1. Do the numbers look good?
The first thing I look at it is some key numbers. These numbers tell me straight away whether it's a company that I might want to start looking at, or if it's a write-off from the jump.
Balance sheet - I take a look at its cash/debt levels. If it's swimming in debt, I usually pass on it straight away. Not because it's necessarily a bad company, but that's not a risk I need to be taking at this stage in my investing career. The probability is it's not a well managed company, or it's very high risk. I also look at its cash balance. I love companies with high cash balances. It shows restraint and patience, and a strong capital position.
Free cash flow - Next thing I look at is whether the company is producing any free cash. Free cash flow is found in the cash-flow statement, and I calculate it as: Operating cash-flow, less capital expenditure, less leasing payments. This gives us the "free cash" the business is producing each year. Lots of free cash means two things - a good business model, and low risk of bankruptcy.
Share price - Lastly I look at how much the business is selling for. If it's selling for a ridiculous price, like 100x sales, I can pass on it right there. Again, there's a possibility it's still a very good business that will perform well, but the risk is too high for me.
2. What's the business?
How does the company make money? Do I understand the products/services the company sells? More importantly, do I use the products and services myself?
If you don't understand the business, you can stop looking into the company right there. Always invest within your circle of competence.
3. Start reading!
If you like the initial numbers and the business model, start reading everything you possibly can about the company.
Start with the following:
- The company’s annual report
- The latest investor presentations
- Articles about the company by Barrons, Bloomberg etc.
- Articles on reddit
- Articles on Seeking Alpha
After you’ve read a few hours about the company, you should be able to give a general overview of what the company does, how it's been performing, and it's plans for the future.
5. Your thesis
The cool thing about a thesis is it's a structured thing you can use the same template for with every single stock. Think of it similar to those science experiments you had to write up at school (hypothesis, method, results, conclusion). It's a methodical look through what the company does and why it would make a good investment.
Here's what your thesis should include:
What is the business?
Write out in detail how the company actually makes money. Let's say we want to analyse META. You would write out it's basic business model, which is advertising on social platforms it owns, plus some hardware sales, plus some other services.
Segment analysis
You need to determine how the revenue is split between different segments. For example, META makes money from Instagram, Facebook, Messenger, Whatsapp, and Meta Labs.
Management quality
Who runs this business? Do they have skin in the game? How much? Have they been adding to their shareholding? How much do they get paid? What's their track record like?
You can do this by looking at recent buy/sells and also ownership percentages on a site like Simply Wall St. You can also look at their Linkedin pages, and my favourite - listen to a few podcasts of them speaking or interviews they've given. I always like to see the CEO speak in person, it gives me a good gauge of their temperament and personality.
Moat
You want to invest in clear market leaders with strong brands, pricing power, and barriers to entry. Those companies are often characterized by high and stable gross margins as well as high and stable Returns On Invested Capital.
META has an enormous moat. The capital and expertise required to create another Whatsapp, another Facebook or another Instagram is substantial. Billions are required, and the fact that people have built up big followings, big group memberships, and huge walls of photos and comments over decades makes switching very difficult.
SWOT
This stands for Strengths, Weaknesses, Opportunities, Threats
You want to sit down and think about all four, and how they apply to this company. Strengths and weaknesses are things like moat, management, cash and debt levels, branding, costs, i.e. internal things. Opportunities and threats are things like interest rates, competitors, tariffs, regulation, i.e. external things.
8. Capital requirements. High capital requirements are usually a burden for a business. Great businesses usually generate lots of free cash due to low capital expenditure needs. For examples, if you need to spend billions on new research and factories every year, it's hard to make a big profit. If you can just churn out products year over year without much capex, that's company will gush cash. Meta is a great example of a company with low capex - it costs them nothing to add a new Facebook or Instagram user. Whether they have a million users or 100 million users, the fixed costs are quite similar.
I usually like a company with CAPEX/Operating Cash Flow lower than 10% to 15%.
Capital allocation
This is of utmost importance. Your CEO's #1 job is to allocate capital wisely. When free cash comes into the business the CEO has five choices:
- Pay a dividend.
- Buy back stock.
- Reinvest in the current business
- Acquire a new business.
- Put it in the bank and wait.
All five are acceptable options, depending on the company. META does not pay a dividend, and instead does a combination of numbers 2 to 5. It has not had a good track record and buying back stock, as it has bought back at inflated prices. It does have a great track record at acquiring new businesses, such as Whatsapp and Instagram - the latter sometimes considered the best acquisition in history. Weigh these results out and decide if you think the CEO is allocating capital wisely or not.
Profitability
You want to make sure this company has the ability to be profitable long term and grow profits long term.
Gross margins are a great example of this - they indicate a strong moat, the ability with withstand harsher economies, and a product that commands a strong price.
You can calculate the gross margin as:
Gross margin = (Revenue - Costs of Goods Sold) / Revenue
The higher the gross margin, the better. A gross margin of 37.2% means that a company needs $0.628 to produce its products while it can sell them for $1. Meta has extremely high gross margins of 80% or more, which is not common in many businesses. For a retailer, those margins would be ridiculously good. When you have low gross margins of 25% of more, that's when the business model doesn't look so hot and is susceptible to a lot of risks.
The free cash flow margin is another great indicator. It can be calculated as:
Free cash flow margin = free cash flow / revenue
The free cash flow margin shows the percentage of sales which are translated into pure cash for the company.
A 30% FCF margin means every sale of $100 will generate 70% in cash for the company.
6. Valuation
Finally, you want to come up with a valuation for the company.
There are many ways to do this, such as discount to book value, discounted cashflows, or any other model you feel comfortable with.
Valuation is a more complex task of stock research, but it's always helpful to have "a number" which gives you a guideline of how much you should pay for a company.
For example, you might have a fantastic company but if the share price is $500, and the valuation is $75, it's likely not going to be a good investments.
This is the common mistake investors make by thinking good companies are good investments. This is not always true.
The most important thing about your investment is the price you pay for it!
A Ferrari might be a nice car, but would you pay $10 million for one?
You can read more about valuation in my blog post, How To Value A Stock.
7. Make a decision
Finally, it's time for you to make an investment decision.
If you have a profitable company, with a business you understand, run by a good CEO, with good profitability margins, low capital requirements, good cash/debt levels, a robust way to navigate their SWOT environment, a strong moat, and is trading at a discount to its current valuation, you might have a good investment on your hands!
Rememeber - there is no rush. There's nothing wrong with sitting on your thesis for a few months or even years before you act on it. In fact, that's smart in many situations.
If you do invest, make sure you revisit your thesis regularly. Things change all the time - the CEO might retire, they might phase out a product and introduce a new one that's not as good (or better!), and so on. It's always important to stay up to date with your investments - remember you're a business owner now, and what kind of business owner doesn't know what's happening with his business?
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