How to analyze a company: value versus growth

Before buying a stock it helps to understand what the company does, how it makes money and whether its price makes sense. You do not need to be an accountant: with a few numbers and good questions you can avoid many mistakes.

Where to find the information

• Investor Relations on each company's website: presentations, quarterly and annual reports.
• SEC EDGAR, the US regulator's public system, with the official filings: the 10-K (annual) and the 10-Q (quarterly).
• Financial data websites that summarize the numbers. Use them as support, but confirm what matters in the official filings.

The three financial statements

1. Income statement: how much it sold (revenue), what it cost and how much it earned (net income). It answers: does the business make money?
2. Balance sheet: what it owns (cash, inventory, buildings) and what it owes (debt). It answers: is it healthy or heavily indebted?
3. Cash flow statement: the money that really comes in and goes out. Free cash flow (what is left after investing in the business) is one of the most important indicators: a company can report profits and still run out of cash.

Value companies: stable and profitable

They are mature businesses that make money consistently. They are analyzed mainly by how much they earn and how much that profit costs:

• P/E (price to earnings): how many years of earnings you are paying for. A P/E of 15 means you pay 15 times one year of earnings. Compare it with similar companies and with its own history.
• Net margin and return on equity (ROE): how efficiently it turns sales and capital into profits.
• Debt: compare it with cash flow; debt that can be repaid in a few years is manageable.
• Dividends: if it pays them, they should come from sufficient cash flow.

Growth companies: the future weighs more

Many do not make money yet, or make little, because they reinvest everything to grow. Judged only by P/E they look extremely expensive; you need to look at other things:

• Revenue growth: how much do sales grow each year? Does it last?
• Gross margin: how much of each sale is left before operating expenses. A high margin (for example in software) allows it to become very profitable as it grows.
• Market size: how much more can it grow?
• Cash burn: if it loses money, how much cash does it have and how long will it last?
• P/S (price to sales): useful when there are no profits yet.
• Rule of 40 (in software): revenue growth plus free cash flow margin; above 40 % is usually considered a good balance.

Questions before buying

1. Do I understand what the company sells and who pays it?
2. Why do its customers choose it over the competition?
3. Is revenue growing? Does it make money, or does it have a clear path to do so?
4. Does it have more cash than debt, or manageable debt?
5. What would have to go right for it to be worth much more in five years? And what could go wrong?
6. How much would it weigh in my portfolio if I am wrong?

What no number tells you

Analysis reduces mistakes but does not guarantee success. Even professional investors are often wrong; that is what diversification and a long horizon are for. At Viernes de Invertir every company in a portfolio has a plain description of what it does, in each portfolio's «Catch up» guide. It is a starting point for your own research, not a recommendation.

What matters to get started

• Read the three statements: income, balance sheet and cash flow.
• Value companies are measured by their earnings; growth companies, by their growth and their path to profitability.
• Ask your questions before buying and decide how much to risk on each one.