Seven Questions that Can Help You Select Better Stocks
Basic Investment Analysis for Beginners
When putting together a portfolio of companies, there are seven basic
questions that every investor should ask. The answers can help uncover
competitive strengths and weaknesses, providing a better understanding
of the economics and market position of the business.
1. What are the sources of the companys cash flows?
John Burr Williams taught us that the value of any asset is the net
present value of its discounted cash flows. Before the investor can
even begin to value a business, he has to know what is generating the
cash. It is important to be specific and avoid making assumptions.
Take Coca-Cola, for example. Billions of people across the world are
familiar with Cokes products.
When you see it on the shelf of your local grocery store, you may have
concluded that it was the Coca-Cola Company that sold the bottled
goods to the grocer. In reality, a look at the most recent 10K reveals
that, although the company does sell some finished beverages, almost
all of its revenue is derived from the sale of beverage concentrates
and syrups to bottling and canning operations, distributors, fountain
wholesalers and some fountain retailers. In other words, it sells the
concentrate to bottlers, the largest being Coca-Cola Enterprises (a
separately traded public company). These bottlers create the finished
product, shipping it to your local store. It may seem like a small
distinction seeing that Cokes ultimate success depends upon the
products sold in stores and restaurants; approached from another
angle, however, and the investor can quickly surmise how vitally
important the relationship between Coke and its bottlers is to the
bottom line.
2. How much cash is generated by the business and when?
Once the investor have has identified the sources of cash in a
business, he must estimate the amount and timing of those cash flows.
A company that generates $1,000 today may be worth more than one that
generates $30,000 in fifty years because of the time value of money.
3. Are the cash flows sustainable?
There was a time when horse-and-carriage manufacturers and streetcar
companies were considered blue chip stocks on Wall Street. The long
history of industry profitability led many investors and analysts to
believe that these businesses would always be solid as a rock. Those
who were astute, however, realized that past history was of no value
in projecting future cash flows due to a shift in the competitive
landscape arising from the advent of the automobile.
One of the ways to evaluate the sustainability of cash flows is to
examine the barriers of entry for the market or markets in which the
company operates. It is going to be much more difficult for a
competitor to enter a business which requires hundreds of millions of
dollars in startup capital than it is for a retailer, which can be
opened for a miniscule fraction of the cost (e.g., there are very few
entities in the world that could start an airplane manufacturer to go
head-to-head with Airbus or Boeing, but you and your friends could
probably gather the capital necessary to lease a space at the local
mall and start your own business.)
4. How much capital does the business require to operate?
Some businesses require more capital to generate one dollar of profits
than others. A steel mill requires huge investments in property, plant
and equipment and then produces a product that is a commodity. An
advertising firm, on the other hand, requires very little capital
expenditure to keep the business going, generating tons of cash for
the owners relative to investment. The less capital a business
requires to run, the more attractive it is to an owner.
5. Does management have a shareholder-friendly orientation?
The way management treats shareholders is the single most qualitative
determinant of success. A CEO that is willing to push for share
repurchases when a companys stock has fallen rather than acquire
another business is much more likely to create wealth than one who is
bent on expanding the empire.
6. Are managements actions consistent with what they say in their
public communications?
If management has stated in the last three annual reports that debt
reduction is the most important priority, yet they have engaged in
multiple acquisitions or started multiple new businesses, they are not
being honest. As a business owner, you only want to be in partnership
with those whose actions match their promises.
7. Is the price attractive?
Price is the absolute determinant of return. A disciplined investor
will find company ABC attractive at $10, but not at $12. A business
generating $5 in profit per year is an excellent buy at $20 per share;
the earnings yield is 25%. The exact same business sold at $200 per
share, however, is only boasting an earnings yield of 2.5% - half the
rate available on risk-free United States treasuries! Even if a high
growth rate was expected, it is lunacy to acquire the stock at the
latter price
