How to analyze a stock

INVESTMENT FRAMEWORK

Industry Study

  • Is this a good business? What are the key success factors to superior performance in this industry?  (Value Added Research “VAR”)
  • Define the market opportunity.  How do competitive products address this opportunity?
  • What are the barriers to entry (“moats”)? (VAR!)
  • What is the relative power of: (VAR)
    • Customers
    • Suppliers
    • Competitors
    • Regulators
  • Who controls industry pricing?  Does the company/sector have any pricing power?
  • How (and how much) can a good company differentiate itself from a bad one in this industry?
  • Do you understand this business?  Test yourself and describe it to a ten year old.  DO THIS!

Business Model (VAR)

  • What is the selling model:  razor/blades? services? one-off contracts?
  • What are the economics of the base business unit?  How does it stack up against competitors?
  • Why is the company good (or bad) at what they do?  Can they sustain it?
  • Is this company growing by acquisition?  How sustainable is that?
  • Be able to easily describe the entire sales process – from order to fulfillment.

Management (VAR)

  • What is their background, and what do their former colleagues, investors, classmates, say about them?  Have they been successful in the past?  (Very important)
  • How are they compensated?  Are their interests aligned with shareholders?
  • Have they been good at allocating capital?
  • Are they buying or selling stock?  How much as a percentage of their holdings, and why?

Company/Cultural Issues (VAR)

  • Is this a great company?  Is it built to last?  What could change this assessment?
  • Can you imagine holding stock in this company for twenty years?
  • If you had access to unlimited capital, how would you feel about your chances of successfully competing against this company?
  • Compare to a weak competitor in the same industry.  What is the difference and why?

Financial Measures First Step:  Check against all the accounting shenanigans in Howard Schilit’s book (Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition)

Balance Sheet

  • What is the company’s capital structure, and how does it compare to its peers?
  • What are the trends in inventory turns, days payable/receivable, and working capital?
  • What are its coverage ratios on interest payments?

Cash Flow

  • What are the company’s capital requirements and cash flow characteristics?
  • How is the company choosing to invest its capital?  CapEx?  Buybacks?  Acquisitions?
  • Does the company need to access the capital markets?  How soon/often?

Earnings/Profitability

  • Regarding the company’s sales model, how visible are earnings quarter-to-quarter, and year-to-year?
  • Is this a fixed or variable cost business?  How much cost leverage?
  • Do earnings grow as a function of unit sales growth, price increases, or margin improvement?  How sustainable is this growth?

Valuation

  • Looking forward, what is the company’s valuation in terms of:
    • Market Value/Earnings
    • Enterprise Value/EBITDA
    • Free Cash Flow Yield (After-Tax Free Cash Flow/Market Value)
    • Market Value/Sales
  • What is the company’s growth rates in terms of earnings, EBITDA, and FCF?
  • What are consensus earnings  estimates, versus your own expectations?
  • What are the key leverage points in our own and the street’s earnings models?  What has to go right, and where is the most chance for surprise?
  • Are their accounting policies conservative and in line with their peers?

Risks

  • What are the big unknowns?  How much can the company control/influence these risks?
  • What could cause this investment to be a total disaster?  How bad could it be?

Other (Timeline/timing issues) DO A TIMELINE!

  • What are the catalysts (triggers) for the company’s proper valuation to be realized?
  • What good news, and what bad news, will affect the company in the coming year?
  • Who owns the stock?  Momentum funds?  Big mutuals? Hedge funds?
  • How difficult is it to build a significant position (float, volume)?
  • Draw a time line of expected events and dates.  What might go wrong and when?

Investment Framework:  Short Questions

1.  Is this a bad business?

  • Who has the power – customers, suppliers, competitors?
  • What are the barriers to entry?
  • What kind of reinvestment of capital is needed to grow?
  • How is the business changing?
  • What is the historic and current rate of success in this business?
  • What are the major risks to the business plan?

2.  What is the major misperception?

  • Why does it exist?
  • Who is responsible for it?
  • What stakes do the various parties have in keeping the stock price high?
  • How popular is the industry?  rising tides lift all boats – for awhile.

3.  Assess management

  • Industry reputation?
  • Past history of success or failure.
  • Straightforward or cunning?
  • Check out insider ownership and selling.

4.  Ratios:

  • EBIT/EV as a percentage.
  • (EBITDA-CAPEX)/EV as a percentage.
  • Growth of inventories to cost of goods sold – are inventories rising faster?
  • Growth of AR to sales and AP to sales.
  • Any accounting changes – smaller reserve for bad debt, revenue recognition, etc.
  • Cash flow/Int. expense.
  • Review Howard Schilit’s red flags

5.  Sentiment:  Are more people bullish or bearish on the stock?

  • Do full media search for articles.  Make list of analyst recommendations.
  • Short Interest?  SIR (remember, the stock that is already short is potential buying power)  Be careful if there is universal bearishness.

6.  Timing

  • What is the expected trigger on the misperception?  Do a time line.
  • Who owns the stock – long term or short term, momentum investors?
  • Has the souffle already risen once?
  • Can the rising stock price be self-fulfilling for awhile (financing opportunities, etc)?
  • Where does the company stand in terms of the fantasy, transition, reality paradigm?

7.  Add when the story starts to unfold — regardless of stock price.

  • Watch for earnings warnings, excuses, etc.  Where there’s smock, there is often fire.
  • Is the company or wall street analyst group in denial of the problem?
  • Watch the ratios, insider selling etc.
  • Even if the stock down significantly from its high, if answering all these questions convinces you that it is still a short, do not cover and consider adding.  See below
  • Does waiting for the new financials feel like waiting for Christmas?  IF “YES”  —–> ADD.
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2 thoughts on “How to analyze a stock

  1. Justin Dorset

    I would just like to thank you for these guidelines. I’m doing my first stock analysis on a manufacturing company for a university coursework and have found this extremely useful.

  2. Olajire

    This is quite revealing. you never imagine what this framework has offered a knowledge-savvy type like me. Thank you & more power to your elbow

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