Investing in Shares Part 2
So last week we discussed the intrinsic value of a share as compared to its market price, we discussed the clear distinction.
However, remember, it’s a share of a Company, so our analysis today should consider how to analyze the company itself and and reach a fact-based conclusion.
Every company is set up to grow, the business of a company is growth, if it fails to grow, it dies.
Valuing a company
So to value a company we must look as three major books
- The Income Statement (Profit and Loss Statement)
This account tracks how much profit the company is making, its short term in focus and its aim is to show revenues and expenses.
- The Balance Sheet
The Balance Sheet is a snapshot of the company’s financial condition. Its focus is usually a year. It shows what the company owns, listed as Assets and owes, listed as Liabilities and how much the shareholders have invested in the business listed as Shareholders Equity
In summary: Assets= Liabilities + Shareholders Equity
- The Cashflow statement shows how the company gets cash, and how that cash is deployed, over a period of time usually a year. The objective of the Cash Flow statement is to show the net cash position of the company.
So how do we value a company, I have a quick checklist
- Market Share; what market is the company in? is that market growing? what share of that market does the companies brand or company have? Are the brands market leaders? reading the Chairman’s and Management comments in the published Annual Accounts will give you an indication of new plans, competitive environment, threats to the company etc, these are subjective, they give you a direction, which must trend towards growth.
- The market share must translate to Sales. Read the Annual Reports, there is a page near the end that has a five-year summary of accounts, Sales should be increasing in percentage terms all these years, if not find out why.
- Sales should lead to Operational Profit (gross profit), i.e. the proceeds from sales should be able to pay for the operational expense of the company eg rent, PHCN, Commissions etc, you can also get this from the annual report of the company. If the company is borrowing to pay salaries that’s a red flag. So the company should make a profit from sales.
- Ultimately Operational Profit should lead to Net profit. The company should also generate enough profits to pay all costs which are not sales related eg government taxes, auditors remuneration, long term investment projects etc. Also, important to look at the 5-year summary. The company should be profitable, unless it’s a new company with high initial costs, in which case you are look see if loss were reduced each year.
- This then translates into cash generated. a company can manipulate profits but can’t manipulate cash earned. You can get the cash earned from the cash flow statement which in my view is the most important measure of financial strength. A good company must produce cash to pay salaries, dividends, fuel cars etc. When you look at the Cashflow statement, you want to view surplus cash generated from Operation i.e. total cash flow less Operational cash and Investing cash flow.
- Cash generated should then be paid as a Dividends, so you are looking at Dividends yields which is the divided paid divided by the price of the stock. However, some companies may not pay a dividend but reinvest that cash earned to grow the company, nothing wrong with that, but then the share price must rise to compensate you for not getting cash.
If you get a positive in all these, then they company seems good. if the trend of market share to sales to operational profit to net profit-cash to dividends is broken, find out why, that’s the analysis part. but also look at, Return on Assets and Return on Equity which are all in the annual report.
Remember a Low Price Earnings ratio is good, an High Earnings per share is also good, and all these are available in the annual report.
Finally remember Management Quality is extremely important. The Company is managed by people, the quality and experience of the management team, is also a very important
So let’s stop here, next week, I will share with you a proven analytical way to build a portfolio in shares