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
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 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.
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.
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.