One of the most difficult things about investing is that it can be difficult to make sense of all of the information available to you. Most companies have an abundance of SEC filings, press releases, and other important documents. Chances are you have read plenty of quarterly reports, financial statements, and company press releases, but do you really know how to interpret these documents?
The documents mean nothing unless you can interpret them properly. That being said, filtering out the proper information is not always easy. I believe that this may be due to the fact that this information is not very relatable. After all, in your daily life, how often do you have to deal with cash flow, assets/liabilities, operating costs, etc.? You may be surprised to find that this information can be very relatable, and therefore understandable, if you know how to think about it properly.
If you are a business owner, you have an advantage. If you are not, you can still make sense of all of this. Every single day, you probably invest in something without even noticing. Just think about the last time you bought an electronic device, such as a smartphone. There are plenty of phones you could have purchased, but you settled on a particular one. You may have been influenced by the price, the value of the phone, the features, the warranty, the customer service, the resale value, etc. The point is that you either consciously or subconsciously thought about what your opinion of the ideal phone was and you analyzed the selection to choose a phone that best suits your needs. Maybe you didn’t buy an iPhone because you perceived it to be a bad value when you compared the cost to the features. Maybe you didn’t buy a Samsung because it didn’t sync well with your other devices. Regardless of the phone you chose, you had a list of criteria you were using to evaluate the product and you found the phone that best matched that criteria.
Investing uses the same framework. You have a list of criteria that you believe make up a good company and you try to find companies that best match those criteria. The thing most people get caught up on is creating the proper list of criteria. Creating this list can be simplified if you can find a better way to organize the information in your head. You should stop thinking of the companies you invest in as mystical entities that are hard to understand. Keep things simple by modifying your thought process. The strategy that works best for me is thinking of public investments in stocks as private investments in companies. This works well for me because I have bought and sold private companies in the past, however, a lot of the strategy is based purely on common sense so anyone can apply this.
Let’s break things down to how you would approach almost any purchase:
1. Is it a good value?
2. Does it fulfill a need of mine?
3. Is it a quality product?
4. Are there better alternatives?
5. Are there any clear red flags?
Let’s run through this thought process on something as simple as going out to eat.
(Yes, I am comparing investing to going out to eat)
Let’s say there is a new steakhouse in town and you are thinking of going.
1. Is it a good value? Are you paying $20/steak or $200/steak? Are the steaks worth what you pay for them? Lower cost doesn’t mean higher value. You get what you pay for.
2. Does it fulfill a need of mine? Am I hungry? Am I in the mood for steak?
3. Is it a quality product? How are the reviews of this restaurant? Do they serve good steaks? Is the restaurant nice? How is the service?
4. Are there better alternatives? Will this new steakhouse be better than the one I usually go to? Can I get a better meal elsewhere?
5. Are there any clear red flags? How is the chef’s reputation? Any cases of food poisioning at this restaurant? Does the restaurant have a good cleanliness rating?
I am well aware of the fact that using the example may seem somewhat ridiculous. Chances are, you don’t read many articles that talk about both stocks and steak. I am trying to make a point here. You make investment decisions subconsciously on a regular basis. These decisions are not difficult because you know exactly what you are looking for. You have a list of criteria branded into your thought process and you utilize that list for easy decision making.
Now, let’s look at this list of questions from the investment standpoint:
1. Is it a good value? How much is a share in the company really worth? If I buy 100,000 shares, how much of the company do I own? What is my money really paying for when I invest in the company?
2. Does it fulfill a need of mine? Does this stock fit my investment strategy? If I want to sell the stock in a year, will it be at the price I want it to? AAPL may be a good value and provide quality product, but they do not match my investment style so I wouldn’t buy and hold shares.
3. Is it a quality product? Is this a good company? How efficiently is it run? Do they sell something that people actually want? What are the chances of this company growing in their competitive industry?
4. Are there better alternatives? Are there any companies in this industry that are doing better/better values? Are there other stocks that are better values? where is my money best spent?
5. Are there any clear red flags? Does the management have a sketchy past? Does the company have a going concern? Are there any lawsuits?
Asking these questions is just the beginning of your research, however, they allow you to approach investing with a similar thought process that you use for making everyday decisions.
Now, let’s get to the good stuff. Let’s look at how you would apply this to a real company.
The goal is to think about companies like a private investment in order to demystify the world of investing.
Here’s a fictional example using an investment into a private company as the basis for comparison. The example is long, so you can skip straight to the lessons if you would like.
Sample Due Diligence Process:
Your friend has been running a restaurant for the past year and has learned that you invest in private companies. He approaches you because he wants you to invest in his company.
Your friend owns 10% of the company and offers you a 10% stake in the company for a $100,000. He believes the company is valued at $1 million so this is a fair deal.
From this one sentence alone, we already have so much information that relates to investing in stocks.
First off $100,000 buys you a 10% stake in the company. This relates to how many outstanding shares a company has. If you buy 100,000 shares in a company, how much of the company do you really own? Well, if the company has 1,000,000 outstanding shares, you own 10% of the company. If the company has 100,000,000 shares outstanding, you only own 0.1% of the company.
First lesson: Look at how many outstanding shares a company has. This determines how valuable each share is.
Another important thing to look at is the fact that your friend owns 10% of the company. This relates to insider ownership of a company. Look at how many shares insiders hold. For this particular example, your friend runs the company and owns 10% of it. He is asking you to buy 10% of the company as well. If the company is so great, why doesn’t your friend have more than a 10% stake in it? Why is he offering you 10% of the company instead of just buying it himself? If the company fails, your friend doesn’t have too much at stake, therefore, he may not be as motivated to make the company succeed. Additionally, this means that 90% of company is available to outsiders. From an economic perspective, supply is high, so price may be lower.
Second Lesson: Look at how many shares insiders own. This can help you see if management truly believes in the company.
Third Lesson: Look at a stock’s float. The float is the amount of shares available on the public market to be traded freely by traders and investors. The lower the float (supply), the higher the demand can be. Higher demand for a stock can allow the stock price to rise faster. This is why a lot of traders go out of their way to find low float stocks. Imagine a stock trades at $0.03/share and you want 100,000 shares. If the float is 500,000,000 shares, it may be pretty easy to get your shares at the desired price. If the float is only 1,000,000 shares, it would be harder to get 100,000 shares at $0.03/share without driving the price up. The lower supply of low float stocks means that demand for the stock can push the price up much faster as investors are “fighting” to get the shares they want.
The last piece of data available in the sentence above is that the company is valued at $1 million. Well, who decided this? Is this valuation fair? This relates to a stock’s market cap. The market cap is the number of outstanding shares multiplied by the share price of a stock. If a company has 1,000,000 outstanding shares valued at $1 each, the market cap is $1 million. The market cap is the company’s valuation as determined by the trading activity. A lot of investors will ignore this metric when placing trades, however, it is important to look at if you are actually investing in a company because this allows you to determine if a company is over valued or undervalued. You want to find undervalued companies.
Fourth Lesson: Look at the market cap to see a company’s valuation. Decide whether you believe it to be overvalued or undervalued.
Let’s move on with the example to help you understand how to value a company.
Being a diligent investor, you want to know more about your friend’s business. How much money do they make? Do they have a lot of liquid assets? What kind of liabilities do they have? Your friend tells you that their restuarant brings in revenues of $500,000 every year, $100,000 of which is profit. They have assets such as their restaurant’s equipment, their building, and some cash in the bank. The equipment is valued at $100,000, the property is valued at $100,000 and the company also has $100,000 in cash for a total of $300,000 in assets. The company is also paying off a $500,000 loan and they still owe their employees $50,000 in wages for a total of $550,000 in liabilities.
This brings up a few things you need to look at. First off, the company makes $500,000 in revenues but they only keep $100,000 of those. As a diligent investor, you wonder where the other $400,000 is going. Is that the cost of food? Is that the cost of paying management and staff? Knowing these things would help you determine how efficiently the company is being run. If the restaurant is spending $100,000/year on their floor manager’s salary, you may decide that the company is being run inefficiently. You can look at a company’s Cash Flow Statement or Income Statement to track expenses and revenues.
Fifth Lesson: Look at a company’s financial statements to see what is “under the hood.” Think about how money is being spent. Is the company getting the best prices on their inventory (Cost of Good Sold). Is the company paying their management team too much (Selling, General, Administrative costs)? Don’t let this part of a company’s financial statement confuse you, as it is very basic. Think about this: If you were trading stocks and made $500,000 on the year but had to spend $450,000 to do so, would you be trading efficiently? Sure, you made $50,000 on the year, but why the hell did you have to spend $450,000 to do so? Apply the same logic to how a company manages their money.
The next important thing to look at is how much your friend’s company owns and how much they owe. This relates to assets and liabilities. Your friends restaurant owns $300,000 worth of assets and owes $550,000 to other people. This means they have net tangible assets of ($250,000), meaning they owe much more than they own. Clearly this is not a good thing. Someone may own a Lamborghini valued at $200,000, but if they have $300,000 in outstanding credit card bills related to the purchase, they really aren’t too well off. You wouldn’t consider that person to be good at handling money, would you? Apply this same logic to a company you invest in. This shows how responsible a company is when it comes to managing money.
Sixth Lesson: Always look at a company’s assets and liabilities. This will help you gauge how much the company owns compared to how much they owe. Essentially, it is the company’s net worth. Look at a company’s net tangible assets to see if they own more than they owe, or vice versa. Don’t treat all assets and liabilities the same. Make sure you understand what they are. For example, a company may have $1.3 million in assets, however, if you look closer you may see that $1 million of those assets is intellectual property. $1 million in intellectual property is worth far less than $1 million in cash. A lot of penny stock companies get tricky/sneaky in this part of their financials so be careful.
Let’s move on with the due diligence.
Your friend’s restaurant has only been open for a year. You understand that it may not be the best idea to base your decision off of only one year of data so you dig deeper. You ask your friend to see monthly financial reports so you can see if the company is growing. Your friend shows you the reports and you see that revenues are growing by 5% each quarter, liabilities are growing at a rate of 10% each, and assets are decreasing at a rate of 5% each quarter.
First things first, you see that the company is bringing in more money each quarter (revenues). This is good. It means the business is growing and more customers are taking an interest in the restaurant. That being said, the company is growing their liabilities (things they owe) much faster than revenues are increasing (10% vs. 5%). Additionally, the restaurant’s assets (things they own) are dwindling at the same rate the revenues are increasing (5%). This means the revenue growth really is not too impressive.
Seventh Lesson: Look at a company’s growth rate from multiple perspectives. Look at revenues, profit margins, assets, liabilities, etc. A company may be able to increase revenues by 100%, but if they have to take out a loan to fund a massive marketing campaign, that may not be too impressive. Let the numbers talk. A company’s growth rate should be looked at holistically. Ask yourself this: is the company getting more or less valuable each quarter? This requires that you look at the company as a whole and interpret the financial statements at a core business level. Revenues may be decreasing or flatlining, but profit margin and assets may be increasing. This would tell you that the demand for the company’s products may be decreasing or flatlining, but the company is running more efficiently internally. Contrarily, the revenues may be increasing while the profit margin decreases and liabilities increase. This would show you that the company is stimulating demand for a product, but they are not scaling up their business model efficiently. In short, think about growth holistically in order to understand what direction the company is moving in.
By now, you have seen a lot of the numbers, but you want to better understand some other elements of the business. You ask your friend if there have been any problems at the restaurant? He mentions that their Yelp page has an average rating of 2-stars, their employee turnover is very high, and some new competing restaurants just popped up in the neighborhood. You proceed to ask him who is running the restaurant and what their plans are for the future. Your friend gives you a list of the key players in the restaurant and let’s you know that the restaurant plans to start franchising in the upcoming year in order to increase profits.
By asking your friend about some of the problems in the restaurant, you learn about the risk associated with your investment. The restaurant has a bad reputation based on online reviews, employee retention is high so their may be an internal management problem, and competition is increasing which may create a going concern. You know know about the business’s weaknesses and the factors that may threaten their existence. This leads to 2 important points.
Eighth Lesson: Look for red flags. Dissect a company’s business and see what you need to be worried about in the future. Any negative catalysts that may be approaching can put your investment at risk. You need to know about these.
Ninth Lesson: Look at competition. A company may be doing well, but there may be another company doing much better. Which would you prefer to invest in? Strong competition threatens a company’s existence. Analyze their competition to understand 2 things. 1) Is there a going concern for this company? 2) Is there a better company I can invest in?
The next question you asked your friend was about who was running the company. A business is only as good as the people running it. If you looked into your friend’s restaurant and found out that their management has a sketchy past and a history of running failed companies, you would probably avoid the investment.
Tenth Lesson: Look at a company’s management. Understand who is running the company and decide whether or not you think they are capable of making it succeed. Every decision a company makes is made my a person. If you know who these people are, you can gain some foresight into the company’s future direction.
Lastly, you asked your friend about plans for the future. Your friend mentioned that they want to franchise the company to increase profits. This could be huge if done effectively. You now know that a positive catalyst is coming and this may make the company more valuable.
Eleventh Lesson: Look at a company’s future plans and see if any positive catalysts are expected. A company may be decent based on their current performance, but a huge deal may be in the works that will take the company to a new level. Know what is expected so you can make a good long term investment.
Summarizing this example:
Here are the facts you collected from the analysis:
Your friend offers you a 10% stake in his restaurant for $100,000.
Your friend also owns 10% of the company
The company is valued at $1 million.
The company brings in $500,000/year (revenues) and keeps $100,000 (net income).
The company has $300,000 in assets and $550,000 in liabilities for a total of ($250,000) net tangible assets.
The company is exposed to risks such as poor customer reviews, high employee turnover, and increased competition.
The company has positive catalysts such as plans to franchise to increase future profits.
Revenue is growing at 5% while assets dwindle at the same rate (5%) and liabilities increase 10% each quarter.
So, Would you invest in this company?
Helpful Tip: Remove the extra zero’s from a company’s financials so they can be easier to understand. You may not be able to internalize the concept of paying $100,000 for a company that brings in $500,000 in revenues, but you may be able to fathom the idea of paying $100 for a company that brings in $500/year.
Personally, I would not invest in this fictional company for the following reasons:
- Your friend, the owner, only has a 10% stake in the company. This doesn’t show much faith in the company’s future.
- The company owes more than they own (net tangible assets). This means the company has a negative net worth. Why pay money for something that has a negative value?
- Revenue is growing at a minimal rate, but liabilities are increasing twice as fast. The company is spending much more than they bring in. How are they going to be profitable like this?
- The company is valued at $1 million. This seems like an overvaluation. They only bring in $100,000 year and they owe a lot of money. Let’s say I were to get 10% of the profits for my 10% investment in the company. That would mean I would make $10,000/year so it would take 10 years to break even on my investment, let alone make a profit. Additionally, this assumes that revenues do not decrease over the years. It also fails to account for the fact that liabilities need to be paid. The chances of me making a profit in the next 10 years are very slim.
- Their are a lot of threats to the company’s existence. The negative Yelp reviews show that the product is not that great. The increased competition shows that their is a lower barrier-to-entry for this industry and making a profit is only going to become more difficult. Employee turnover is high meaning that management does not know how to keep their employees happy.
- Sure, a franchising plan is in the works, but the company hasn’t even made their current business model successful yet. How are they going to make a new one successful?
All of these numbers are made up and the analysis was not very in-depth, however, it is meant to serve a point. The main point of this entire article is to think about what every number means and how you can relate that to thought processes you already use. This helps you understand what exactly you are investing in. When you hear statements such as “The company brought in $1.8 million in revenues during the first quarter?” does it mean anything to you? No, that can mean anything. You need to put it in context in order to understand whether this is truly a good investment.
Make investments in public companies relatable to your daily life. Everyone can take different approaches to this based on how their brains work, however, the end goal is the same: demystifying investing.
Someone else may read the example above and decide that it looks like a good investment even though I didn’t. That is 100% okay. Everyone has a different investing style so everyone will want to invest in different companies. The goal is not to make the same decision as the majority of people; it’s to understand what you are analyzing. You need to be able to make sense of the abundance of data you have access to. If you can do that, you are ready to start investing.