How To Look For Great Companies

Warren Buffett had once said, a market crash provides us with a rare opportunity to profit by buying great companies at cheaper prices.

So what is a great company? What Warren Buffett meant was a company with solid business fundamentals.

How to find a great company? That is the million dollar question.

In this post, I would like to explain the process of analyzing the fundamentals of a company and point out some aspects of the process that makes it challenging for non-professional retail investors to do so.

To set expectations, I will not go into the technical details of fundamental analysis or valuation methods. My aim is just to explain the general concepts.

Fundamental Analysis

To quote investopedia: Fundamental analysis (FA) is a method of measuring a security’s intrinsic value by examining related economic and financial factors.

So the goal of fundamental analysis is to measure the true value of a stock by analyzing the economic and financial factors pertaining to the stock.

There are quantitative aspects of fundamental analysis which can be found in the financial statements and qualitative aspects of fundamental analysis such as management, economic factors, business model, corporate governance, brand and market share which are less tangible.

Let us start with the most obvious piece of fundamental analysis – analyzing the financial statements.

The Financial Statements

The financial statement is a like a person’s health screening report. An analyst going through the financial statements is like a doctor going through the health screening report attempting to evaluate a person’s current health condition.

In a health screening report, all aspects of the health screen are reported – your height, weight, blood pressure, cholesterol level, blood count etc etc…

Likewise, the financial report will report all aspects of the financial health of the company, the balance sheet, income statements and cash flow statements.

All Aspects Of The Financial Statements Are Considered

When a doctor examines your health screening report, he is not going to look at your just the top two organs, e.g. your heart and your lungs and come to a conclusion that you are in the pink of health.

Instead, he will scrutinize every piece of information in the report trying to spot anything out of the ordinary no matter how small, then only will he come to a conclusion about your health.

Similarly, all data in the financial statements should be considered and all aspects of the company should be evaluated. In fact, we should be paying extra attention to any outliers in the statements.

Often, we need to look at the profitability, assets, liabilities, cash flow and earnings growth and combine them to create a better picture of the financial state of the company.

Interpretation Of The Data Is Subjective

Different doctors can look at the same report and may give different advice and different diagnosis.

Similarly, different analyst can look at the same financial statements and arrive at different prices for the company’s stock.

There is no fixed formula or method of how much should we weigh each aspect of the company. It all boils down to the individual analyst’s judgement and experience.

Should we give a higher weight to profitability or cashflow? Which ratio should we use price to earnings, price to book, price to earnings before interests, tax and amortization?

Some analyst use a Discounted Cash Flow Model to valuate the stock price; others use a Dividend Discount Model.

There are so many different ways you can arrive at the intrinsic value and there is no single right way to do it.

Financial Ratios are Relative

When a doctor looks at your cholesterol level, he does not always have an absolute threshold, i.e. more than this level and your are unhealthy.

Instead, he will always compare your cholesterol level with people in your age group, gender and ethnicity and determine whether your cholesterol level is within the normal range. This is because people are biologically different and can have varying levels of differences and still be considered healthy.

Likewise, when you look at financial ratios of a company, you should always consider it relative to companies in the same industry.

A price to earnings (P/E) ratio of 20 might seem high but if it were a tech stock, it would be normal or even considered cheap.

Some of the common ratios used (non-exhaustive):

  • Price to Earnings (P/E) – How much price you pay per earnings
  • Earnings per Share (EPS) – How much earnings you gain per share
  • Debt to Equity – How much debt relative to your equity
  • Return on Equity – How profitable for each equity invested
  • Working Capital Ratio – How easy to turn assets to cash to pay off short-term liabilities

Financial Statements Represents Past Performance

Your health screening report informs you of your current health status. It does not guarantee your health will stay the same in the future. That is why we regular go for health screenings, to check our condition and keep track on our health as we age.

This is the main limitation of financial statements as they represent the past performance of the company.

Analyzing the financial statements gives us a good baseline estimate of what the company is currently worth and we could use it to project to the future.

However, if we want to be more accurate and thorough, we should consider other factors as well and build upon your baseline estimate.

This is where we need to consider the qualitative factors associated to the company.

Qualitative Factors

So in this section, we will move from being doctors to insurance underwriters.

A doctor is interested in diagnosing the issue with your health and treat it. An insurance underwriter is interested in how long you could live, in order words, how likely you are going to be healthy in the future.

The underwriter will use your health screen report along with other qualitative factors like your lifestyle, your occupation, your family hereditary history and any other data that might be a potential risk to the insurance company. The higher the risk, the higher the premium the insurance underwriter will demand.

Likewise, investors do not buy a stock because they think the company had done well in the past, they buy a stock because they think it will continue to do well or better in the future.

After looking at quantitative factors, investors should start looking at the qualitative factors which are not as straightforward to quantify.

If they find any potential risk related to the stock, they will demand a risk premium on stock price – a discount. In other words, they will price the stock lower because of the higher risk.

Here are several qualitative factors of the company (non-exhaustive):

  • Business model
  • Competitive edge of the business.
  • Management
  • Corporate governance
  • Brand
  • Market share

Business Model

The insurance underwriter will find out your lifestyle to determine whether you smoke or drink alcohol regularly or living in highly stressful environments. This is because certain lifestyles can have higher risk of developing health conditions.

Likewise, when we look at companies, we need to examine the business model. How do they make money? How profitable is their business model?

Some business models scale very efficiently like tech companies (that is why they tend to have higher growth rate). Some business models are very human resource intensive and do not scale as well.

All these will affect the fundamental value of the company and analyst and investors will price this factor into the stock price.

Competitive Edge

As an insurance underwriter, I will need to find out whether the insured is in a high risk occupation such as working offshore on an oil platform working with hazardous chemicals or just a sedantary office worker. The nature of the occupation increases the risk of illness or death.

Similarly, we need to look at whether the company is in a fiercely competitive sector or whether it has build itself an economic moat which gives it a competitive edge over the rest.

Certain sectors or industries have very low profit margins and extremely competitive like the commodities market – agricultural markets, raw materials etc etc…

Certain sectors command high premiums and companies had built huge moats around their businesses that make it very hard for companies to compete with them, I am thinking of tech companies like Apple, Amazon, Facebook, Google etc etc…

Those tend to be priced higher because of their competitive edge over the rest of the players in the market.

Management

Is the person a disciplined person who will likely exercise regularly? Or is the person compulsive and would eat all kinds of unhealthy food? How well that individual can manage their diet and exercise regimes can help us predict whether he will continue to remain healthy for many more years to come.

Likewise, we often also look at the experience or competency of the management of a company.

A great management would mean a company that can implement their strategies precisely, respond and adapt to changing environments.

If the management track record has not been good, this is a potential risk which many investors might not want to pay a premium for. Thus, you can expect lower valuations from the analysts or investors.

Corporate Governance

Will the person hide information of pre-existing conditions or hereditary diseases in their family background? Is the person trustworthy? Will there be a moral hazard?

Likewise, a company with good corporate governance which has clear policies that govern the relationship, roles and responsibilities between the managment, directors and stakeholders.

Companies with good governance ensure accountability between all parties. Investors will want companies that are trustworthy, ethical, transparent and fair. Having good corporate governance will help ensure those values.

No one would want to pay more for a shady company with very poor governance because there could be fraud, money laundering, tax evasion or different kinds of risks.

Macroeconomic Factors

As an insurer, I will also take into consideration the conditions within the country at a broad level to calculate the premiums for my insurance policies. For example, what is the average life expectancy, how is their healthcare, are the air and water polluted, the sanitary conditions, etc etc?

All these play a part in determining the risk I will be taking offering insurance to the people of this country.

The lower the life expectancy, the higher the premium I will demand for this country.

Likewise, geopolitical factors heavily influences the fundamentals of a company. The more instability the region, the higher the risk it will have on the company and thus I will only be willing to buy the stock at a larger discount.

Political instability will affect business fundamentals. You do not have to look very far for examples, the US-China Trade War, Brexit, Oil War etc etc…

Global trade tension could also adversely affect profit of companies, especially those that are heavily reliant on global supply chains or global markets.

Additional Points

Usually, analysts will start analyzing from a top down approach, meaning analyzing macro economic factors to microeconomic to the company factors.

You can also do it from a bottoms up approach from business factors, microeconomic factors to macroeconomic factors, like how I did in this post.

It is not easy to consider all factors of a company, that is why professional teams of analysts, experts of certain industry, economist and researchers all work to evaluate stock prices.

To add more complexity, there are also huge companies that span across multiple sectors and have new and innovative business models with diversified revenue streams.

Take for example Amazon, a company that started selling books online and had since evolved its business offering e commerce marketplace, fulfillment centers, Amazon cloud services(AWS), advertising services, subscriptions services and many more.

Even Disney, a traditional media company operates media networks, multiple huge theme parks and resorts, owns huge merchandise business, produces movies and even ventured into streaming services online. It becomes increasingly hard to put a price on these kinds of huge multi sector companies.

To top it up, all the factors that we look into are the known factors. We cannot know the unknown unknowns and therefore cannot price it into the stock.

An example of an unknown unknown is a black swan event called COVID-19 which I think you will be quite familiar now.

COVID-19 devastated the economy of many countries and affected multiple industries and sectors globally.

Conclusion

Evaluating the true value of a company is not easy. The financial statements only provide a good baseline estimate to start with. We have to evaluate multiple factors to improve our valuation.

It is no wonder that Warren Buffett also advocates buying into companies that you understand because there are so many other qualitative factors that are hard to quantify the true value.

Finding a great company is not easy and requires a lot of hard work and effort.

For me, I prefer to just buy all the companies in a total market index. Some of the companies in it are bound to be great companies.

Let me know if I had pushed the analogies too far. I hope that they have been useful in explaining the process of fundamental analysis.

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Author: Fatty's Finance

Finance is like health. It becomes an issue if it is not well maintained. I want to help you get back in shape!

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