# How to Analyze Companies

Having found a bunch of leads to look into, the next step is to analyze the companies — to sort out the good from the bad. In this post, I describe how I do exactly that.

# What makes a company ‘good’?

The purpose of a company is to benefit its shareholders. As a result, the return that these shareholders receive on their investment is arguably the most important metric for a company.

# Return on Equity

The de facto method for gauging shareholder returns is aptly called ‘return on equity’. The return on equity (or RoE) is just the yearly profit divided by the company’s equity:

$\text{Return on Equity} = \frac{\text{Net Income}}{\text{Equity}}$

If you’re unfamiliar with the term ‘equity’, it’s a measure of how much the outstanding shares of the company are currently worth. (Basically, if you add up all the money that’s been ploughed into the company since it started — how much would you get?)

To improve RoE, the formula suggests we simply need to increase net income. That’s only slightly helpful, mainly because it’s not very actionable.

Breaking down the formula can get us a much better result:

$\text{RoE} = \frac{\text{Net Income}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Assets}} \times \frac{\text{Assets}}{\text{Equity}}$

Notice that the formula hasn’t changed; ‘sales’ and ‘assets’ cancel out to give us the same end result. The formula, in this form, is known as the ‘Dupont Model’:

• $$\frac{\text{Net Income}}{\text{Sales}}$$ represents “profitability”, which tells us how what portion of the revenue a company generates is actually profit.

• $$\frac{\text{Sales}}{\text{Assets}}$$ represents “operating efficiency”, a measure of how well the company employs the assets it has in generating sales.

• $$\frac{\text{Assets}}{\text{Equity}}$$ represents “leverage”. Also known as the $$\text{Equity Multiplier}$$, it can be increased by taking on debt (and using that to increase assets).

In summary, the 3 ways to improve RoE are through higher profitability, increased operating efficiency and leverage.

When assessing whether to invest in a company, it’s important to understand the overall RoE trend, as well as the trend of its parts.

### Leverage

I’ll start with leverage, since that’s the most likely to kill a company. Additionally, I want to make sure that any company I invest in doesn’t expressly rely on interest for operations — a strong sign that it may not be a halal investment to make.

The downside of leverage as a source of capital is that it needs to be paid back no matter what — and that defaulting could result in the company going bankrupt.

Things to look out for when assessing the likelihood of a company to default on it’s debt payments

• Does the company have debt? If so, assess:
• Liquidity risk (ability to meet ST needs)
• Solvency risk (ability to meet LT obligations)
• How do we measure a company’s reliance on debt?
• Debt (as reported in financial statements)
• Equity multiplier
• How do we assess liquidity risk?
• Quick Ratio
• How do we assess solvency risk?
• Interest Coverage Ratio
• Debt/Equity Ratio
• Corporate Bond Yield (published on Finra, if available)

Beyond managing the insolvency risk inherent in leveraged companies, we need a way to measure what the shareholders are left with it the company does in fact go bankrupt

Assessing Liquidation Value

Since debt holders are paid before shareholders in the event of bankruptcy, we’d need to determine what assets are left after the creditors are paid back - and then divide this remainder amongst all the shareholders.

That is:

$\frac{\text{Tangible assets - Liabilities}}{\text{Shares outstanding}}$

You can even discount tangible assets to arrive at a more conservative figure or, if you’re being criminally conservative:1

$\frac{\text{Cash + Marketable Securities - Liabilities}}{\text{Shares outstanding}}$

In summary, when assessing the impact of debt on a company, we’d need to know:

• Extent of debt (debt, equity multiplier)
• Liquidity risk
• Solvency risk
• Liquidation value to shareholders

Beyond analyzing what the company is worth right now , we should consider the potential upside. Of course, we’d want to look at historical performance to get an idea for what we can expect in the near future.

Let’s talk about the two remaining factors: Operating Efficiency, and Profitability.

## Operating Efficiency

This is an easy one, so we’ll get it out of the way before talking about the monster that is Profitability. Recall that:

$\text{Operating Efficiency} = \frac{\text{Sales}}{\text{Assets}}$

Essentially, it’s a measure of how well the company employs the assets it owns to generate sales (i.e. how ‘efficient’ it is in its day-to-day operations). Another term for this is $$\text{Asset Turnover}$$ — the higher, the better.

## Profitability

In theory, profitability is an easy one to assess:

$\text{Profitability} = \frac{\text{Net Income}}{\text{Sales}}$

Easy. Just divide the profit by the total sales.

There’s just one problem: the darn $$\text{Net Income}$$ has a habit of bouncing around like crazy!

So at times, we need to move higher and higher up the income stream — excluding things that would otherwise drive Net Income below zero and into loss-making territory:

Term Also known as…
Revenue Sales
- COGS Cost of Revenue
= Gross Income Gross Profit
- Operating Expenses (excl. D&A) Excluding Depreciation & Amortization
= EBITDA
- Depreciation & Amortization
= Operating Income Operating Profit, EBIT
+ Other Income - Interest - Taxes
= Net income ⭐ Profit (or Loss), Earnings

That means looking at things like Operating Income, EBITDA or even Gross Income (you better believe things are desperate when you need to look that far up!) — which exclude things like tax, interest and Depreciation & Amortization.

Compare to industry average ratios to get a sense for what the median performance is like, and how the target company compares to it’s peers.

I like companies that are smaller in size (and therefore more likely to be overlooked/written off) and that are trading at a fraction of their Tangible Book Value. Here, you just need the company to not go bankrupt (which most people already think it will) — and if escapes bankruptcy, you’re in for some massive gains.

# Other Factors

Also, I’d probably have to consider other ‘softer’ factors when trying to predict where the company may be in the future. This includes:

• Insider trading activity
• Does management care?
• Growth Strategy
• Recent board/executive changes
• Read posts from analysts with a successful track record on Seeking Alpha
• Charts (Technical Analysis), specifically around RSI, resistance levels, etc

# Open Questions

• Optimal portfolio allocation between industries
• How much emphasis I need to place on industry outlook (i.e. macro-indicators, industry research, etc)

The sort of companies I’m interested in, the ‘deep value’ companies — I’m not expecting stellar financials. I come in knowing that there’s something wrong, and it’s just a question of figuring out whether the risk is real, or perceived.

1. This does not take into consideration preferred shares, and their liquidation preference, assuming there are any of course. In case there are, we’d need to consider the share count, the dividend dues as well as the liquidation preference. If a company goes bankrupt, for instance, preferred stockholders will get paid before common stockholders. It’s important to remember, however, that if a company ends due to bankruptcy, paying creditors is the priority over paying preferred and common stockholders. Another unique feature of preferred stocks is that they have a fixed dividend