When you buy a stock on the stock market, you purchase a piece – however small – of a real company. The value of a stock reflects the company’s ability to generate profits in the future. That’s why identifying the right companies is crucial if you want your investment strategy to succeed.
Of course, this is easier said than done. Here, we’ll explain how company stocks are valued and rated and share some tips for determining a company’s future success and avoiding mistakes.
How Are a Company’s Stocks Rated?
In its simplest form, a company is a money-making machine, like a sausage maker. When ingredients (or inputs) are passed through the machine, the output is hopefully a superior and appetizing sausage product. For companies, whether private or trading on the stock market, money gets fed into them through equity investments or debt. That company then uses its resources to process the money invested into more money through its cash flow cycle.
How do you know if you’ve picked a good company? Measure the amount of money coming out versus the amount going in, and hopefully, you end up with a satisfactory ratio.
To better understand how companies are rated, you have to understand the machine or company’s three working components. There are the inputs, i.e. the monetary resources that the machine ingests. There are the outputs, i.e., the monetary resources that the machine generates. And last but not least, there is the machine itself.
Inputs: How Do You Determine the Cost of Capital?
Companies need financing to get their business rolling. Expenses incurred to acquire durable and fixed assets, such as land, plants, machinery, etc., are called capital expenditures (or capex for short). Businesses also need funds to finance their ongoing operations. This is what we call working capital: the amount of money available to the business to replenish inventory, settle current expenses and pay their employees until customers pay what they owe, which may be several days or weeks after the company’s goods or services are delivered. The sum of the funds needed for working capital and capital expenditures of a business is called total capital.
All this capital isn’t going to fall from the sky. And since companies don’t operate in a vacuum, they constantly compete with other money-making machines to attract capital. Indeed, investors can decide where they’ll put their money. The better the machine looks, the more likely they are to allocate capital to it, and therefore, its cost of capital will be less expensive. In other words, investors will put their money towards companies they believe will be the most profitable for them, given the risk involved. The tipping point that makes investors willing to invest their capital is the cost of capital.
In the long run, the cost of capital is driven by efficient market rules that factor in the risk. The variables that determine the cost of capital include the risks involved and the expected return from similar investments. Therefore, the cost of capital is set by what investors require in return for investing money in a company. A company gets a passing grade when it makes enough profit to offset the amount needed to pay for the cost of capital. However, good companies don’t settle for just a passing grade – they strive to get an A+!
Permanent and Temporary Capital: Finding the Right Mix
The capital used to finance a business includes permanent and temporary capital.
Common stock is considered permanent capital. This type of financing is more expensive for the company since the investor must entrust his savings for an indefinite period, and the return is never known in advance. There is also a considerable risk that the return achieved will differ from the expected return.
Bonds, debentures, and other types of credit are known as temporary capital. This type of financing is less expensive for the company since its maturities and payments are established in advance, and it is ranked higher in priority in case of bankruptcy.
Good companies know how to find the right mix of permanent and temporary capital, and each industry has its standards of excellence. The weighted average cost of capital is a company’s financing cost based on its various sources of temporary and permanent capital.
One of the first steps in evaluating a business is to study a company’s balance sheet and compare its debt load relative to its peers in the industry. To find a great company, you need to find one that can generate good profits without relying too much on bank loans or other debt. This way, a more significant portion of the cash flow is attributed to the unitholders. We’re talking about this when we say a company has a strong balance sheet.
Outputs: Determining EBITDA, Profits and Cash Flows
A successful company makes money. But how do you accurately measure a company’s real earnings?
EBITDA, profits, and cash flows are all used to determine the money generated by the machine. These measures each have strengths and weaknesses, and it is important to understand them and their interactions to evaluate a business properly.
You’ll hear or read the acronym EBITDA very, very often. It stands for earnings before income taxes, depreciation, and amortization. EBITDA, operating profits, and gross margins are tools that we use to measure a company’s profitability.
Since it doesn’t make sense to apply the financial impacts of a plant purchase to a single year when such a plant can last for decades, depreciation is used to mitigate the effects of such a purchase over several years. Depreciation is a method of quantifying and distributing the impact of large cash outflows, such as a plant purchase over some years, i.e., over the probable useful life of the asset. This method is based on assumptions made by the company’s management and can be used to distort the company’s actual results.
EBITDA can eliminate some of the potential accounting manipulations that can overstate results. However, interest, taxes, depreciation and amortization are all part of a company’s expenses, so they must be taken into account to get an accurate picture of the company’s profits. EBITDA is often used to evaluate a business since removing these three categories of expenses gives you a better idea of the operating results.
Profit is a company’s net earnings after all expenses, as measured according to generally accepted accounting principles, have been deducted. This metric is meant to represent a company’s true profitability. However, accounting methods for profitability are based on various assumptions and techniques and can temporarily disguise a company’s financial reality. Profit has the advantage of considering all company expenses, but its assumptions can be manipulated and/or distort a company’s economic reality.
Cash flow is the money that goes into the company’s bank account. We get free cash flow by subtracting the capital expenditures required to support fixed and other assets. Free cash flow is an excellent tool for evaluating companies, but it does not consider the purchase of long-term assets acquired in the past.
Learning how to use the different metrics requires a thorough knowledge of finance, but here’s what our experience has taught us:
- Good companies tend to get better – their profitability ratios show upward trends;
- The different profitability ratios are all important, and attention must be paid to the various aspects of profitability;
- You have to watch out for companies that may use financial engineering to hide poor operating performance;
- You must be able to identify discrepancies between operating and total measures. For example, when a company shows strong EBITDA growth but internally generated contracting cash flows, this could be a sign that something’s fishy.
The Company: What Factors to Look for When Researching Stocks
A company is a collection of different resources used to create value. Good companies generally have a competitive edge over other companies. Some have brand names (Coca-Cola, Nike, Lululemon), while others have high barriers to entry (CN, CP, Suncor). Some enjoy regulatory advantages (Canadian banks), while others benefit from commercial patents (Qualcomm, Pfizer, AbbVie) or technological advances.
The recipe for good business is often straightforward. Quantitative research by Nomura shows that the simpler the language of a company’s CEO, the better the company’s returns. Incidentally, Warren Buffet, best known as one of the most successful investors of all time, has an essential rule: to invest in companies whose business plan is simple and that he can easily understand. To quote Peter Lynch, another well-known and successful investor: “Never invest in any idea you can’t illustrate with a crayon.”
The table must be set to cause a chain reaction. By chain reaction, we mean that the solid profits generated by a company’s human, material, technological and financial resources can be reinvested to develop even greater profits that can create a growing cycle of profits. That’s how you know you have a good catch!
Good companies must be able to generate a profitability ratio greater than their cost of capital. More specifically, the money coming out of the machine is measured using ratios such as return on equity, return on total assets, and return on free cash flow.
The higher the company’s return relative to its cost of capital, the more the company will be able to reinvest in its business, creating a chain reaction that is meant to be exponential. This is the key to finding those rare investment gems. This parabolic growth allows us to mitigate the many inevitable pitfalls of financial analysis, as we’re working with incomplete data and assumptions to estimate forward-looking information.
Mistakes to Avoid
You should avoid investing in companies with a profitability ratio equal to or lower than their cost of capital. These companies are often described as corporate zombies. Abnormally low interest rates have contributed to their proliferation since the financing subsidized by current monetary and government policies keeps them on life support, preventing their demise.
Chasing companies that generate a very high dividend can be a double-edged sword. Beware of companies that don’t reinvest in their business. Companies that create a very high dividend may look attractive but may also be guilty of not reinvesting in themselves. They are, therefore, more at risk of ending up with outdated facilities or equipment and losing out to better-equipped competitors, falling into a self-feeding, downward spiral.
Beware of novelties. In the short term, the cost of capital can be influenced by unsupported beliefs and theories. For example, when cannabis was deregulated, investors mistakenly believed that, like the illicit trade, companies in the cannabis industry would eventually start printing money. Also, when new industries emerge, investors are often dazzled by the novelty of the thing and the anticipation of potential profits. They are willing to throw money at the mere sight of a few mockups or vague projects. While new companies like Tesla or Netflix can be born from this dislocation of the short-term cost of capital, more often than not, they fall prey to the rules of long-term competitiveness. Indeed, new industries and discoveries require an extreme juggling act between the capital needed to fund growth and the amount of money from it. Investors often see their share of the pie shrink (diluted) by adding new shareholders when new shares are issued to finance growth.
An important point when finding a good company is to make sure you buy it at a good price, as overpaying can undermine the performance of even the best companies.
Even after finding a good company and being smart enough to buy it cheaply, the game’s not over yet. Now, you have to be patient. Even the best-oiled machines take years to create wealth. As Warren Buffet says, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”
Finding good companies to invest in is not easy. It takes the right tools and, ideally, years of experience to avoid the pitfalls of the financial markets and thus benefit from the added value of a good investment.
