10 steps to analyze a company

Why analyze a company when you buy its shares?
You essentially become a co-owner of the business. Imagine that a friend of yours offered you a profitable investment in some business — would you begin to figure out what kind of business it is and what it can bring you? Obviously.

But for some reason, when it comes to stocks, many investors limit themselves to reviewing news about the company or the opinions of analysts. And all the answers to the questions lie in a document called financial statements. We’ll show you how we turn a long and complex document into a company rating using our method.

Our eyestock rating consists of 10 indicators, each of which we compare with a so called benchmark. We set the benchmark for our system ourselves, using best practices, investment experience and maths methods. Having received the comparison results for 10 parameters, we build-up the company’s rating, taking into account the importance of each indicator. In other words, all 10 components of the rating have different weights.

In this article we will talk about all 10 indicators that we use to analyze a company so that each of you can use our method in its entirety or borrow something from it to create your own strategy.

The first indicator is called Gross margin. It tells how much money a company has saved from its revenue after all the costs incurred to produce goods or services. This is a very good indicator of whether the company has any significant market share or competitive advantage over the others. If this value is equal to or greater than 40%, then the production of goods or services itself is very economically efficient, and the company has good prospects for growth of the business itself.

The second indicator is Net profit margin. After a company has produced its products, it needs to be sold! And for this you need to incur administrative, business, marketing expenses and all other types of expenses not related to operating activity. The less a company spends on these items, the stronger its market position, which means that investing in its shares promises a huge potential profit. If the indicator value is more than 20%, such a company can be called strong.

However, the numbers that we see in the “net profit” column cannot always be trusted! A company may report a profit of 1 million, but only 500 thousand was credited to its accounts. What could this mean? In this case, the quality of the company’s earnings can be characterized as quite low. The remaining 500 thousand turned out to be only paper or accrued profit. If we return to the language of formulas, we can divide the cash flows from operating activities for the last 12 months by the net profit from the income statement and evaluate the earnings quality. If this ratio is 100% or higher, this is a very good signal for investors.

As you noticed, all of these 3 indicators evaluate the profitability of a business and serve as a measure of the level of competitive advantage of a business. In order for the algorithm to be integral and logical, we combine them into one block, which we call Profitability.

At the second stage of company analysis, we evaluate the debt burden and how far-sighted the company’s management is, and by what means the company achieves success today. For simplicity, we call this block Balance.

Let’s go into more detail.

If we subtract its liabilities from all the company’s assets, we get the value of equity. In financial analysis, it is customary to evaluate the debt burden using the classic debt-to-equity ratio. The standard values of this indicator can be used differently, just as the interpretation of this indicator by different analysts differs. We are convinced that an ideal company should be able to keep its debt under control. This means that debt not only should not exceed equity, but also be significantly less. Twice. For reliability.

However, this indicator can be subject to objective criticism, since it does not take into account the real cash flows of the business. And this is important, since many companies use revenue, profit and cash operating flows to internally assess their debt burden. To make our model comprehensive, we added another ratio to the debt/equity one. It is cash flows from operating activities to debt or CFO / Debt equity. In other words, the debt can be as large as you want, the only thing is matter that the company earns sufficient funds to cover and service it. If operating flows for 12 months completely cover the amount of debt, we consider such a company to be a reference company according to this criterion. Of course, in practice no one will pay off debt in this way immideately, but the meaning of the indicator is different: it is a kind of stress test.

The current ratio is also an important part of our puzzle. We compare all current assets and liabilities. That is, those assets that can be turned into a cash within 12 months, and those liabilities that must be repaid within the same period. Why do this? Short-term borrowing is easier to attract, but more expensive! Therefore, it is very important to monitor whether the company is abusing them. To a certain extent, this indicator can serve as a leading indicator of debt burden problems. If current assets exceed liabilities (and in our case with a reserve), then everything is fine.

After analyzing the indicators of profitability and debt burden (or balance), there are still 2 stages left: assessing the effectiveness of the company’s management and the stability of its development.
At each step we analyze 2 parameters.

Return on equity (ROE) is one of the most important parameters for analyzing any company. One hundred percent! The return on equity ratio shows how much net profit a company earns per unit of its equity. If this value is less than the risk-free rate or the return of a stock market index, then a question arises about business efficiency. Therefore, we use 20% as the evaluation standard.

However, it is important not to fall into the trap of a very high ROE.
For example, the profitability of AAPL is enormous — 158% as for the reporting period of December 2023.
This is almost 8 times more than our standard. Does that mean AAPL will get x8 to its rating score?
Firstly, the rating is configured in such a way that even though the profitability will be 1000%, the score will still be limited to x2.
Secondly, for such a cases we need a second efficiency measurement indicator — ROIC or return on invested capital.

We use assets less cash and current liabilities as invested capital, but retain short-term debt and a small portion of annual revenue. Also, in the ROIC formula, profit before taxes is used in the denominator to level out the influence of jurisdictions, so the businesses can be compared with each other.

Apple’s ROIC is also very high, but 57%, not 158%. It allows a more objective assessment of the management efficiency in this company.

The benchmark and weight of ROIC are the same as ROE.

The final step.
Imagine that 2 portfolio managers offered their services to you. They want to take control of your savings and show you their results for recent 5 years.

The first manager demonstrates high, but not stable results. In one year he has +70% return, in another only +30%, and in the third -40% and so on. The second manager shows more modest results around 20%, but stable. Who would you trust with your money?

I hope you would choose the second one. Because higher stability or sustainability indicates that the probability of achieving success in the future is higher.

In order to search for the most stable companies within the system, we calculate the ratio of the average increase in net profit and the spread or volatility of these values over 2 years and 5 years. To do this, the standard deviation function is used in the denominator. It is easier to show stability over a short period of time, so the average profit should exceed its deviation, while over a 5-year period we will be happy with their equality.

Let’s sum it up. Here is the rating for Apple Inc.

So, 10 indicators, 10 benchmarks, 10 comparisons. And the only rating. We tried to make sure that a company that scores 100 percent points is truly remarkable. If we return to the example of Apple, then the final rating of the company according to our method is 109%, which is 9% higher than the “benchamrk” or kind of ideal company to invest. What does it mean? We assess the company’s business as attractive from a current point of view, or, in other words, it is a relevant idea for investors.

However, do not forget that even the best company can be bought at too high a price and see your capital melt away in the short term. To prevent this from happening, you need to assess the value of the company along with its business indicators, but we will talk about this in another article.