Step one: understanding the business model
First of all, you need to familiarize yourself with the companys business activity. What is it that the company does? How does it make money? What are the particularities of the industry in which the company operates? What position does the company hold on the market and how does it position itself compared to its competitors?
What - if any - are the companys crown jewels (meaning the most profitable business activities)? Is there a competitive advantage (a very low unit production cost, barriers to entry, monopoly, etc.)?
Whats the profit margin like? Is it exceptional or sustainable? And what about the normalized earning power, the fixed costs structure and the average profitability (this means calculated for the long cycle) of each division?
You may have guessed it already: its impossible to grasp (and even less so to evaluate) the financial dynamics of a company without a good understanding of its business activity and the market conditions it operates in first. Step two: a thorough look at the accounts
Next up is the examination of the balance sheet over the years in order to gauge the financial position of the company. Is the company well-capitalized? Is the amount of debt sustainable? Is the liquidity satisfactory? In case of prolonged stress, will the company be capable of absorbing unfavorable market conditions without compromising its survival?
Once this first health check is done, we take a look at the evolution of the companys equity (minus prospective dividend payments or share buybacks of course), the reconciliation of the accounting results with the cash-flows, the profitability of the invested capital and the nature of the various items on the balance sheet.
At this stage, the classic pitfall is to stop at the financial ratios because none of them exempts the analyst from further research and a critical revaluation. For example, certain companies report extraordinary profits as the result of very specific market conditions
While others seem to be operating on a serious deficit but in reality they invest (efficiently) in their growth and therefore have to be evaluated based on non-financial criteria for instance, the quality of their research pipeline, the increase of their user numbers, etc.Step three: tracking the capital allocation
The capital allocation covers everything the management decides to do with the resources it has at its disposal: the equity the shareholders have entrusted them with, the credit granted by the creditors and the accumulated profit (if of course there is any).
Its thus about constant decision-making. Where do the resources go? Against what expected return and what risks? In the long-term, the intrinsic value of the company will evolve depending on the quality of these decisions. When people say that the management creates or destroys value, they refer to the return it generates (positive or negative) on its reinvestment strategy.
The goal of the analyst is to track the circulation of the money over the years and to measure the profitability of the different investments made in the working capital need, the fixed assets or the acquisitions. This is how the analyst should evaluate the quality of each decision (a tedious task!) and judge the quality of the management.
Sometimes, for example, when its a mature business, its better to return the capital to the investors (via dividends or share buybacks) than to reinvest it in the business.Step four: building a financial model
A sophisticated model would without a doubt create a false sense of control and this illusion could make the analyst or investor take a thoughtless risk or perceive the nuances of the situation badly. Often its wiser to rule with a few common sense considerations and to work based on simple and careful hypotheses.
The author has recently been involved in the valuation of a well-known travel website (TripAdvisor). The highly-specialized financial model encompassed dozens of variables among which the traffic, the average revenue per buyer, the growth of certain sectors of activity, the upkeep of the market share, the reinvestment needs for the technology tool, the inflation of the advertising budgets, the mobile conversion rates, etc. in other words, many uncontrollable and unpredictable parameters.
Its better to find yourself roughly on the right track than precisely on the wrong track. In this case like in many others simplicity incarnates (almost) always the ultimate sophistication because the more complex a system is, the more fragile it becomes as the slightest unanticipated deviation of a parameter leads to a series of repercussions that are likely to derail all the fine mechanics. Step five: valuing the company
This is undoubtedly the most artistic part of the process. Its about estimating a fair company value the underlying thought, of course, being to then pay a price thats lower than this value to buy it.
Remember: a share is an ownership title for the equity of a company, not a lottery ticket; a wise shareholder reasons like an owner rather than a speculator and thus knows how to distinguish the price (that he or she pays) from the value (that he or she obtains).
If a companys fair worth is hundred million euros but its traded at fifty million on the market, the security margin is considerable (50%) and allows to absorb a number of analysis errors. Conversely, were walking on thin ice if, for example, we pay hundred fifty million for the same company: at the slightest mistake the price will match the value or even go below it and the capital loss will be painful.
There are various methods to value a listed company: the discounted value of the cash-flows, the sum of the parts, the NAV, etc. One article, unfortunately, isnt enough to cover all the subtleties
But to keep it simple (which often is the most efficient), investing in companies with a high return on equity and a satisfying financial position when theyre being traded at reasonable profit multiples (for example ten times or less) often turns out to be a perfectly optimal long-term strategy.
Translated from the original article