Company Analysis

Overview of Company Analysis

Once weve completed the economic forecast and
industry analysis, we can focus on choosing the best
positioned company in our chosen industry
Selecting a company will involve an analysis of:
The companys management
The companys financial statements
Key drivers for future growth
Obviously, we are looking for companies with the best
management, strong financials, great prospects, and that
are undervalued by the market
Always remember that the past is irrelevant, what you
are buying is future results
Evaluating Management
Strong management is vital for companies to perform in
accord with the highest expectations of investors
Unfortunately, evaluating the quality of a companys
management team is very difficult, especially for
individual investors
Professionals have the advantage in that they have many
contacts within the industry who are familiar with the
management team, and they can visit the company and
talk with the team personally

Evaluating Management (cont.)
As an individual, there are several things you can do:
Read the 10k it has information on the background of
executives and board members. Information includes age, pay,
stock ownership, etc
Read the business press There are often stories which provide
insights into the character and abilities of senior management
Call investor relations They can answer any reasonable
questions that you may have
Study the financial statements Good management leads to
solid financials


Evaluating Management (cont.)
Despite your best efforts at judging managements
ability, things can go wrong
History is replete with examples of formerly great
managers running their new companies into the ground
Here are a few examples that come to mind:
AT&T C. Michael Armstrong
Sunbeam Chainsaw Al Dunlap
Apple Computer John Scully
Long-term Capital Management John Meriwether, Robert
Merton, and Myron Scholes (the latter two were Nobel Prize
winners in economics)
Financial Statement Analysis
There are three statements to watch:
Income statement
Balance sheet
Statement of cash flows
Two major tools:
Ratios
Growth rates
The Income Statement
The income statement provides us with
information about the firms revenues and
expenses over some previous time period
(usually quarterly, semiannually, and annually)
The key variables to watch are revenues, gross
profit margins, operating profit margins, net
profit margins
We especially want to evaluate the quality of the
firms earnings
Quality of Earnings
Under GAAP, companies are allowed fairly wide latitude on how they
recognize revenues and handle extraordinary income and expenses
Many companies freely admit to managing or smoothing earnings,
believing that it adds to the stability of the stock price over time
Analysts need to watch for such shenanigans, as it may signal problems
Here are a couple of recent examples of questionable quality of earnings:
Qwest Raised revenue recognition questions when analysts discovered that
they had counted all of the future revenues from a 20-year contract as current
earnings.
Waste Management Had trouble recently when it tried to claim as
extraordinary its expense for painting its huge fleet of trucks. This added 3
cents per share (about 10%) and let them beat expectations by 2 cents (see
Waste Management Excludes Some Expenses in Accounting, WSJ Online,
23 Aug 2001)
Priceline.com Was claiming as revenue the entire price of an airline ticket
when, in fact, they only received a commission on its sale and never actually
took ownership of the ticket
Quality of Earnings (cont.)
Another thing to watch for are pro-forma or as if earnings. Some
analysts have described these as all the good stuff and none of the bad.
Many companies, especially those in the new economy, began reporting
pro-forma numbers a few years ago. The funny part is that the Wall Street
analysts went along with the game, even long after it became clear that there
would never be any real earnings. (See notes on Reg G below.)
Also, look for where earnings are coming from. Increased sales, or
decreased expenses? Sales can increase forever, but costs can only be cut so
far. Generally, when costs are cut to increase profits, this must be looked at
as a temporary boost.
These types of issues lead to serious questions about managements
truthfulness and bring into question the quality of the firms earnings.
Typically, when these things are revealed, stock prices drop as investor
uncertainty rises

Earnings Manipulation
The Balance Sheet
The balance sheet describes the assets, liabilities,
and equity of the firm at a point in time
Key variables to watch on the balance sheet are
cash, accounts receivable, inventories, and long-
term debt
Always remember what Benjamin Graham said
in Security Analysis, liabilities are real but the
assets are of questionable value.
The Statement of Cash Flows
Ultimately, cash is king and the statement of cash flows tells us exactly why
a firms cash balance changed
The statement of cash flows is far more difficult to manipulate than the
income statement, and can help to gauge the quality of earnings
The Cash Flows from Operations section is the most important as it
measures the cash provided by the day to day operation of the business
A company could, for example, show steadily rising revenues and net
income, but negative cash flows from operations. How? If accounts
receivable is rising. This can only go on for so long before the company has
grown its revenues right into bankruptcy because it isnt collecting on those
sales. Positive earnings must always be confirmed by positive cash flows.
This statement is as important, if not more so, than the income statement.
Always examine it to find out what management is doing with the
shareholders money
Analyzing Financial Ratios
Financial ratios are the microscope that allows us to see
behind the raw numbers and find out whats really going
on
Financial ratios fall into five categories:
Liquidity
Efficiency
Leverage
Coverage
Profitability
When analyzing ratios always remember that no one
ratio provides the whole story, and that the standards for
each ratio are different for every industry
Liquidity Ratios
The current ratio, quick ratio and cash ratio all
fall into this category
They help us to see if the company is able to
meet its short-term obligations
Efficiency Ratios
The efficiency ratios tell us how effectively
management is using the firms assets to
generate sales
Inventory turnover, accounts receivable turnover,
days sales outstanding, fixed asset turnover, and
total asset turnover all fall into this category
Leverage Ratios
How much debt does the firm have? Thats the question
answered by the leverage ratios
Examples are the debt ratio and debt to equity ratio
Remember that lots of debt is great as long as sales are
increasing, but terrible if sales decline
Some debt is, without a doubt, good, but too much can be
disastrous
Especially be on the lookout for companies with a high
proportion of fixed costs (high operating leverage) and
with lots of debt. Airlines are a good example
Coverage Ratios
Coverage ratios are most important to creditors,
but whatever is important to creditors is
important to shareholders too
Examples of coverage ratios include the times
interest earned ratio and the fixed charge
coverage ratio
Profitability Ratios
Investors tend to focus the most on profitability
ratios, but the others are important as well
Examples include the gross profit margin,
operating profit margin, net profit margin, return
on assets and return on equity
Using Financial Ratios
There are two key uses of financial ratios:
Trend Analysis Looking for trends over time in
ratios. For example, wed like to see that the
inventory turnover ratio is rising. Normally, at least
five years of data should be used.
Comparison to Industry Averages If we assume
that, on average, the firms competitors are doing
things right, then it makes sense to make these
comparisons. This can also help to identify areas of
relative strength and weakness
Growth Rates
Growth rates of various variables are important
as well
Key variables to calculate growth rates of are
revenues, operating profits, and free cash flow
Manipulation of Financial Statements
Financial statements may be manipulated in a
number of ways to help identify key trends:
Common-size
Common base year
Inflation adjusted
Each of these techniques can provide insights
that are not easily seen on the unadjusted
financial statements