Getting started on picking and analysing stocks: Part 2
This is written by @fayewang, stock market analyst at investingnote.
How to analyse a stock: step by step guide on how to do fundamental analysis
I would like to share my method of analysis in this part. I believe that there are different investment strategies, and my method of analysis in this article is just one of all the possible approaches. My method of analysis puts more focus on the operating performance because I believe that the stock price in the long-term will depend on whether a company has a sustainable business, and I would also like to emphasise the phrase ‘long-term’ here because I am a fundamental investor and I think my method will be more applicable for medium/long term investment.
1. Start with the financial statements
Financial statements are crucial because they show the performance summary of companies. Normally, they are audited and released on an annual basis. From, financial statements, investors can get the detailed explanations of a firm’s operating performance, financial positions, strategies and prospects. They are valuable and useful because all the numbers reflect a firm’s operation and management directly. Furthermore, such information is un-paralled because it comes direct from the companies themselves. In order to conduct analysis in an efficient way, I will break them into several parts, and filter the data according to my analysis criteria.
a) Income Statement
Also known as ‘consolidated profit and loss account’, income statements provide analysts and investors with a straightforward gauge for performance. This statement can answer three questions that investors care about the most: 1) how much revenue did the firm generate 2) how much expenditures did the firm spend and 3) how much profit can the firm distribute.
As there are varieties of ratios or indicators you can choose to estimate the firm’s performance, I will introduce the indicators that I usually use in my analysis.
Revenue and revenue growth
As revenue gives a first impression of a company, it gives investors a rough idea how it is doing. Before checking other numbers like expenditure, revenue provides information about how much money a company can generate from its business. If you observe a firm with declining revenue, that may mean that the firm is facing problem with running its business or is experiencing unfavourable economic situations.
Another important thing to note is the growth rate of revenue. It indicates a company’s potential for further expansion, and it is also a good indicator that can show the developing stage of a firm in a business cycle. To be more specific, a company with revenue growth rate higher than 10% can be viewed as a growing company at the expanding stage, while those with ranges between 5%-10% can be seen as enjoying reasonable steady growth and might also be experiencing the peak of their business. For companies with revenue growth lower than 5%, it can indicate that it is already a mature company and may be falling into the recessionary stage. Particularly, negative revenue growth may indicate serious problems of a business or even the start of an economic recession if many firms witness decline at the same time.
Net profit and profit margin
Net profit is the number after subtracting all the expenses from revenue, and thus reflects the cost management and efficiency of a company’s operation. As it also shows the result after the deduction of taxation and interests, it can be considered as the net value that a firm has created from its business. In some cases, a company’s net profit can be low even when the amount of revenue is high, which shows the inefficiency of cost management.
Profit margin represents how much of sales actually paid off and is earned by the company. It is suitable for comparison amongst a company’s peers because it can eliminate the size and scale differences between companies. Looking at the absolute amount of net profit only is not sufficient in analysis, it would be more relevant to compare it with industry peers. For example, the net profit of Singapore airline in FY2015 is $406.7 million, while Cathay Pacific held $6 million net profit in 2015. Based on the absolute amount, Cathay Pacific definitely has a smaller scale and lower profit. However, in the financial year of 2015, Cathay Pacific observed higher profit margin of 5.9% as compared to 2.6% of SIA group, which means Cathay Pacific has a higher rate of converting sales to company earnings.
Some firms also put basic and diluted earning per share in their income statement, and these ratios will be discussed in the “stock information” section later on. As investors, we also have to bear in mind that time matters here, hence the comparison on a year-on-year (yoy) basis or on a quarter-to-quarter (qoq) basis can give you different analysis results.
b) Balance Sheet
The balance sheet shows you how well the firm utilizes its assets and how much liabilities does the firm owe to its debtholders. Therefore, the whole sheet can show the firm’s overall financial position. There are three parts in the balance sheet: Assets, Liabilities and Shareholder’s Equity. The basic formula is known as Assets = Liabilities + Equity. The underlying principle is simple: all the funds that company can use for acquiring assets is either raised from borrowings or from issuance of equity.
Namely, there are 2 key principles for analysing a balance sheet:
i) Check specific items based on the nature of the company’s business
(Source: Shareinvestor financials)
The first picture is the balance sheet components of Sheng Siong,
The second picture is the balance sheet components of M1.
The items stressed in the balance sheet can be different according to the types of firms. Using supermarket retailer like Sheng Siong as an example, a majority of their non-current assets will be property, plant and equipment (PP&Es) such as retail outlets, while their current assets will include inventories, trade & other receivables, and cash & cash equivalents. Sheng Siong does not have much intangible assets and non-current liabilities because they sell physical commodities and are focused on high liquidity. Hence, if there is a higher amount of inventories and lower amount of cash and receivables at the same time, it implies that they might have problems with selling their goods. However, things are different with companies in different industries. Take M1, the telecommunication service provider for example. M1 holds a larger amount of non-current assets (which is their fixed assets and licences) than their current assets. Compared to Sheng Siong, M1 also owns a greater proportion of non-current liabilities in their balance sheet because they may have signed long-term contracts.
ii) Investigate items with extraordinary numbers
Analysts should pay attention to “extraordinary numbers” such as too much debt, or some unusual change in numbers. For example, a sharp increase/decrease of receivables from previous financial year. Debt can be a great source of capital and can benefit companies by creating a certain tax shield. However, they can also bring stakeholders headaches when the company bears the burden of heavy debt. For example, Ezra has seen their net debt-to-equity ratios over 100% before they went bankrupt. This example illustrates that several ratios can be used to test the solvency and liquidity of a company, such as debt-to-equity ratio and interest-Coverage Ratios, you can check more here.
c) Cash Flow Statement
Cash flow statements show the details of a firm’s cash inflows and outflows. In simpler terms, shows exactly how a firm earns and spends every dollar in their operation. For cash flow analysis, I will usually focus on 2 items specifically: 1) net cash generated from operating activities and 2) free cash flow.
Net cash generated from operating activities directly show you whether a firm earns more from selling goods or providing services than their purchasing expenditure. This indicator is similar to net profit, but focuses on the flow of cash in their main business activity. Free cash flow (FCF) here refers to the ‘cash and cash equivalents at end of the financial year ’ in the cash flow statement, and represents the amount of cash a firm can spend freely on certain purpose. However, free cash flow can also be tricky because the number is cumulative based on the amount at the beginning of the financial year. Hence, when a firm has a higher free cash flow at the end of financial year, it might not mean that it actually generated a higher net cash as compared to the previous year.
Normally, the higher the number, the better the performance. From my perspective, as long as the firm is able to generate stable and positive net cash, it is a good sign. If there is huge change in the FCF, the reason should be shown in the notes section of the report.