When you are making a decision about buying a business there is no doubt you would want to know everything there is to know about the business to be able to make an informed decision. The same should be true of investing because, after all, investing is just buying a part of a real business.
But where do you begin? Sometimes the amount of information can be overwhelming if not collected and analysed intelligently.
At Farnam, part of our core investment decision making process is a checklist so we can ask the same questions of every company we analyse. No business will ever pass every checklist item, but after completing it, we have a very good idea of whether or not it is worthy of our investment.
This is the checklist that we use in our day to day analysis. Use it in making your own investing decisions. And if you’d like a condensed version, you can download one here.
The business is simple and is something you understand
Warren Buffett has never invested in a business that he didn’t understand. This is (one reason) why you’ll never see a high tech stock on the Berkshire Hathaway books. If you can’t understand the business, how can you know if they’ll continue making money. If you can’t explain what the business does to a 6 year old, you don’t understand it.
The company has an economic moat that keeps competitors at bay
The best businesses do something special that is not easily replicable by competitors. The moat could involve a strong and valuable brand image, patents, or even expensive capital or specialised knowledge required to start up a similar business. An economic moat will generally translate into the ability for the business to set their own prices, rather than have the market determine the prices.
It is important to note that commodity style businesses do not generally have a strong economic moat and usually compete on price. It must be an exceptional business for Buffett to invest in a commodity business.
The company is a price maker
The best companies are those that have control over the pricing of their products and can increases prices without losing fear of losing customers. This tenet pulls in factors from competitive forces, the quality of the product and the loyalty of the customers.
The company either makes a boring product or operates in a boring industry
This may seem counter-intuitive, but a boring industry is good. It doesn’t attract the attention of brokers and it generally won’t be a hotly-contested market environment. At the end of the day, you want a company that makes money more than one in a sexy industry.
The company is in the rapid expansion phase of business
There are three vague phases a business will pass through: Start-Up phase, (the riskiest), where it finds its market and works out the best way to serve it; the Rapid Expansion phase (safest), where the company duplicates its success in new markets; and the Mature phase, (most problematic), where the company prepares for the fact that there are no easy ways to expand.
The company does not rely on contracts for business
The best type of business is one that has an annuity style revenue stream. A company that relies on a small number of large contracts could see earnings take a sharp downward turn if one contract is cancelled, or even worse, if future contracts become scarce.
The company has shown it is able to duplicate its success in multiple locations
Expansion stories are great. It shows that the company has a business model that works and can be adapted to different geographies. If a retail company has one store and it is IPO’ing so it can expand into many stores be very careful, as management has not yet proven it is capable of successfully replicating their success.
The company is recession proof
Many companies follow the cycle of the economy, meaning that their performance will be relatively predictable, if unstable over the long term. The best companies are ones that do well when the economy is doing well and don’t miss a beat when the economy falls into recession. Therefore, companies that sell necessities, rather than that which is merely desired are likely to do better in a recession.
Bear in mind that in an economic downturn, the share price may still take a beating, but if the underlying business remains on track then it is just a waiting game for the market to re-rate the stock appropriately.
The company has a low reliance on a single product
Or conversely, the company sells a variety of products, each contributing significantly to profits. You need to ask yourself, if a particular product goes away or is made obsolete, will they still continue to grow?
The company has an even spread of customers
A high dependence on a small number of customers could lead to two potential disasters:
- The customer finds a new supplier and leaves a significant dent in your revenue;
- The customer doesn’t leave but has significant bargaining power which can reduce the company’s revenue.
Neither of these things are beneficial for a company.
The company’s earnings are not heavily regulated by the government.
Some great companies receive their revenue from government sources, either directly or indirectly. But if the government is able to change the amount of revenue received in relation to a changing budget the earnings will always be at risk. An example would be medical companies whose services are subsidised by the government. A reduction in this subsidy would increase the cost for consumers and subsequently reduce the demand.
The company is ignored by the brokers
In value investing, the best companies are those that are growing and are undervalued. If many brokers are pushing the stock out to their clients to buy, the price is likely to pushed up higher due to basic economics.
Does the company have any upcoming catalysts that are likely to rerate the stock price?
A catalyst could include a positive reporting result, regulatory changes, an accretive acquisition, etc. They might be widely known facts, but are not reflected in the stock price yet.
The company consistently grows its earnings
There are a number of different ways to measure this. Look at EBITDA, net profit after tax, revenue. However, you also need to look at how these earnings are being made. If they are continually issuing shares the profits are highly likely to go up, but investor value has been slashed because there are more people wanting a slice of the pie.
The most telling ratio is earnings per share (EPS), i.e. how much of this year’s profit will each shareholder receive. If this continues to increase, happy days.
The company consistently grows it owner earnings
‘Owner earnings’ is a term coined by Buffett that adjusts for capital expenditure. Because capital expenditure is depreciated over time the net profit figure can often be a bit misleading, such is the nature of accounting standards.
Owner earnings = net profit – capital expenditure + Depreciation and amortisation.
This adds back the amount of capital expenditure expensed from previous reporting periods and removes the amount spent and capitalised in the current period.
The company creates more than $1 of market value for each $1 of earnings it retains
Over a 10 year period, calculate the total retained earnings per share and divide by the change in share price (10 year total EPS/10 year change in share price). Ideally, this should greater than 1.
If the company creates less than a dollar of market value over this time span, you can assume that more value could have been created by the shareholder elsewhere than invested in the company. Therefore, rather than retaining the earnings on the balance sheet, it should have been paid out as a dividend or through a share buy-back.
The earnings yield is greater than the interest rate
Earnings yield is calculated as EPS/market price.
It determines the return of your investment if purchased at the current price. For example, if a stock is worth $1.00 and makes $0.05 EPS, its earnings yield is 5%, which is currently above the interest rate. If it is below the interest rate, you might as well have your money in a bank account.
Have any abnormal items greatly affected the earnings of the company?
While abnormal items are very real and contribute to net profit in a legitimate way, in order to analyse the company over time, this can skew your view. It is best to remove this one-off from your analysis in order to get a realistic view of the company.
Note that an abnormal items can either increase or decrease earnings.
The profit margins are improving, or at least being maintained
To answer this question, measure the NPAT margin, EBIT margin, and the Gross profit margin as a percentage of revenue. They will likely each follow a similar trajectory but will each tell a slightly different story. This shows the company’s ability to reduce costs or maintain price increases.
The PEG Ratio is less than 1
The PEG ratio = P/E / NPAT Growth. If the stock is trading on a high multiple but is easily recognized as an excellent company, the PEG can give some context to the PE by assessing how fast the company is growing. A PEG of less than 1 generally means that the PE is justified based on the amount of growth the company has either achieved or is forecasting.
For example, if a company has a P/E of 24 but is growing its NPAT by 30% a year, the PEG is 0.8, which may help to justify the high multiple.
If it is an acquisition story, EPS continues to grow
Many companies are acquisition fiends and will raise capital to make (hopefully) accretive acquisitions that will immediately add to their bottom line.
Generally speaking, when capital is raised, the shareholding is diluted which will reduce the earnings per share. But if EPS can be maintained from the acquisition even after the capital raising, then this is a good thing.
Balance Sheet Strength
The company has consistently high return on equity (ROE)
ROE is the profit made as a percentage of shareholders equity. I.e. for every dollar invested, the company made x%. Note that this is different to the earnings yield because the market cap of the company is not linked to shareholders equity.
A return on equity of >15% is considered acceptable.
The company has consistent return on invested capital (ROIC)
ROIC is the measure of the effectiveness of the capital deployed into returning earnings in the business. ROIC = ((net income – dividends)/total capital), with capital being the sum of debt and equity. Unlike ROE, it only considers the retained earnings (i.e. net profit less dividends) not total earnings.
The company has consistently high return on assets (ROA)
ROA measures the productivity of the company’s assets. Rather than measure net profit as a percentage of equity, it uses assets used in generating earnings for the company. Remember, the assets of a company include the debt and equity so ensure you include this in your assets calculation.
Are there any hidden assets that cannot be financially measured?
Hidden assets give companies a competitive advantage and inflate the value of the company in a way that cannot be presented on the financial statements. Hidden assets could include brand names, patents and unrealized property gains.
Inventory as a percentage of revenue is remaining constant or declining
Increasing inventory is an issue because it means the company is having a hard time selling stock and may have to run discounts to make way for new items. This means that they are receiving lower margins leading to lower revenue and may lead to inventory write downs as the stock is worth less than management expected. Both of these scenarios will impact the bottom line.
Total shares on issue are either remaining constant or decreasing over time
Increasing shares on issue can mean that the company is not generating enough cash flow to support the growth of the business. This has a dilutionary impact on the business, meaning that the earnings now have to go around to more investors.
This is not a hard and fast rule though. The exception is if the company has been able to increase EPS despite increasing total shares outstanding. This means that that the capital used from the issue of securities was used to grow the business faster than it otherwise could have. This is generally the case for acquisition stories.
Shareholder’s equity is rising continually
Shareholder’s equity is the difference in the value of assets and liabilities, or net assets. Put differently, it is the amount that has been contributed by shareholders and includes share capital and retained earnings, out of which dividends are paid.
If shareholder’s equity is rising then the amount financed by, or owed to, shareholders is rising, and is a measure of a company that is increasing in value.
Be wary of companies with high levels of goodwill
The reason this checklist item is not equivocally put is because there is no hard and fast rule surrounding it. Goodwill is the premium paid for a business over and above the tangible assets. Therefore, the quality of goodwill can vary significantly. It is largely dependent on the ability of acquisitions to continue to produce earnings.
A high level of goodwill can artificially inflate the net assets of a business and therefore the perceived value of the company can be overstated. If earnings do not flow from acquisitions as expected, then an impairment to the goodwill may need to be recognised to write down the value. This will reduce the apparent strength of the balance sheet and will also cause a reduction in net profits.
Cash flow and Debt
The company has consistent, positive operating cash flow
When analysing a stock it is important to closely analyse the cash flow statement of the company. While not strictly related to profits, it shows the actual cash inflows and outflows of the bank account(s) and includes cash for debt inflows, investing outflows and cash from capital raisings.
Operating cash flow is that which is directly linked to the operations of the business and mainly includes cash receipts from customers and payments to suppliers and employees. It both reflects sales and the ability of the company to collect its accounts receivables.
Cash conversion is consistently close to 100%
Since most companies report on an accrual basis, revenue may be recorded but not actually received. Cash conversion is the ability of a company to turn their revenue into actual cash. It is calculated as: Operating Cash/NPAT
As receivable rates can fluctuate from year to year, the cash conversion rate will often vary, so look at the average over a few years to get an accurate picture.
Receivables are growing slower than revenue
Similarly, the receivables amount (an asset) reflects the accounts that have not yet been collected from sales.
Decreasing receivables as a percentage of revenue demonstrates that the company is improving in its ability to collect its receivables, which will in turn improve cash flows. Conversely, if receivables are growing, the question should be asked if this is just a short term or cyclical abnormality or there is a problem with the process.
The company does not require a large amount of capital expenditure to remain competitive
Calculate what capex is as a percentage of revenue for the last 10 years. If this number is increasing, or is consistently high, it means that a high proportion of revenue each year is being spent on remaining competitive, rather than being spent on activities that are likely to grow the business or otherwise increase shareholder value.
The company has the capacity to pay off their debt (from EBIT) in the next five (5) years
Even though they most likely won’t pay off the debt in this time, it is comforting to know that they could if they needed to. This gives you some peace of mind that the current level of earnings will keep the creditors at bay for the foreseeable future.
Ideally, the company will hold no debt, but debt is generally a cheaper way to grow than through equity and allows growth beyond the capabilities of the current cash inflows from operating activities.
The current ratio is greater than 1
The current ratio disregards the long term assets and liabilities on the balance sheet and measures the ability of the company to meet their short term financial requirements.
A ratio of greater than 1 means that current assets are greater than current liabilities and is an indicator of a strong balance sheet.
The company has a low debt/equity ratio
The debt to equity ratio measures the level of long term debt compared to shareholders equity. A lower debt/equity ratio ensures that the company can continue to meet its financial obligations, even when the economy is in a downturn.
Interest is low as percentage of revenue
As you will know, interest is cost of money, and interest is an indicator of the level of debt the company is in. High debt isn’t always a bad thing, especially if it is secured against a realisable asset like property, but you must always ensure that interest payments are not unnecessarily reducing earnings.
Quality of Management
Has the company stated what their intentions are to grow the business?
For fast growing companies this will probably be obvious, but for existing, established businesses, maybe less so. It is important to know what their plans are so you can assess whether or not you think the growth trajectory is feasible and if not, you can adjust your assumed profit growth accordingly. If they don’t have plans to grow the business, you should consider the reasons why you are buying in the first place.
The company does not have any related-party transactions with any of the board member’s family
If any of their suppliers are related to the board of directors it is possible that they might not be receiving the best price for the goods or services. This conflict of interest could be hurting the bottom line.
The management has a solid track record in delivering on promises
It is one thing to consistently earn impressive profits, but to forecast this and deliver shows both the confidence management has in the business, and also the visibility management has on future earnings.
Conversely, consistently missing guidance will undermine any faith investors have in the management and the company.
If buying the company for its dividend, the dividend has been consistent and continually increasing
An increasing and stable dividend is a function of increasing and stable earnings. One thing to note though is that it is important that a dividend should only be paid if the company is not able to turn one dollar of retained earnings into more than $1 of market value (see Financial Characteristics).
The company only acquires companies that are closely related and can offer synergies
If a company has an excess of cash beyond the requirements to grow sustainably, management has three options:
- Pay out a dividend so the investor can invest it how they wish;
- Acquire a company where they understand the fundamentals and can integrate into the existing business; or
- Acquire a completely different business to ‘diversify’, in which the current management do not have any relevant skills.
Options 1 and 2 are significant better than option 3.
Management owns a significant portion of the business.
The best type of manager is one that acts with the best interests of the shareholders in mind. Regardless of whether or not management has been buying, if a high percentage of shares are owned by management then you can be sure that management will make decisions that will positively impact the shareholder because they want their shareholding and wealth to increase as well.
Similarly, companies with long term incentive plans that involve the issue of ordinary shares are likely to have a similar effect.
Management are buying shares
Management is arguably in the best position to truly understand the state of the business. As such, if they are buying they probably know that the business is in good shape. This can be a very good indicator that you are onto a winner.
Conversely, management selling down a position is not explicitly a conern, as there are more reasons to be selling than the business is in bad shape.
The company has a low ownership by the institutions
Institutions include the managed funds, the hedge funds, the big banks, etc. Low ownership is good because if one or more big institution begins selling, the impact on the price can be severe. If fear is involved the impact can be even worse.
The stock is not surrounded by hype
It can often be tempting to jump into a hot stock that is showing unbelievable gains day after day. It might very well be an excellent, growing company and it just keeps growing. You don’t want to miss out. However, this often leads to the price being inflated well above its fair value and any bad announcement or adverse change to trading conditions could burst the bubble with tremendous effects.