Researching a Business

Researching a business is a process and we want to show your ours. We show you the high value locations of company information relevant for an investment. These locations are all free and open source. No large subscriptions or expert knowledge is needed, just a computer and your own experience. Now more than ever, the retail investor has access to research, invest, or trade with relatively low overhead costs. Even most trading platforms are commission free today. Even the seasoned professional should find value in this checklist The perfect time to start/continue learning about business and investing is right now, today!

To understand a business, you’ll need a basic understanding of accounting and the fundamentals. To upskill your accounting knowledge, check out these videos on YouTube:

1. Income Statement: Link

2. Balance Sheet: Link

3. Statement of Cash Flows: Link

Beyond the fundamentals, the investor needs to consider a series of questions on the underlying company. The 10 steps below provide a strong baseline for understanding a company.

1. Reasonable price appreciation

2. Type of company

3. Revenue stream

4. Strategy

5. Industry

6. Competition

7. Managing the company and incentives

8. Current valuation

9. Margins and return on capital

10. Risks

Sources for Researching a Business

Below are the main free sources (And what they're used for) you need to access to gain a pretty good understanding of what a company does, how to analyze it, and continuously monitor the business. These sources are referenced throughout the post. Those sources are:

1. Yahoo! Finance (News, financial data, great historical data with premium membership)

2. SEC Edgar (Company filings like 10k) (I use this for learning the business model, revenue streams, strategy, and management incentives)

3. The company’s website

4. ROIC.AI (I use this for reading quarterly transcripts. The other functionality is much like yahoo/wisesheets, where there's relevant financial data)

5. wisesheets.io (Super valuable formula-based model building within excel)

The Process

Below, we walk through the high-level considerations of each step. In separate posts, we expand on what to look for and different nuances. Investing is a process, not an outcome so it's important that the reader leverage as many different authors to gain a wholistic understanding of your own investment style and define your personal circle of competence.

1. Reasonable Price Appreciation

The reasonable price appreciation is a function of market capitalization (or market cap), valuation (price paid), and the current macro environment. The market cap provides detail on the company’s size in relation to other company’s that exist, the markets expectation of future cash flow, and a gauge for size in relation to the market or a company's TAM (Total Addressable Market). For example, if one is looking for a multi-bagger, then a smaller market cap in relation to the rest of the market is more desirable then a larger market cap, but with considerably more risk.

All things being equal between Monster and Coca-Cola, Monster has a stronger chance of becoming a multi-bagger based on the current price. An increase in price of 10x for Monster would result in a market cap of $530 billion (not including stock buy backs or dilution). A 10x in Coca-Cola would make the company worth $3 trillion. Trees do not grow to the sky and at some point, the investor needs to consider what type of "future" growth exists in a company.

The lesson here is that the smaller the market cap, the more room there is for a company to grow if the current price is reasonable. (one wouldn’t expect a small cap company with a price over revenue of 25x to appreciate in price. The company may be growing fast physically, but the price appreciation is nil). Company’s will only ever grow so large, and the larger the company the more energy needed to get the stock to grow.

2. Type of Company

This is super important because an investor should only invest in companies that fit their strategic vision. Answering this question up front saves a lot of time by filtering out companies that do not match your strategy. Type of company should be a conditional statement up front in your analysis to filter out inapplicable companies.

There are five main types of companies:

1. Stalwarts

2. Growth

3. Cyclicals

4. Turnarounds

5. Asset Play

A quick hint: If the company is a small cap, no dividend, and growing revenue then it’s most likely some sort of growth company. If large cap, with stable or declining revenues, and a dividend then you’re looking at a stalwart

Stalwarts

These companies are the old mature cash flow machines. The companies have wide moats and healthy cash flows, but the bulk of their growth is behind them. These companies should be expected to have revenue grow at a pace equal to the US economy (3%). Investing in stalwarts requires a return either through dividends or stock buy backs. Any sort of price appreciation will be minimal or match the market rate of return. This is because the market will have certain expectations already built into the price, and the company has low probability of outperforming those expectations. Stalwarts will continue to acquire smaller business, provide dividends/buy backs, and manage expenses to provide investors a consistent rate of return.

Typically, these stalwarts are larger mature companies. They’re generally less risky than smaller growth companies. The stalwarts are less risky because of the wide diversification in customer (revenue) base, strong branding, and low reliance on any one internal manager. Additionally, larger companies experience operational efficiency due to economies of scale, ability for incremental technology improvements, and greater negotiating power over suppliers. Technology improvements over time will continually improve a stalwarts operating costs and provide incremental margin expansion. Their cost of capital is much lower because of this lower risk. (i.e. a stalwart can go access credit at a much lower rate because of a higher bond rating and has lower equity volatility.) This stability and lower risk should require higher multiples on cash flow.

Growth

Growth companies are smaller in nature. (but technology companies are proving this isn't always the case) Typically, there is more market opportunity and the company adds some value proposition to a new or existing industry. Growth stocks are betting on much larger cash flows in the future than they presently have. Thus, these growth stocks tend to be overpriced when the market is confident about future growth.

There are two main ways that a company can grow its cash flow:

1. Acquisitions (Inorganic)

2. Investing in capital assets and increasing capacity (Organic)

All companies can continue to grow, but growth companies will not be distributing dividends and will have very little free cash flow. A growth business should be plowing most if not all cash flow back into the business through investments in higher synergy acquisitions or capital assets to increase capacity. The tricky part is how they finance this growth. A company can grow by reinvesting free cash flow, taking on debt, or issuing stock. For example, technology growth companies show negative cash flow and rely heavily on issuing stock to grow faster than their natural cash flows allow.

Growth companies are also severely sensitive to the business cycle and interest rates. Growth stock can demand a high premium on valuation during ascending business cycles. (they might be selling for 25 times revenues while stalwarts sell for 4-10 times revenues). When the business cycle turns down and revenues collapse and/or interest rates rise as assets sell off, growth stocks will see valuation collapse. This means the underlying business may not have changed but the price the market is willing to pay is drastically different. You can loose more than 90% on a growth stock with just valuation collapse. If you want to see this reasoning from a model standpoint, compare long duration and short duration bond prices with varying interest and coupon rates. Long duration bonds get crushed when interest rates rise.

Cyclicals

All businesses are cyclical in some ways, but a cyclical business exists in specific industries that are highly sensitive to the boom bust of the business cycle. Examples of cyclical industries are:

1. Construction

2. Travel

3. Commodities

4. Non-necessary goods

The cyclical businesses perform very well from the bottom of the cycle to the top of the cycle but revenue and earnings drop of the cliff when the economy slows down. It’s important to understand if one is dealing with a cyclical industry because the valuations behave differently. When dealing with cyclicals, the P/E ratio is backwards…Sell when a cyclical when the P/E is lower than normal and buy a cyclical when the P/E is higher than normal.

Turnarounds

As Warren Buffett often says, “Turnarounds rarely turn.” We won’t spend too much time on turnarounds because the company is usually in the dumps for a reason. A turnaround is a form of company that has lost market share, branding, pricing power, etc and is valued extremely low. The valuation is low for a reason, however because there is a significantly lower probability that the company will recover. If looking for a turnaround to invest in, the company should have a good unique product with a new/revitalized management that has a sound strategy for the turnaround. If the product isn’t good, an investor should walk away.

Asset Play

An asset play is similar to a turnaround where an investor is looking for the market to recognize value that is currently overlooked. Asset plays may have a super low price/book ratio or the investor believes that the balance sheet is not accurately showing an asset value. (This is a function of the accounting rules. For example, land is not allowed to be marked to market value on the balance sheet. Companies that have massive amounts of land on their balance sheet from 1900’s are still holding that land on the balance sheet at 1900 prices. If an investor believes that land value will be realized somehow and is currently being overlooked, that’s an asset play

3. Identify the Revenue Stream

How a company makes money is the most important factor. Learn why revenue is important and what to look for here. Revenue is divided into two main parts:

1. Price of the unit being sold

2. Quantity (volume) of the unit being sold

Historically, the largest factor in long term sustainable growth is growth in revenue volume. This in turn leads to sustainable earnings growth (assuming costs are controlled). Identify the recurring and growth nature of revenue volume.

This information is open source on SEC Edgar. Let’s walk through the process to identify a company’s revenue stream.

Type “Monster Beverage” into the search bar and click on the link (or hit enter).

The following screen shall appear. Click on the “10K” drop down and find the most recent 10KThis page will appear, click on the table of contents. The description of revenue will be hiding in one of two places, either Item 1: Business or Item 7: Management’s Discussion and Analysis. If there is no obvious description of revenue, then the company is not worth investing in. A company needs clearly defined sales channels. In Monster’s case, the revenue is described in section 7. This section is the most common location for revenue descriptions. Section 1 is also great info for understanding the business but Section 7 has more details on the particulars. The company sells a lot of products but most of the revenue is attributable to one branded item, Monster energy drinks. The other brands are part of the “strategic brand” representing the companies future revenue growth engine.Further on in Section 7, there is a dedicated “Net Sales” section. The company will talk through metrics that help investment decisions. Notice here, that Monster is attributing most of their year over year (YoY) revenue growth to Volume.

4. What is the Strategy

A company’s strategy is in the 10k filing at SEC Edgar. Follow the same procedures from above to get into the 10k document. In the 10k document, click Ctrl and “F” at the same time to pull up the search function. Type in “Strateg” and click enter. A company should have have a strategic initiative for growing the company. If not, the company may not want to grow, which results in no significant growth in share price.

Searching on “Strateg” helps include “Strategy” and “Strategic” in the search results. For example, Monster has a strategic brands business segment which is lower revenue than the Monster brand but much higher gross margin. Growing this segment will result in higher net income growth resulting in more cash and higher stock price. Additionally, the company wants to expand into international markets and the alcohol industry. All of this information was gathered from searching “Strateg” within the 10K. See screenshots below:

5. What is the Industry

The industry determines what type of company the reader is investigating and the growth characteristics for that company. There are two main company characteristics when reviewing for growth stocks in an industry:

1. A company that is in an emerging industry

2. A company that is bringing a new production/service to an old existing

The easiest way to gain a quick understanding of the industry is on a company’s summary page on Yahoo! Finance. Scroll down and view the “Company Profile” summary. Or for more in depth, click on the “Profile” tab.

6. What is the Competition

Competition is dynamic and may change over time. The competition will typically be reported in Item 1 or Item 1A. Otherwise, if you know the industry then you can infer what the competition is. For simplicity purposes, hit “CTRL+F” in the 10K filing and search for “Competition.” There with either be a description of types of competition or a direct mention of other companies. Monster does a great job of breaking out competition by individual product.

7. Who is Managing the Company and What are the Incentives

Management analysis is more qualitative and is hard to assess for the individual investor if there’s no prior performance history by the managers.

The first step is identifying who is on the management team. Go to SEC Edgar and look up the company’s 10K filing. The list of executive management will be under Item 10 titled Directors, Executive Officers and Corporate Governance.

The second step to performing due diligence on management is to look through the incentives. The incentives may be in “Item 11: Executive Compensation” on the 10K filing but most companies reference out to the annual proxy statement titled “DEF 14A: Other definitive proxy statements.” There are multiple of these statements so choose the one that is immediately after the release of the annual 10K.

Look up executive compensation, equity compensation, and any bonus plans in the table of contents of the DEF 14A Proxy Statement. Monster’s incentives are based on “Adjusted Operating Income.” The definition for this metric will be listed in the 10K or in the DEF 14A Proxy Statement. In Monster’s case, it’s in Appendix A of the Proxy Statement. Search for “Adjusted Operating Income” to identify.

8. Current Valuation

It doesn’t matter how great the company is, if you overpay then there’ll be a terrible return. I recommend going to Yahoo Finance to review the valuation metrics. I have a premium account which provides access to all historical data within Yahoo’s database. This is not necessary, but I love it. The free version will work fine for performing due diligence on a stock.

Ultimately, cash flow and the multiple paid for cash flows are the only two variables that matter. See “How to Value a Company” to learn about discounting cash flows. Bonds and annuities are easy to value because the cash flows are known. Stocks are more complicated, thus are more volatile.

9. Company Margins

A company’s margins are valuable for several reasons:

1. Provide hints into the moat the company has in the industry.

2. Additionally, the margins show the growth potential over time. For example, if a company has operating margins of 20%, it’s reasonable that the operating earnings will grow at 20% annually overtime. This makes sense if all operating earnings are reinvested in the business and the rate of return is 20%.

3. The last main point is margin expansion. You’ll want to identify if the company plans to expand margins in the future due to lower costs or a change in the way they generate revenue. For example, Monster’s “Strategic Brands” have higher margins. If this becomes a higher mix of revenue, Monster’s margins will expand leading to higher cash flow.

Where can you Find a Company’s Margins

There are three main margins that an investor will need to know:

1. Gross Margin

2. Operating Margin

3. Free Cash Flow (FCF) Margin

The easiest place to find a company’s margins is yahoo finance. Go to Yahoo! Finance and search MNST. There is a bar with several tabs. Click on “Financials”

Once on the financials page, the income statement shows gross margin and operating margin. To find these margins, we want to

1. Divide gross profit by total revenue (in the 2021 case: 3,108,513/5,541,352 = 56%)

2. Divide operating income by total revenue (in the 2021 case: 1,603,249/5,541,352= 23%).

The third margin, free cash flow/revenue is found on the cash flow statement. On the Yahoo! financial tab, click “Cash Flow”

The FCF will be on the bottom. In the 2021 Case: 1,098,288/5,541,352 = 19.8%

Finding Margins in the SEC Filings

Valuable information on margins is reported in the 10k on SEC Edgar. Many companies track performance through a specific margin metric. Monster tracks performance by the “gross billings” metric as outlined in the 10K filing. This is a revenue metric but many companies will highlight some sort of “margin” performance for year over year comparison.

10. Risks and Uncertainties

The 10-k will list out managements defined risks to the business.  Unfortunately, most of these risks are boilerplate which means all companies have the same “risks.” Competition in the risk/business section is unique between companies and we highlighted that above.

Risks to a stock are largely the price one pays, and the amount of total money paid for the stock. Risk is exposure and is known. Uncertainty is the unknown. Uncertainty shows itself in volatility which is the market reacting to information. Known Risks are largely priced in to market prices so when an event occurs that's against that pricing, large movements take place. Even though risks are none at "t" point in time, there's a probability that the risks can change at "t+1". There are two ways to look at risk:

1. Identify all known and unknown risks, assess them against current pricing, and continuously monitor these risks and developing risks over time. This is exhausting because you're really trying to gain some predictive or hyper reactionary ability. With this strategy, one is trying to outthink the market. Through this view, risk is volatility.

2. Control one's exposure to risk. This is extremely efficient if one has the luxury of controlling exposure. In this strategy, you identify that an investment will have risk, that risk is largely unknown and will change over time, and you have zero predictability in managing these risks. Through this view, risk is total investment.

Since we can’t see the future, an investor needs to accept the risk of an investment as total. Risk questions you need to consider are:

1. What is the type of company?

2. Will the company grow?

3. At the current valuation, will negative or positive news affect the stock?

4. Is the revenue and business model viable long term?

5. Am I comfortable losing a large portion of my investment if the thesis isn't correct?

6. What is the size of the company? (Small caps are more volatile…Can you stomach the volatility?)

Risks that the company discloses are reported in Item 1A: Risk Factors on the 10K filing.

Summary

Reading through these steps and getting more familiar with the terms and resources will provide one the tools to begin a solid due diligence process. These steps are critical for understanding a company.