Stock analysis is both an art and a science. While there are objective methods of analyzing stocks, such as using financial ratios and examining company financial statements and performance, there are also subjective elements to stock analysis, such as interpreting industry trends, projecting future cash flows, and assessing the quality of management. To place financial analysis strictly in one of the categories does it a major disservice. A successful investor must be able to balance objective analysis with subjective analysis in order to make informed investment decisions. Ultimately, the best approach to stock analysis is one in which both art and science are integral.
Likewise, there are also multiple methods of determining whether a stock is priced fairly or whether the price is lower or higher than the underlying fundamentals. Fundamental analysis is, by nature, a complicated process, and there are no objectively correct methods of analysis. In other words, the way in which I analyze stocks is not the way to analyze, but merely one possible way to analyze stocks.
My method involves examining the company according to ten factors: three that are critically important, three of moderate importance, and four of lesser importance. This is not to say these ten factors are the only ones which have a bearing on the value of a stock. However, I have found that these ten factors tend to bring the most important information to the surface while suppressing instinctual biases.
Before going through the factors, I first gather some background information about the company. Specifically, I ask myself:
- How does the company make money?
- In which industry does the company reside?
These two questions are crucial to understanding the company and its business plan. Only after answering these questions do I walk through the ten factors.
Factor 1: If the company is not yet profitable, how is growth supposed to happen, and is profitability even possible? If already profitable, can the company maintain these profits over the long term?
I am not opposed to owning stocks of unprofitable companies, so long as there is a viable path to profitability in the near (3-5 year) future. For example, in the 1990s and early 2000s, Amazon had yet to achieve positive net profits on an annual basis. However, it was clear from the beginning that Amazon was investing heavily in building out its business nationwide to supplant traditional brick and mortar retailers by offering numerous products at prices that brick and mortar stores could not match with their high overhead costs. It was only a matter of time until Amazon could scale its way to consistent profitability. On the other hand, companies such as DoorDash will find it difficult to ever turn a consistent profit because it has very little control over the prices it can charge without pricing itself above what the level of demand could justify.
For companies that are already profitable, it is important to determine whether the profits can be sustained even during economic and industry downturns. For example, Bank of America has generated profits every year for the last ten years, despite recessions and fluctuating interest rates, while Halliburton is highly exposed to the oil and gas industry and has seen its fortunes shift from year to year along with the price of oil.
Factor 2: What is the company’s financial condition? Is it healthy for a company of that size and type?
This factor typically involves a deep dive into the company’s balance sheet as well as a projection of future profits. Most companies are capitalized with a mix of equity and debt. If a company has no debt, it is literally impossible for it to go bankrupt. These companies are usually extremely financially resilient as long as they do not suffer from multiple years of negative cash flows. However, even if a company has debt, it does not mean that the financial condition of the company is poor. A company that has a debt-to-equity ratio of 2.00 but that has been and continues to make consistent solid profits is healthier than a company with a debt-to-equity ratio of 0.50 that is unable to generate profits.
Larger companies are generally more financially resilient than smaller companies because they have an easier time raising additional capital during rough periods. They are also more likely to have a diversified business model which can provide alternative revenue streams to keep them afloat when other segments of their business struggle.
Factor 3: Does the company have an economic moat? Will the profits and/or potential for growth attract new entrants?
An economic “moat” is a competitive advantage a company has over current or potential competitors. Moats can take many forms, such as strong brand recognition (Apple), existing economies of scale (FedEx), patents and other intellectual property (Pfizer), and an established network of customers and users (Google). A company with a large moat is able to exert pricing power to increase its profitability without compromising its market share. On the other hand, a company with no moat will struggle to maintain profitability over the long term.
Relatedly, it is important to analyze whether a company that has fewer competitors will be able to maintain that position. Growing industries and the promise of significant profits can entice new entrants which will compete on price, driving down profits. For example, the booming personal computer industry in the 1980s and 1990s led to the establishment of numerous PC manufacturers, including Dell, Gateway, and Compaq, but stiff competition drove most of these companies out of the market (or out of business). Other industries have high barriers to entry, which prevents new companies from entering the market and taking market share from existing participants. For instance, the enormous upfront costs to build out cable and fiber optic networks throughout the nation make it extremely difficult for another company to enter and compete with existing cellular network providers.
Factor 4: What are the input and output markets and industries? Are they growing? How reliant is the company on them for success?
In 2020 and 2021, at the height of the pandemic, it was clear how much the auto industry relied on semiconductors. The semiconductor shortage led to the lowest production of new cars in recent memory and, despite higher prices, restricted the amount of profits car manufacturers could generate. For other companies, the output industry may be what precludes growth. During the same time period, Boeing incurred enormous losses in part because airlines reduced their orders of new planes due to weakening travel demand.
Input and output industries can also be a boon to a company, especially one that commands the majority of the market share in its industry. As mentioned before, despite the personal computer boom, many manufacturers eventually went out of business. The biggest benefactors from this boom were not the companies that made it out alive, but rather the company which had a near monopoly on the operating system software used by all of the PCs: Microsoft. Microsoft benefited from the growth in this output industry even as the companies in the PC industry itself cannibalized each other.
Factor 5: Is the company located in a well-regulated jurisdiction with a stable government?
The U.S. has the most stable financial system and government in the world, granting U.S. stocks a level of stability unmatched by any foreign stocks. Close behind are companies in other democratic nations such as the U.K., Germany (as well as many other E.U. countries), Canada, Australia, and Japan. These countries benefit not only from having relatively strong and stable currencies, but also having fairly strict securities regulations.
Although many investors are enticed by companies in emerging economies, such as Brazil, China, and India, I have several reservations about putting too much money in those companies. Although the swift economic growth these countries have been experiencing is indeed attractive, the lack of financial regulations exposes investors to a greater degree of risk than they face in more stable economies. For example, while publicly-owned American companies are required by the SEC to file financial statements and reports every quarter, Chinese companies with American Depository Receipts (ADRs) are only required to file financial reports on an annual basis. The amount of time between reports makes it difficult to detect shifts in a company’s outlook or, worse, fraud.
Factor 6: Are insiders buying the stock? Are they selling it at a higher rate than the industry as a whole?
There is perhaps no clearer indicator of positive company outlook than when company insiders are actively purchasing the stock (compared to being issued stock options as compensation). As any employee knows, you have greater insight into both the successes and failures of your employer’s business than an outsider. When insiders choose to purchase their company’s stock with their own funds, it means that they believe, based on their knowledge of non-public information about the company, that the stock is undervalued.
Insiders are also able to see problems on the horizon long before outside investors. If they are selling a large percentage of their ownership in a rapid time frame, it generally indicates that they see long-term challenges ahead for the company that may restrain its future performance. Additionally, comparing the rate at which insiders are selling the stock to a company’s peers in the industry can also serve as a warning that the company may not believe in its ability to compete.
Factor 7: How well is the company managed? Has executive turnover been more frequent than average?
It goes without saying that management can have a positive or negative impact on the future performance of a company. However, I still consider this factor to be lower in importance for two reasons. First, assessing the competency of management is quite difficult without being able to audit the company in person for an extended period. Company leadership is not a simple thing, and it can often take years to see whether executives’ decisions have improved or weakened the company. Second, even the best executives make mistakes, including ones which can doom the company, and even the worst executives can often churn out profits. As famed investor Peter Lynch said, “Go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”
One method of determining the skill of company leadership is to see how long they have held their jobs. Generally speaking, the longer an executive has been at a company, the more knowledgeable they are about the company’s strengths and weaknesses. A tenured executive also has a longer track record with which to gauge whether their decisions have translated to the bottom line. Conversely, if a company has been a revolving door for executives, it could indicate that there are systemic cultural problems within the company or that the board of directors simply has no idea what it is doing.
Factor 8: Who owns the company? Is it a controlled company?
The composition of ownership of a stock can be informative of the proper stock price of the company. Companies with a high percentage of insider and institutional ownership may have the confidence of professional investors, which can help stabilize the stock price, but consequently it can also reduce the odds that a company is undervalued.
Controlled companies are companies of which a significant percentage (usually more than half) is owned by a single person or entity, such as private equity. A controlled company is not necessarily a negative, but it can have multiple downsides that must be taken into account before purchasing the stock. For example, the financial interests of individual investors of a controlled company may not be aligned with those of the controlling shareholder. It is not unheard of for the controlling shareholder to make decisions that are beneficial to the shareholder at the expense of the public shareholders. It is also the case that controlling shareholders can be a net positive for the stock whenever the controlling shareholder makes decisions which benefit the company’s long-term growth prospects rather than prioritizing short-term gains to the detriment of long-term performance. A company’s financial reports often shed light on the motivations behind the controlling shareholder.
Factor 9: How has the stock performed over the past five years in terms of both stock price and earnings per share?
As the saying goes, past performance is not a guarantee of future results. It can, however, be informative as to the type of growth, if any, investors can expect in the future. A company that has consistently increased its revenues and profits year after year could generally be expected to continue that trend – at least for a while.
At the other end, a company which has seen its stock price and earnings decline for several years is not necessarily a poor investment. It could be that the company has just begun to turn a corner and reverse the trend. This can especially be the case for a company in which management (or ownership) has just changed hands.
Regardless of whether a stock has been going up or down, its stock price should always be related to its earnings per share. If earnings increase, so should the stock price, and vice versa. It is when the stock price and the earnings become untethered that often presents the best buying or selling opportunity.
Factor 10: What do analysts covering the stock say about it and why?
I also like to examine what professional analysts say about the company. Do they believe that management is generating the best returns on investment it possibly can? Do they point out any risks I have failed to account for? It is the qualitative information that I find the most useful from professional analysts. I do not put much stock in (pun very much intended) quantitative measures such as price targets and buy/sell recommendations, which tend to follow the crowd rather than reflect independent analysis, although I do find that consensus earnings estimates tend to be fairly accurate, at least one quarter ahead.
Finally, after examining each of the ten factors in detail, I ask one final question: What is a reasonable P/E ratio for the company given its industry, track record, and plans for the future? From this P/E ratio, I use the current earnings to estimate a fair value for the stock price. As a margin of safety, I discount the estimated fair value of the stock price an additional 10% to determine a “safe fair value” for the stock. If I believe the stock is a good long-term investment and is suitable for my portfolio, I set a limit order to buy the stock at or below its safe fair value that expires before its next earnings date.