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What I Analyze

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January 22, 2007 – Comments (13)

The first thing I look at when researching a company is the cash flow statement. Cash flow from operating activities is the cash the business produces, so I always want this number to be steady, positive, and hopefully improving, but as long as its positive and steady it gives me confidence to do more research. Cash flow from operating activities should be low or negative. This is the cash a company gets from issuing debt, selling stock, borrowing from the bank, etc., so it's best if it's negative. Cash produced from the business should be fueling growth, and checking the correlation with financing activities is the best way to do that. This is what I look at with small-caps especially, if a small company can fuel its own growth, I'm interested immensely. The cash flow statement is the most important statement but gets the least amount of attention -- always make sure to check it. If the company is reporting great earnings growth but is borrowing from the bank to fuel that growth, it's not that great of a company.

The next thing I look at is the balance sheet. The ideal balance sheet is one with a high amount of cash and cash equivalents with no debt. But, different companies operate in different ways, so some will always have debt. Utilities almost always have high amounts of debt, because that's the way they operate. Basically, I like to see a company that has enough cash so that it could handle at least 2-4 quarters of a business slow-down. If a company needs $30 million per year to operate, I'd want the company to have $30 million in cash, and hopefully not too much or any long-term debt. You can get the rough amount a company needs to operate by adding cash from operating activities to cash from financing activities. Just get a rough idea of how much trouble the balance sheet could keep the company above water, because business problems are bound to come up sometime. If the company has so little cash that they'll need to borrow from the bank for cash during a rough spot, I'd stay away from that company.

I actually don't pay too much attention to the income statement. If the cash flow statement and balance sheet both look good, the company should be able to produce earnings, but that depends on management. With the income statement, just see if margins are holding steady, if earnings are growing, maybe seeing which quarters are weakest for the company (for example, most retailers have poor quarters in the summer months). I analyze the statement, but I don't feel it's quite as important as the balance sheet and cash flow statement. It has its value, just not quite as much as the other statements.

The P/E is a touchy subject. It's great if it's low most times, but if it's high I see why it's high. You will almost always have to pay a premium for a company's growth. Starbucks has always been trading at a premium since going public in 1992, and many people have shied away from them as a result (which is fine, don't go past your comfort level). With the P/E, if it's a great company that's producing nicely and has a strong balance sheet, I'll be willing to pay a premium in most cases. See if you think the stock deserves the P/E it's getting based on what you found in the statements. Should it be higher? Is it low compared to the company's competitors? Is it high for a reason? The P/E is a pretty good indicator of how the market is pricing the stock compared to the industry or its competitors, but other research needs to be done.

Everything else that I check is mostly available on Google and Yahoo! I take a look at management, just to see how much experience they have with the company or industry and how long they've been with the company. See how things have gone since they've come aboard. I do a quick check to see how much insiders own of the company and see what their recent activity has been with the stock. I don't let this affect my decision, but I like to know what insiders are doing. I think high inside ownership with a smaller company is a good sign, because smaller businesses are risky choices, but I feel more comfortable if management has a good stake. I also like this because managers of smaller companies often aren't as wealthy as exec's at ExxonMobil, Coca-Cola, etc.

Look at a company's press releases, and if management gives guidance, see if they've met it. Many managers are too optimistic, and I don't particularly like that. If management's met it's word, I take it as a good sign and give them trust that they'll be able to meet estimates in the future. Press releases often show what growth the company is aiming for, and while it might be different from my estimates, I make a note of it.

Finally, I look at the company's web site to get a deeper understanding of the company's products, and take a look around through the online investors area (often called 'Investor Relations' on a company's web site). Some companies have webcast replays available online, and if they do, I try to listen to the most recent one (webcasts are where management discusses the latest quarter and gives the opportunity for people to call in and ask questions).

After looking through all of this, you'll get a great idea of where the company is and where management wants to take it. Some are easy to analyze, some are more difficult. Overall, it takes me probably 3-5 hours to analyze a company this in depth. It's actually not too hard, just research what you can when you can. It gets easier after you try it out a couple times, you may even develop your own things to really look out for. Be patient, maybe start with companies you already roughly know about, and see how it goes. I think the reason many people find it so difficult to analyze financials is because they don't know what to look for, but I think everything above is key and can be the basis of the research.

Here's a summary of what I analyze, in this order.

-- cash flow statement

-- balance sheet

-- income statement

-- P/E

-- management

-- insider ownership and activity

-- press releases - look for estimates/guidance, among other things

-- web site (product info, investor relations)

-- webcasts, if available

13 Comments – Post Your Own

#1) On January 22, 2007 at 3:04 PM, beatmonger (99.59) wrote:

Excellent post, thanks for your insight.

I'm somewhat new and have my own way of doing things (I pay closest attention to valuation and cash flow), but this method makes sense intuitively and I'm probably going to adopt it.

Thanks again!

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#2) On January 23, 2007 at 11:23 AM, devoish (99.07) wrote:

Pencils2,

Thank you for your postings, but I am confused and have questioons.

You write:

"Cash flow from operating activities is the cash the business produces, so I always want this number to be steady, positive, and hopefully improving, but as long as its positive and steady it gives me confidence to do more research".

I got that, but then you write:

"Cash flow from OPERATING activities should be low or negative. This is the cash a company gets from issuing debt, selling stock, borrowing from the bank, etc., so it's best if it's negative".

Did you mean financing activities?

And if so my final question has to do with the accounting.

If a company borrows x dollars on the cash flow statement is it recorded as a positive number as income, or (x) number as debt. I am believing it is the former but I am new at this.

Thanks for your blog,

Steven

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#3) On January 23, 2007 at 9:44 PM, TMFPencils (99.82) wrote:

Hi Steven,

Yes, you are correct, that should be financing activities. If a company borrows from the bank, it is recorded as positive data in the financing activities section. Same thing if it sells or issues stock or issues debt. Does this answer your question? If not, just let me know.

Best,

David

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#4) On January 24, 2007 at 9:38 AM, devoish (99.07) wrote:

Yes, That helps, thank you. Which gets me to another question. In the next paragraph you write:

"You can get the rough amount a company needs to operate by adding cash from operating activities to cash from financing activities".

I do not get this at all. I thought a companys expenses were from investing activities? And I am not sure why you add in cash flow from operating activities. I thought that operating activities needed to be larger than investing activities and that equals profit, and that financing activities made up the difference in a company that is losing money.

What is it that I misunderstand?

And thank you.

Steven

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#5) On January 24, 2007 at 4:21 PM, TMFPencils (99.82) wrote:

Hi Steven,

I'm not sure if I completely understand your question, but let's see if I can help.

Investing activities are usually made up of Capital Expenditures (although it depends on the company), which is the amount used by a company to upgrade physical assets such as property, industrial buildings or equipment. Investing activities is basically investments or improvements by the company into its current physical assets. It isn't really fees or expenses.

The reason you add operating activities and financing activities is because this gives you the rough amount a company needs to operate. If a company produces $20 million from operating activities but needs to borrow $5 million from the bank on top of that ($5 million in financing activities), the company needs (or needed for that specific time period) roughly $25 million to do what they need to do. On the other hand, if a company produces $20 million from operating activities but buys back $5 million worth of stock (which is -$5 million in financing activities), it only needs roughly $15 million to do what it needs to do.

Does this make sense?

Let me know if you need any more help!

Best,

David

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#6) On January 24, 2007 at 10:04 PM, devoish (99.07) wrote:

O.K.

The dull ache my head feels may be the beginning of understanding?

Cap Ex. makes sense to me. I am guessing Cap Ex. could be a positive number if property was sold?

And investments could also be either(negative) if for example money was (spent) on Certificates of Deposits, and then positive 3 months later when they came to term?

Thanks,

Steven

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#7) On January 24, 2007 at 10:47 PM, XMFCramerica (95.41) wrote:

pencils,

very informative post.

you are, without a doubt, a Master Fool.

- Mike

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#8) On January 25, 2007 at 11:28 AM, TMFPencils (99.82) wrote:

Hi Steven,

Yes, I believe you are correct. If a company has a good amount of cash, I like to see it reinvest at least a little bit in the business in this way. However, if it's a company struggling to find cash, I would question it investing a lot into property, equipment, etc. It's definitely something you'd want to find out about (i.e. why they are investing so much/so little). You should be able to find this info in a company's SEC filings.

If you have any more questions let me know!

Best,

David

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#9) On January 25, 2007 at 4:43 PM, devoish (99.07) wrote:

David,

Thank you for the help.

I am going to try to wrap my brain around this by looking at cash flow statements, hopefully with some new understanding.

It seems this should help alot with companys that should be making money, but not as much with companys that are "developing the next big thing" which I guess you still just have to believe in whatever it is they are developing.

I should warn you I may read your post about valuation.

Thank you,

Steven

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#10) On February 05, 2007 at 12:45 AM, dwot (97.50) wrote:

I look at companies differently, and I think I miss a lot of things that you say you look for. I look at the P/E and the company's assets. I will accept a high P/E for a small growing company, but not a mid or large cap. They may do well, I just figure it is much harder to grow a big company to catch up to its P/E than a small one, and a history that they trade on what I see as bubble P/E means squat to me. I'm not going there.

I'm also not interested in a company trading for more than about 3 times its assets. And again, there are lots of companies that trade for 1/5 or 1/10 their book value. I'm just not all that interested.

I guess I then I try to understand where the profits are coming from and what can affect them.

I just did a blog on Roca mines on the venture exchange. The price dipped this past week and I really loaded up on it. This company is going to make so much money this year. In my blog I mention that they are going to be mining grades at 1%, I think, and actually, this year the grades that they are mining are 2%. I think they only have enough 2% grade to mine the one year, which is why I used the 1% figure.

The money is enormous, 2% of a ton is 44 lbs per ton, and production of 150,000 tonnes is 6.6 million pounds. I've been using a 3 million pound figure to come up with $75 million for an $82 million market cap business. 6.6 million times $25/lb is $165 million.

The costs are about $70/ton. At $25/lb moly that leaves $1000/ton profit, at $20/lb moly it is $800/ton.

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#11) On February 05, 2007 at 1:09 AM, dwot (97.50) wrote:

Dang, I hate it when I make a mistake in forum I can't correct...

The 2% is MoS2, and that works out to 3.75 million pounds, so using the 3 million pounds figure is best.

But, they may also have time to mine another 60-90 tonnes before the year end for another 1.5 to 2.25 million more pounds.

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#12) On February 05, 2007 at 3:37 PM, dwot (97.50) wrote:

I was thinking that I would find it very interesting if you looked at a stock step wise through this process.

And how do you evaluate a stock without a business history like you are describing?

A stock that was mentioned to me is OXIHF on the OTC. This company is marketing one of these cash card types of things that isn't tied to a bank account. It looks like they've lined up so very good partners and are perhaps into a place that they could become highly profitable, but I'd like to see someone tear this one part with their analysis.

I have a small position in, and with the way it has taken off, well, it is up 83% since I picked up in January. Why is it the small positions that do this?...

Anyway, I guess understanding this one isn't as straight forward to me as Roca, so I looking for someone else's perspective on it. Also, if you were to look at where they started, it looks seedy to me, but like they found something potentially good.

http://www.o...essroom.html

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#13) On February 05, 2007 at 5:46 PM, TMFPencils (99.82) wrote:

Hi drom,

<< And how do you evaluate a stock without a business history like you are describing? >>

I usually stay away from companies that have only been around for a year or two (as a business, not being public), but if there's one that interests me I'd see if they have the resources and product to have a good rate of expansion over the long-term. I don't really care how long a company has been public, but new businesses are ones that I usually stay away from, at least at the start of things. I'd look for the normal things -- good balance sheet, strong cash flow, etc. -- and follow them for a few quarters to see if they can expand the business and sustain good numbers.

So, with new businesses, I'd hold off investing in them right away and see how they do.

I think your style of analysis is a good one - it's very similar to Ben Graham's conservative analysis techniques, he wanted stocks that were dirt-cheap (everyone does, but he didn't go for anything else). I like investing in growth companies, but it definitely is riskier and your money will be volatile in the short-term. You've got to have a long time frame as well.

Let me know if you have any more questions.

Best,

David K

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