When you buy a stock on the stock market, you are buying 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 for mistakes to avoid.
How Are a Company’s Stocks Rated?
In its simplest form, it helps to think of a company as a money-making machine, kind of 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? Simply measure the amount of money coming out versus the amount of money 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 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 that is 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 delivery of the company’s goods or services. 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’re in constant competition 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 the less expensive will be its cost of capital. In other words, investors will put their money towards companies that they believe will be the most profitable for them given the risk involved. The tipping point that makes investors willing to invest their own capital is called 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 risks involved, as well as the expected return from similar investments. The cost of capital is therefore 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 that is used to finance a business includes both 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 of time and the return is never known in advance. There is also a considerable risk that the return achieved will be different 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 their maturities and payments are established in advance and they are 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 own standards of excellence. The weighted average cost of capital is a company’s cost of financing 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. In order to find a great company, you need to find one that has the ability to generate good profits without relying too much on bank loans or other debt. This way, a larger portion of the cash flow is attributed to the unitholders. This is what we’re talking about when we say a company has a strong balance sheet.
Outputs: Determining EBITDA, Profits and Cash Flows
A successful company obviously 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 their strengths and weaknesses, and it is important to be able to understand them and their interactions to properly evaluate a business.
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 the profitability of a company’s operations.
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 impact 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 a number of 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 has the advantage of eliminating 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 in order to get a true 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 the net earnings of a company after all expenses, as measured according to generally accepted accounting principles, have been deducted. This metric is meant to represent the true profitability of a company. However, accounting methods for determining profitability are based on a variety of assumptions and techniques and can be used to temporarily disguise a company’s financial reality. Profit has the advantage of taking into account all categories of expenses of the company, but its assumptions can be manipulated and/or distort the economic reality of a company.
Cash flow is the money that goes into the company’s bank account. By subtracting the capital expenditures required for supporting fixed and other assets, we get what is called free cash flow. Free cash flow is an excellent tool for evaluating companies, but it does not take into account the purchase of long-term assets that were 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 cash flows that are contracting, 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 simple. In fact, 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 a basic 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, with the goal of generating 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 that is 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 in order to estimate forward-looking information.
Mistakes to Avoid
You should avoid investing in companies that have a profitability ratio that is 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 ultimate 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 generate a very high dividend may look attractive, but they 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. As well, when new industries emerge, investors are often dazzled by the novelty of the thing and the anticipation of potential profits and so 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 new discoveries require an extreme juggling act between the capital needed to fund growth and the amount of money that comes out of it. Very often, investors see their share of the pie shrink (diluted) with the addition of 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 puts it: “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 an easy task. 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.
