How to do analysis of a company? Part 1

The one thing that really frustrated me at school and at work was the lack of systematic ways of going about doing analysis of companies and industries. I remember asking my professors and my old bosses, so just how do you go about researching a company? What are the things that you need to cover? Meaning critical areas that you need to check into when you research a company and more importantly, how to interpret your findings, what their implications on the stock price and the company performance.

So I decided that I was going to do a series on research and analysis. What are the key things to look at? Where to find them? What do they mean?

First, the financials. Normally, I find companies through my friendly stock screener, either google stock screener or yahoo stock screener. I find both very useful. I key different parameters in and it comes up with a list of companies. Thus the companies I look at already fall within certain parameters in terms of their financials.

First thing I look at is the balance sheet and income statement. I look up the leverage of the company. Debt is neither inherently good nor bad. It's just a form of capital. The company needs to balance its needs to match its current economic situation. Having said that, in the current economic climate, having too much debt is a definitely liability. Especially if its coming due. Companies, like GGP, have gone bankrupt due to their inability to re-finance its debt. Others like Cemex (NYSE: CX) have had their share price greatly depressed due to the overhang of the re-financing question on the company's future.

Bear in mind the absolute amount of debt is only part of the picture. The amount of debt should be thought of in relation to the amount of revenue (long term debt to EBIT or EBITDA etc), debt as a proportion of total capitalization, amount of debt versus equity. All this can be quickly calculated. My rule of thumb is 3.5x EBITDA for an ordinary business (by which I mean manufacturing or simple, non-financial services) is about as high as I am comfortable with. In this current climate, 3.5x is kinda steep. Not because the company can't pay its interest expense but more because some of that debt will probably not be able to re-finance if it comes due. Having said that, there are some industries like utilities that operate consistently with very high leverage (6 or 7 times EBITDA) and have no issues. But they are more often the exception.

After that I look at revenue trends. Is it going up? Or is it going down? Are there any large jumps in revenue? Why is that so? Did they acquire another company? Do they consistently keep buying companies? Does that result in an increase in net profit margins?

There are a number of companies out there that are serial acquirers. Esp during times when credit is cheap. Most often their acquisitions fail to deliver the goods. I've realized that big acquisitions are really hard to pull off successfully. It's often easier to do small acquisitions and integrate them well. A good example of a serial acquirer that adds value is Danaher (NYSE: DHR). These guys have a dedicated team that conducts M&A. They have a whole business system set up around acquiring companies and integrating them into DHR. They are very meticulous and stick to their knitting. They don't venture out of their space. They acquire only specialty instrument companies. That's their niche and they are very good at it. However, DHR is the exception, rather than the rule. Most companies don't have the discipline to acquire businesses that they understand or the setup to integrate their acquisitions. And so they should just not do it.

One more point, where would I find all these financials? A good starting point is yahoo finance. I don't trust the numbers absolutely, there are sometimes mistakes. But it's a good starting point. The reason it's good is 'coz all the stats and ratios are contained in the key stats tab. Later, I go to the Edgar website for the 10Ks and 10Qs. Another good place is the company website. Often the company has the 10Ks and 10Qs in pdf format, so I go there and download them. It's a lot easier to read and I can save it on my computer.

I'll post more on research and analysis as we go on. Hope you enjoy reading this blog.

If you have any suggestions, case studies or ideas. Please feel free to tell me (shaunhhh@gmail.com).

PS. A good book I found on equity analysis is "The Art of Short Selling" by Kathryn F. Staley. It gives a good thorough, all bases covered look at equity analysis. 'coz you often have to be more cautious and thorough when you are short a stock.

Another good book is the Interpretation of Financial Statements by Benjamin Graham. This one is shorter and more of an introduction. It's a classic though.