Did you find yourself wanting to jump in on the recent hysteria with Game Stop by dropping your life savings on this stock as it skyrocketed up the charts?
Before you get burned, you may want to take a step back and understand some of the basic foundational elements that should be considered when investing in a company. Picking a stock based on social media hype or current headlines is a disaster waiting to happen.
You can’t truly be confident in your investment without researching what makes the company a company.
We here at Mangrove Investor are all about risk mitigation and when we evaluate opportunities, we do deep research to make sure a company has the underlying foundation needed to be a recommendation.
It’s not quite the dirty dozen but here are ten areas that, at a minimum, should be reviewed when deciding if a company warrants your money.
It starts at the top
The CEO is the face of a company and how they lead or behave can directly impact stock performance. Where would Apple be without Steve Jobs, how much influence does Elon Musk have on Tesla? Whether they are visionary leaders or have eccentric behaviors, company leaders can directly influence stock performance.
CEOs help determine the strategic direction of a company, but they can also make or break the business with their decisions. If the market does not have confidence in a company’s leadership, then this may well be reflected in the stock price. If you don’t think so watch a company stock when there are leadership changes.
Is the company bigger than the CEO, what I mean by this is what would happen if there was a sudden change in leadership? Is the company bigger than its CEO?
Business Model or No Business?
In its simplest form this means how does the company make money? However, this is done it should be relatively clear how a company business model works.
For a company like Amazon or Walmart it is a wide audience for high-volume low-cost products. Where a company like Tesla or Apple provides higher cost products to a more loyal following willing to pay a premium.
If you can’t figure out how the money is made, then you may want to consider not giving them any of yours.
Special Sauce!
What makes you special? And the same needs to be asked of a company you are about to invest in. Does the company have a competitive edge over the rest of the competition? This edge can come in many forms such as scale, Amazon or Walmart sheer size can be a barrier for other companies to compete. Apple’s rabbit and loyal following allows them to charge premiums for their products, or a brand name that is synonymous with a product like asking for a soda by saying give me a Coke, it endears recognition and loyalty.
Some special sauce barriers may not be as wide and need to be understood when investing in a company. Such as a patent that is about to run out. If there is success, there will always be those lurking in the background waiting to pounce. Companies need to understand what makes them special and always stay one step ahead of the competition.
This day and age, it is more important than ever for a company to stay in front of its special sauce. The rate of change and the new digital age, innovation is faster than ever. There is a long list of companies that found themselves left behind because they failed to recognize their special sauce was just a packet of ketchup. Blockbuster, Toys R’ Us, Polaroid, Boarders, Kodak and many more.
More and More Revenue
Revenue, revenue and more revenue, you want to see revenue growth year over year. This is not necessarily an indication of profit (other factors need to be considered) but is a key indicator that the company is at least growing in the right direction. If the revenue trend is generally upward then it is a sign that company is doing the right things and sales funnel seems to be working well.
Assess your Net
OK your revenue, revenue and more revenue look great! But what you’re peddling cost you more to make then what you are selling so it is all for nothing.
Net income is a bottom-line indication of a company’s growth with profit. If a company’s net income trend is decreasing, then growth may not be sustainable. This may be a sign that that the company’s operation is becoming inefficient. On the other hand, if net income is increasing over time, that’s a good thing showing the company seems to be growing and operating effectively.
So, check the net!
Sure, profit but how much?
Ok you got revenue and looks like you’re making some coin and have a net profit. But what does that really mean for the health of a company. Net profit margin is a key indicator expressed as a percentage as opposed to a dollar amount.
There are some fancy calculations to get you there, but we will not go into that, you can look it up if you really want. What is good to understand is that examining net margin is a great way to assess whether a company’s current business practices are working. Because it is expressed as a percentage it is useful when trying to compare profitability of different company’s regardless of their sizes.
For example, if a company reported a net profit margin of 20% then for every dollar generated the company keeps 20 cents.
There are a bunch of variables that can impact profit margin and it will fluctuate depending on the life of a company. Additionally, profit margins generally range differently depending on the industry sector. For example, services industry or even software companies you would expect higher margins then say an automobile manufacture or transportation company which generally have higher operating cost. When evaluating a company, it is good to compare at similar industry competition to decide how well they may be performing.
Regardless, net profit margin is perhaps one of the most important measure of a company’s health.
Debt – it’s about balance
Debt-to-equity ratio tells a story about a company’s financial capabilities. The ratio highlights the amount of debt (it’s liabilities) a company is using to run their business.
Understanding if a company’s debt is rising, falling, or steady can help to understand if a company is being overwhelmed by financial obligations or has room to expand.
As an example, Clean Cuts Yard Care wants to expand their business to a new neighborhood. They need more mowers so they can mow more grass and make more money… they go to the bank to ask for a loan. The bank looks at Clean Cuts balance sheet and finds $120,000 in assets (cash, equipment, etc.) and $100,000 in liabilities, mostly loans. This means they have a current equity position of $20,000. The bank divides Clean Cuts liabilities ($100,000) by its Equity ($20,000) to derive a Dept to Equity Ratio of 5. What this means is Clean Cuts has 5 dollars of debt to every 1 dollar of equity. Clean Cuts is highly leveraged. Well, for the bank Clean Cuts is very risky. The loan request is denied, and Clean Cuts cannot expand into more neighborhoods.
Clean Cuts competitor, Dirty Cuts was also looking at that same neighborhood for expansion. The bank looks at Dirty Cuts balance sheet and finds $150,000 in assets and only $50,000 in liabilities. This means they have a current equity position of $100,000. Dirty Cuts Dept to Equity Ratio of 0.5. What this means is Dirty Cuts has 50 cents of debt to every 1 dollar of equity. This low dept to equity ratio makes Dirty Cuts a low risk so the Bank approves the loan and Dirty Cuts take over the new neighborhood mowing their way to even higher profits.
Keep in mind that a company holding dept is not necessarily a bad thing. There just needs to be a balance. Its more about leveraging dept where appropriate and taking advantage more cost-effective cash opportunities. A company that has a very low ratio may reflect that they are not taking advantage of the cash they have for investment opportunities. On the other hand, being over-leveraged can limit a company’s ability in executing strategic business needs.
Companies need to understand their debt-to-equity status so that they can make knowledgeable decisions about important financial strategies.
The P over the E is where it Be!
Is that stock overpriced? And I do not mean is it expensive because the individual stock price is big bucks… heck a share of Berkshire Hathaway can cost a mere $400K more or less. Apple comes in at around $140 per share. Does this mean one is a better than the other? The answer is no because the share price does not tell us anything about the value of the company.
For this we can look at the price-to-earnings ratio (P/E ratio). This is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS)
P/E ratios are useful to comparing companies within the same industry. It can be used to determine how much investors are willing to pay for a stock relative to the company’s earnings.
Using Clean Cuts and Dirty Cuts again let’s examine how P/E ratio may influence your decision to invest. In this case both Clean Cuts and Dirty Cuts stock cost $10 per share. Clean Cuts EPS is $2 so its P/E ratio is 5 ($10 share price divided by $2 EPS) Dirty Cuts EPS is $5 so their P/E is 2. What this means is if you buy Clean Cuts you pay 5 dollars for every 1 dollar of earnings. But if you buy Dirty Cuts you pay 2 dollars for every 1 dollar of earnings. Using the P/E ratio buying Dirty Cuts seems to be a much better deal. Mow On Dirty Cuts!
Keep in mind you want to use P/E ratios relative to the same industry and it is not a single indicator of performance, only one of the many measurements to gauge a stocks value.
Free Money
Paying dividends by a company is often an indication of a more mature company with stability. Especially companies that have paid dividends over a long term. A dividend payment can signal that management has a positive outlook, which again makes the stock more attractive. This can cause a greater demand for a company’s stock therefore increasing its price.
Not all companies pay dividends and that can be ok. Many well-run companies choose to re-invest the cash back into operations. Young expanding companies typically will not make dividend payments as they are funding growth and opportunity. This can also be true for even well-established companies as they may reinvest earnings, to fund new initiatives, pay debt, or acquire other companies.
Doing Good
Yes, all the above is important for what makes a good investment. But to be truly good we here at Mangrove Investor believe a company must also “Do Good.”
When evaluating a company for investment opportunities we recommend looking for companies that align your values. In the past, thought was there must be a tradeoff between companies doing good and providing higher returns. We strongly believe that companies that operate with values can provide gains but more important reduce risk.
Again, there is a long list of companies that ignored certain operational values for the sake of increased profits only to have it all come crashing down. British Petroleum Deepwater Horizon explosion, PG&E fires & gas explosion, Volkswagen emissions scandal, and many more.
Doing good may be the last on our list but we here at Mangrove Investor would argue the most important.
For the Good
Michael Nichols
