The clever way to an­a­lyse com­pa­nies on the stock mar­ket

Ap­ply­ing a growth, risk and qual­ity frame­work can help you sort out the winners from the losers

Shares - - SHARES SPOTLIGHT -

Know­ing ex­actly what to look for in an in­vest­ment is not easy but ‘growth, risk and qual­ity’ is a use­ful frame­work which can help you sep­a­rate the po­ten­tial winners from the losers on the stock mar­ket.

GROWTH

Growth is im­por­tant and will help dic­tate how a busi­ness is val­ued by the mar­ket. Quite of­ten in­vestors will fo­cus on earn­ings growth to the ex­clu­sion of all other fac­tors but this can be a mis­take be­cause it is possible to in­flate earn­ings in the short-term through clever ac­count­ing.

It there­fore makes sense to also look at growth in cash flow. The lat­ter is the life blood of the busi­ness and is what a com­pany uses to ser­vice any debt, in­vest in staff, equip­ment and tech­nol­ogy and, in some cases, pay div­i­dends.

Some early-stage com­pa­nies will not yet be gen­er­at­ing cash flow or earn­ings. If a com­pany re­mains loss-mak­ing it is worth look­ing at its cur­rent net cash po­si­tion in re­la­tion to its cash burn (the pace at which it con­sumes its cash) and de­ter­mine if it can get to break-even point with its cur­rent re­sources. If it can’t the com­pany may have to is­sue new shares to raise funds and thereby di­lute ex­ist­ing share­hold­ers.

It is also im­por­tant to un­der­stand where a com­pany’s growth is com­ing from. Is the growth or­ganic (i.e. gen­er­ated by the ex­ist­ing busi­ness) or is it driven by takeovers?

If the lat­ter is true you need to con­sider if the com­pany is suc­cess­fully manag­ing the risks as­so­ci­ated with ac­qui­si­tions. Namely that it might over­pay or strug­gle to in­te­grate the ac­quired en­tity suc­cess­fully. Earn­ings might also be grow­ing be­cause a com­pany is cut­ting costs – but that will only be a tem­po­rary cat­a­lyst.

RISK

Pur­su­ing growth in­dis­crim­i­nately leads to an in­crease in risk. There are three main types of risk to con­sider:

• Busi­ness risk. How risky are the prof­its and cash flows of the com­pany?

• Fi­nan­cial risk. How much debt does the com­pany have? Can it eas­ily ser­vice this?

• Rep­u­ta­tion or gov­er­nance risk. Is the com­pany well man­aged and act­ing in your in­ter­ests?

In terms of sig­nif­i­cantly re­duc­ing risk it is im­por­tant a com­pany with high busi­ness risk does not com­pound this sit­u­a­tion by hav­ing high fi­nan­cial or gov­er­nance risk as well. Com­bin­ing two of these risks in­creases the dan­gers ex­po­nen­tially.

QUAL­ITY

A third fac­tor to con­sider when look­ing at a com­pany is its qual­ity of earn­ings, which is a com­bi­na­tion of:

• Pre­dictabil­ity. Are prof­its sus­tain­able? How easy is it to fore­cast prices, vol­umes and costs?

• Con­trol. What can man­age­ment in­flu­ence? Is there an abil­ity to in­flu­ence prices or just man­age costs?

• Real per­for­mance. Are the earn­ings be­ing de­rived from the core busi­ness, and not from one-off fac­tors? Are they backed by cash flow?

By ap­ply­ing the three el­e­ments of growth, risk and qual­ity you will have a much more com­pre­hen­sive view of how the com­pany is per­form­ing and what it is worth. In par­tic­u­lar you will be well equipped to work out if the bal­ance be­tween risk and po­ten­tial re­ward is one that suits your in­vest­ment goals.

Re­mem­ber the com­pet­i­tive po­si­tion of a com­pany is ul­ti­mately what drives its growth. This is where the firm sits in the peck­ing or­der of a mar­ket rel­a­tive to its peers.

The firms with the best growth prospects will have a strong com­pet­i­tive po­si­tion based on qual­i­ties such as strong brands, ex­cel­lent op­er­a­tional per­for­mance or technical ex­per­tise.

These at­tributes could be con­sid­ered ‘bar­ri­ers to en­try’ for com­peti­tors. If a com­pany is pro­duc­ing or do­ing some­thing which can­not eas­ily be repli­cated by oth­ers it should be well po­si­tioned for growth. It will also have pric­ing power – the abil­ity to in­crease the price of its goods and ser­vices with­out un­duly af­fect­ing de­mand.

In­vest­ment guru War­ren Buf­fett colour­fully ex­plains what pric­ing power, and its ab­sence, means for a busi­ness: ‘If you’ve got the power to raise prices with­out los­ing busi­ness to a com­peti­tor, you’ve got a very good busi­ness. And if you have to have a prayer ses­sion be­fore rais­ing the price by 10%, then you’ve got a ter­ri­ble busi­ness.’

MEA­SUR­ING YOUR RE­TURN

A ‘share’ is just what its name im­plies – by buy­ing one you are tak­ing part own­er­ship of a busi­ness.

On­line trad­ing can de­lude you into think­ing a share is just num­bers and let­ters on a screen but it is not. By in­vest­ing in a com­pany’s shares you are en­ti­tled to a slice of rev­enues, earn­ings and ul­ti­mately cash flows gen­er­ated by said com­pany.

There are two ways we can get a re­turn from a stock: cap­i­tal gains, re­alised when we sell af­ter they have ap­pre­ci­ated in value; or in­come, from those shares which pay a reg­u­lar div­i­dend.

Though many small cap com­pa­nies pay a div­i­dend a lot of growth com­pa­nies pre­fer to in­vest their cash in the de­vel­op­ment of their busi­ness rather than re­turn it to share­hold­ers – po­ten­tially mak­ing cap­i­tal gain a more rel­e­vant con­sid­er­a­tion.

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