The process of trying to determine what stocks to buy and sell can be a very monotonous and iterative experience. For any company being evaluated, an investor must ask the same fundamental questions over and over again in order to truly assess the investment opportunity. The level of detail required to answer these questions are a function of time you have. If you have lots of time, you can dive more deeply into the nuances and intricacies of the company’s business model. For most investors, all that is needed is an understanding of the core elements of the business. Make no mistake; these questions have to be answered at minimum a basic level in order for you to have complete understanding of the company before you commit your hard earned money to buying into it. Most people I’ve had the pleasure to work with often buy stocks without even knowing what they company does or sells yet they can tell you all the specs of a vacuum cleaner they have researched for 4 months. Below I’ve listed 8 questions to ask when evaluating a stock. As we go through the questions let’s try to answer them by taking one company as an example to illustrate. I decided to choose Apple Inc..
1. What do they sell?
Stocks are pieces of paper representing ownership of businesses. Companies are not created because nature dictated they should be. Profit generating businesses are created to sell something be it a product and/or service that the owners perceive society will want in large quantities. When you look at companies, it is the first fundamental question to ask. What are the core products and services that the company sells? Often in larger companies this can be answered by looking at how the company is structured with products and services often having their own separate divisions. In other cases if a company is structured by geography, the product lines will be found under each regional umbrella.
Let’s use the example of Apple Inc. What does Apple sell? Well they sell computers, phones, tablets, software, and media content. You may want to drill another level into the specific models of computers, tablets, software they sell as well as their catalog of media content they sell via iTunes. If we wanted to, we could dive deeper into understanding the products in terms of specifications and price points.
2. Who do they compete with?
Chances are the company is not the only one’s selling the same product or service. There are likely to be other companies offering a similar or slightly similar product at higher or lower price points. Understanding or being aware of the level of competition the company faces can give us insight into how large the demand is for their product and potentially how much revenue, profit and market share they can be expected to take in the future.
3. Who buys their products and services?
You know what the company sells. Now you want to know who would actually buy their goods and services. Who are the main customers for the company? What are their characteristics and background? Why do they buy the product? In the case of Apple, their main customers are mostly general consumers who skew younger in age and higher than average income. Small companies that do a lot of graphical work also are a big customers of Apple. Apple products also tend to be priced higher than other consumer technology companies. I’m being very simplistic here. Again you do a whole market research analysis or market segmentation of their client base if you have the time.
4. Will they buy it over and over again?
How often will a company’s client base buy their products? Can they be counted on to be repeat customers? Repeat customers mean repeat revenues and the greater the repetition, the greater for long term sustainable cash flow which will ultimately bode well for the stock price. Looking at Apple, their customers are also extremely loyal to the brand and will defend it to the bitter end. It almost borders on a cult like behaviour in that no matter what Apple sells, they are willing to camp out all night just to get their hands on the latest iPhone or iPad.
5. Do they make money?
We’ve gone through 4 questions and we have yet to look at any numbers and metrics. It is only now that we can start looking at some financials. At the end of the day, the company can create amazing profits but if they can’t produce and sell them at a profit, it means very little. It’s at this point, we can do a deep dive into a company’s Income Statement to get a sense of their profitability. We want to know specifically what their operating profit looks like because this number tells us how effectively they are selling their core products and services. We can drill down into looking at sales and profits of the various product segments and look at trends. If the company is not profitable and just as important, cannot demonstrate a consistent ability to be profitable, then your analysis should pretty much stop here. When we look at Apple’s sales and profitability numbers, we can see that it has been one of the greatest creators of wealth in the world. The company has been growing its revenues and profits at an insane rate.
6. What do they own and who do they own money to?
While profitability is very important, we need to ask about the quality of those profits. The best way to answer this question is to look at the company’s profits in relation to the quality of the company’s assets. The Balance Sheet, which is a statement of how the company has raised money and what investments they have made in assets to generate those profits can help us answer this question. We want to know the composition of the companyâ€™s assets. Are they heavy into intangible assets like Goodwill? Do they have enough cash in the bank to meet short-term operational financial obligations? What is the quality of the company’s buildings, equipment, and factories? Are they brand spanking new or are they due for a rebuild? When you look at Apple’s balance sheet the first thing that strikes you is how much cash they have in the bank. At $156 BILLION, they have more cash to invest than countries. The Canadian Government has an annual budget of almost $200 billion to put it into perspective. With that much cash on hand, you can feel somewhat certain the company is not going out of business anytime soon and more importantly, it has the internal financial resources to make appropriate investments that can create future wealth.
On the other side of the balance sheet, we find the liabilities and shareholders equity accounts which tell us how the company has raised capital to finance the business. Did they borrow from a bank or issue bonds (Liabilities) or did they sell ownership in the business in the form of stocks (Shareholders Equity). From Apple’s perspective they have carried very little debt like most technology companies do but recently they did issue a large amount of debt, mainly because interest rates are low and most of the cash they have is in foreign deposits meaning if they withdrew it and brought it back to the US they would have to pay tax. Issuing debt is a cheaper alternative as they have a huge bank account that can be used as collateral. Looking at Apple it appears they own a lot of assets and owe very little to other parties, which implies that Apple’s Net Worth (Assets –Liabilities) is very high.
7. How risky is their business?
At this point of our questioning we should have decent idea of how risky the business is. In other words how sustainable it will be in the long term. Is the company run effectively and in a line of business that will allow it to compete and be successful or will it go out of business? From looking at the balance sheet we can assess by looking at the debt level and its ability to generate cash how sustainable the company is from a financial perspective. From a business operation perspective we can now determine how effective the company’s products and services are in generating sustainable sales in the future. When we look at Apple, it operates in a very competitive industry, but it has demonstrated that it has the capability to innovate and sell products that people want. It can also generate extremely high levels of cash to make the business highly sustainable.
8. Is the stock cheap?
It is great that a company can create products and services that society wants and can do so profitably. It can have wonderful management that makes effective decisions on how invest its capital. However, this does not mean the stock is a good investment. Great companies and stock prices unfortunately do not go hand-in-hand. The stock market may have already built these elements into the stock price and as a result, the stock may be already priced at a level that the company is worth and may not go up more. The timeless motto of stocks is you buy them low and sell them high. As an investor you want to buy stocks that are selling at a discount to what the value of the company is worth and sell them when they have reached its intrinsic value. There are various methods to determining if value of a company’s stock. You can value them on a relative basis (compare them to other similar companies in terms of Price/Earnings multiples) or you can value them on a future discounted cash flow basis, where you project a company’s earnings and discount them back to a present value. Each has its pros and cons, however what is key is that you need to establish whether the stock is trading at a discount because you ideally don’t want to buy stocks when they are full price or marked up. In investing you never want to play full price. Frugality is more often than not rewarded. You want to buy stocks of great, well run, well managed companies that have a manageable level of risk when they are on sale. In the case of Apple, at one point in 2012 the stock was trading at over $700/share making it the largest company in the world. It was probably trading at full or higher value. Then the stock got killed (even though it was still profitable and selling lots of iPhones but not as much as the market thought they should) and fell as low as $390/share. At that point, Apple was probably trading at a discount to its value and would have been an ideal opportunity to buy the stock when it was on sale. The company was still generating meaningful profits and sales. The stock proceeded to go back up to $550/share. The question would then be is it still on sale or it is it fully priced?
Making a decision to buy a stock requires that you ask and answer these 8 questions. By answering them you can rationally formulate a better understanding of what is driving the stock price of a company and use that understanding to make an educated investment decision. There are no guarantees that every decision you take by answering these questions will be successful but the chances are good you will make more successful decisions than you will unsuccessful ones.