest competitors look like in the above? Picking any single company is the equivalent to NOT picking hundreds of others, wouldn’t you want to know what the others are doing? I do. For this it’s important to know what universal ratios we can expect from company to company. Knowing the ratios like P/E, Debt ratio and PEG, and the range the travel helps to know quickly how a company stacks up to rest of the companies that exist. Tracking the trajectory of a company’s debt and income quarter over quarter is time consuming. But knowing that a company’s debt ratio is below the average is a quick way to qualify and disqualify a company.
How does a company behave? This is difficult to quantify and even harder to predict, which is why banks have high paid analysts that travel to shareholder meetings, speaking events, and charity gatherings just to get a feel for the intentions of the board of directors. Without the resources they commit to stalk the decision makers at a company we are left to read and interpret their reports. This is admittedly a commitment to their Information Bias, but between analysts and headlines and a consummate tracking of their history we can get a feel for how a company habitually manages its cash hoard. We can characterize a company as “growing”, “acquiring”, “dividend raising,” which is helpful when assessing its potential. This, while part of fundamental analysis, is far more art than science.
The whole process gets harder for casual investors when they are doing research into a companies alternatives, tracking investments they don’t have a stake in is usually skipped but an essential part of being objective. Most investors want the upside to an investment, and not the work, pretty simple. This is why the most successful investors outsource the due diligence, and management of their investments. It’s far easier for private and public managers of money to evaluate long run predictive habits of investment managers or passive strategies then it is to constantly monitor the universe of investment options.