How to Evaluate Companies Before Purchasing Their Stock
While investors cannot know everything about any given investment — predicting the future isn't easy — investors should know enough to have reasonable forecasts about the future.
Stocks are representative of ownership in a business — an organization with suppliers, customers, employees, buildings, and office furniture.
Finding a good stock means finding a good business that is priced at a reasonable valuation. Here's how to evaluate companies before purchasing their stock.
Sourcing Vital Information
The best way to evaluate a company is to work with source documents. I'm not talking about analysts' commentary or posts on SeekingAlpha. I'm talking about the nitty-gritty SEC documents that companies must file as a public company.
The key SEC documents are:
- 10-Ks and 10-Qs: Each year a company will file a 10-K (also known as an annual report) and three 10-Qs (which are quarterly reports). These reports can span hundreds of pages, but they contain some of the most vital information for an investment decision. Besides the raw financial data in financial reporting, pay particular attention to the “management discussion and analysis” section, which contains information about the business from the perspective of key insiders and managers.
- DEF 14-A: This filing is a proxy statement which contains information on the board of directors, major shareholders, and upcoming votes in which shareholders can participate. You should collect the names of directors from this document and Google them for any biography, or other information you can find. You want to make sure that managers have a history in this particular business or industry before investing. You'll also want to take note of the major shareholders, and what their interest might be. If you run into Carl Icahn in a DEF 14-A, you'll absolutely want to know what this activist investor has in store for the company you're evaluating.
There are also other documents that are not sent to the SEC. Larger companies will prepare an earnings presentation when they report quarterly earnings, then post it on the investor relations portion of their website.
Use this information to get a better idea of exactly what the company does, where it's growing, and how it intends to make decisions in the future. SeekingAlpha also logs transcripts of conference calls, which can be used to get a feel for what the business's managers see for the company in the future.
Competitive and Business Analysis
The single biggest risk to any business is that of competition. Any thorough analysis is one which surveys information on your potential investment, but also the information of key competitors.
For example, you shouldn't buy Coach without understanding Vera Bradley. You shouldn't buy Anheuser-Busch InBev without understanding Molson Coors.
The best way to understand a very big company is by breaking it down. Anheuser-Busch InBev isn't just Bud Light. It's a globally diversified company that sells in markets ranging from Mexico to Brazil and China with hundreds of adult beverages in its portfolio.
A proper analysis is one which breaks down the company into several different units. For example, it's slow-growing American business should be viewed separately from its fast-growing business in Latin America.
You'll want to look at a business as if you were the sole owner and customer all at the same time.
- Can I really understand this business? (This question alone can save you thousands of dollars and hour and hours of research. I know nothing of the pharmaceutical business – I'm no doctor – so I avoid it at all costs.)
- Why would I buy this company's product?
- Why is this company's product better than its competition?
- How does this business maintain an edge over other businesses in its industry?
- How does this company's sales move with the economy?
- Where does the company position its product? Is it a low cost leader or a premium brand?
You should also question the quality of the management:
- What do the managers really care about?
- Are they experienced in this particular industry?
- Do the managers have a significant stake in the company's stock?
- How are managers compensated? Do they earn based on sales? Net income? Or are they compensated based on returns on the business's investment dollars?
- Do managers want to be the best at one thing, or mediocre at several things? (Focused management is key!)
Goal: Crush Your Dreams
Every business looks great on paper. Every investment opportunity looks like a multibagger just waiting for your investment. But the goal of any analysis should be to destroy your reasons for owning a business. It should compel you to avoid an investment, not make one.
The best investors are those who can be most critical of a business and, after being so critical as to try to kill the idea, if the business still looks good, then its an investment worth making.
Remember, there are more than 3,000 companies in the Wilshire 5000 index. You don't have to buy the first business that strikes your eye.