Written by Millionaire’s Digest Team Member: Sam Sanderson
Founder & Owner of: Simplistic Success
Millionaire’s Digest Team, Contributor, Business, Entrepreneur and Successful Living Writer
One of the key components of long-term investing is finding strong companies that will have a consistent dependable growth pattern. Proper value investments can be achieved through financial statement analysis of stock(s) you are interested in investing in.
The income statement or profit and loss statement provides details of a companies revenue and expenses. This information is important for current and future valuations.
It is important to not only see the way a company is trending (Revenue up or down) but to know why. There are a couple common causes for increased revenues.
Increases in price with proper marketing will increase revenue. Apple is famous for charging a premium price for products and selling them at large volumes. They are successful because they have exceptional marketing and create new desires for consumers. The Macbook, for example, provides minimal added functionality to comparably priced laptops but the combination of hardware and software creates an extremely desirable product. It is important to be able to evaluate qualitative factors that will be demanded by the marketplace.
Increased production will drive an increase in sales. A big factor in the oil and gas industry, increased production is often correlated with sales. As long as there is a desire for your product, the more that you produce the more that your company will generate revenue. Be wary of companies overproducing leading to high storage costs and potential losses from products going bad or becoming obsolete or outdated.
New products are most relevant to tech companies because of their short product life cycle. An introduction of a new product does not always imply an increase in stock price. Often stocks will have a short term dip in share price following new product introduction. Although Companies can have substantial growth in revenue by creating new desirable products. A successfully product release can result in the long-term growth of the stock.
The expense section of the income statement can give insight on cost efficiency. Many companies are built on large volumes of sales so the cost per unit must be minimized. The easiest way to compare cost’s of similar companies is through their contribution margin. The contribution margin is an evaluation of a companies ability to cover their variable costs as well as fixed costs. What is left after that is the company profit. This number can be calculated as a margin and then that percentage can be compared with other companies.
In general, expenses should be evaluated on a percentage and prior year basis. What percentage has this expense increased/decreased by compared to revenue. If there are unexplained expense increases compared to competitors there could be issues in the value of the stock. Capital must be properly utilized and as an investor, this should be your number one concern when it comes to expenses.
Research and development
The opposite can be said for R&D where it is much harder to evaluate how a company is managing capital. Companies like Google and Apple will have large expenses in research and development, a lot of these expenses cannot be capitalized because of their ambiguous nature. The exception to this is when a company purchases another company with research and development expenses then these expenses are capitalized. This is an issue because it understates the Total assets in a company, and must be taken into account when investing in the industries with high R&D expenses.
Companies with high dividend payouts are attractive and can be great investments as long as they have a stable market value. Chevron, for example, has a dividend yield of 4.05% or $1.07 per share while still maintaining growth( Up 26% over the last six months). The reason for their higher dividend payouts is there ability to have stable earnings. Stock’s that pay a dividend are a great investment as long as they continue to grow. Getting paid to wait!
Technology companies on the other hand typically do not pay out dividends because they prefer to reinvest earnings back into their company. Facebook, Amazon, Netflix and Google all do not pay dividends. That is not to say they are not good investments there is just a larger emphasis on market capitalization growth. Some companies choose not to pay dividends so they can improve company efficiency, expand reach, create new products or services, improve existing ones and do many other various things.
In Warren Buffet’s letter to his shareholders, he said that if one dollar or more could be created in value for each dollar his company paid in dividends it would be a better use of capital. The use of net earnings should be an area of focus for long-term investors.
The balance sheet or statement of financial position provides a statement of the assets, liabilities, and equity of a company at a particular point in time. It can be thought as a snapshot of a company. Balance sheet timing should be taken into account when assessing the validity of Balance sheet numbers.
An asset is a resource with economic value that a corporation owns or controls with the expectation that it will provide future benefit. One of the factors in the asset section is cash. A company should be constantly reinvesting their cash and excess cash could mean a future large investment or dividend payout.
Total assets held in a company can be used to assess the liquidity and the likelihood of return of capital.
Leverage through debt or preferred shares can drastically increase a companies growth. During positive times a company can use leverage to increase earnings and expand to other areas. Although companies who do not succeed and have a large ratio of debt financing will fail quicker. Another thing to note is common shareholders are paid last so it makes a riskier investment when companies have substantial debt. Debt can be a great way to help company growth, but too much debt can also cause a company to go under. Pay attention to industry standards to find out what is a normal amount of debt among competitors in the industry. Debt-to-equity is a great starting point to seeing how leveraged a company is.
For example debt financing is very common in the Real estate industry. Companies with large debt can invest in additional properties and increase revenues. A proper debt to equity ratio must be maintained in order to have a proper margin of safety. In economic downturns, market values can deplete and debt can be called.
Return on equity
Return on equity or ROE is defined as the earnings produced per each dollar. It can be calculated as follows: Return on Equity = Net Income/Shareholder’s Equity. The ratio determines the effectiveness of the money employed by shareholders. Financial analysts consider the return on equity ratios in the 15-20% range as representing attractive levels of investment quality. Investors must be wary of high debt values affecting this ratio, as a company could pursue debt instead of issuing equity.
Earnings per share
EPS is calculated using this formula: (Net Income – preferred shares)/ Weighted average shares. Investors can also use Diluted EPS which incorporates warrants and convertible debentures. One of the most important financial measures of stock, EPS can be very valuable to investors. EPS measures the amount of net income that is available to shareholders or reinvestment back into the company. A positive trend in EPS should be a consideration for investing in a stock.
Market Value per Share / Earnings per Share is a ratio that helps determine how the market values a particular stock. If a company has a P/E of 10 an investor is willing to pay $10 for $1 of current earnings. A rising P/E ratio is a speculation of future earnings to increase. In general, when comparing stocks in a similar industry the company with the lower P/E ratio is the better investment. The median P/E ratio of an index determines the benchmark for stocks, currently the S&P 500 P/E ratio is 14.63.
Hopefully, this helps with your understanding of some of the indicators of value when analyzing the financial statements of a company. I would love to delve into these topics further in the future if anyone is interested. I encourage everybody to search up a couple of their favorite companies that they are excited about and begin to analyze and learn about their financials. You could start to compare them to others in their chosen industry to begin to get a sense of industry standards and where your company ranks. Best of luck and I hope everybody is headed on their road to financial success.
Article Credits: Sam Sanderson
Millionaire’s Digest Team, Contributor