by elmads

Introduction

Knowing how a company makes money, is also understanding generally what it does.

On an individual employee level, when somebody ask us what we do for a living, we usually answer such question in a generalized manner, either by saying what we do at work and/or our degree. That’s usually how most of us tell others how we make money. Companies also do this, but they usually communicate their business via their comprehensive reports.

In the first part of this two part articles. I wrote about the initial simple steps that I follow in order for me to be able to understand what a company does. “How to Understand & Research a Public Company from Scratch”

Once I am able to grasp and understand what a business does, I then move forward to the next step, and this is reading the Management Discussion & Analysis (MDA) and its Financials.

Yes, you read that right, we continue further by reading the report, unfortunately. 😂

Management Discussion & Analysis (MD&A)

Every annual, half year, quarterly reports and call transcripts of a company has this portion. This is where the management discusses the performance of the company in a given point in time. They talk about the compliances, risks, goals, new projects, capital allocation methods and their future plans.

Why is this important? well because this the section can guide us to the possible future of the corporation, based on what the management says it has done, is currently doing and will be doing.

To make it clearer, just look at it in this point of view.

• The 1^st step of understanding a company reflects the present time of what they do, while
• The 2^nd step of reading the MDA, is to paint a picture of the company’s future based on the actions they are taking now and will also plan to do.

I’ll use Meta platforms as an example.

Step 1: Access again their Annual Reports, then find the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Then Click the link.

https://investor.fb.com/financials/default.aspx

In here, Meta platforms discussed their revenue performance in 2021, and compared it to 2020. Maybe you’re wondering why 2021? why not 2022 as that is the current year in this time of writing. This is because Annual reports are always released after a few months at the end of every year.

If it is a quarterly report, then they will compare a certain quarter of the said year to the same quarter last year. For instance, 1^st Quarter of 2022 performance (from January 2022 to March 2022), vs 1^st Quarter of 2021 performance (from January 2021 to March 2021).

Step 2: Access the most recent earnings transcript of the company as shown below.

https://investor.fb.com/financials/default.aspx

First, let me explain what is an earnings call. It is like is a conference call between the management of a public company and interested parties eg; investors. This is like a quarterly or annual report, but instead of us reading it, the management will be the one discussing the report via a webcast to the interested parties for a couple of minutes, or hours.

Similar with written reports, the management will discus the performance of the company, their earnings, their analysis for the company, their plans and goals in an earnings call. The best part here is the question and answer portion of the interested parties at the end of the management’s presentations, as most concerns about the company will be further discussed.

The earnings call transcript, as the name implies, is the written record of the conference call. If we want to hear the conference call itself, then we could access the webcast which can also be seen in the company’s investor relations portion where the reports are placed.

That being said, not all public companies will have a recorded webcast and sometimes not even a call transcript.

Financial Statements

Here is the boring yet most crucial part of investing. The financials of a company, don’t worry, my way of understanding a company from scratch through reading their financial statement is a straightforward process.

It’s a quick analysis where you would not need to have the advance knowledge on how to read the numbers in the statement, but we do certainly need the fundamental knowledge about it.

I made 3 blogs discussing the basics of every financial statement titled “The Income Statement”, “The Balance Sheet” and “The Cashflow Statement”. You could check these blogs of mine.

What I initially look into are the following; based on each financial statement.

1.) Income Statement

• Revenue Growth – Increasing year on year
• Earnings Before Interest & Tax / Operating Income Growth – Increasing year on year
• Income Growth – Increasing year on year
• Profit Margins – this is computed by dividing the Net Income of a company to their Revenue in a given year. This should be either increasing, flat or fluctuating year on year. A decreasing Profit Margin may indicate a lot of thing such as increasing costs to produce their revenue (Could indicate losing competitive advantage), or operating costs, increasing taxes or payments for their debts.

Let’s take a look at Meta’s 10 years data for its Revenue, EBIT, Income and Profit Margin shall we?

2.) Balance Sheet

What I quickly check and focus on here is the company’s debt.

Debt to Equity should be low and/or manageable – In an individual’s finances, it’s how much debt do we have relative to our net worth. I always look for less than 100%. The debt to equity portion is dependent on the industry of the company. The telecommunications companies tend to have higher ratio of 100%, this is because they are a capital intensive business, meaning they need large capital to maintain their business.

I’ve discussed Debt-to-Equity and other liquidity ratios comprehensively in my articles titled “Fundamental Analysis – Liquidity & Debt Metrics Part 1“ & “Fundamental Analysis – Liquidity & Debt Metrics Part 2“

Remember that if the debt is larger than the company’s net assets (Equity), then their financial health is riskier than others. Like for example if economic recessions happen, a corporation will still need to pay their debt obligations even if they become unprofitable because of the recession. If ever a company goes into bankruptcy, how will they pay their debts when their debts are greater than their assets? That’s not even the worst part, because the owners of the business (shareholders/investors) would lose all of of their invested capital in the company because nothing can be returned to them once all assets are sold. Why? well because the priority in bankruptcy is to always pay first their creditors, then the preferred shareholders and lastly the common shareholders only if there is still money left once creditors have been paid.

I’ve discussed bankruptcies in my article titled “Bankruptcy in the US”.

Below is Meta’s Debt to Equity

3) Cashflow Statement

Increasing Free Cash Flow – Free Cash Flow is the real and true amount of money that all businesses generate. Money of a company stemming from their cash flows from operations less capital expenditures.

As much as possible, I look for companies who have an increasing Free Cash Flow. In an individual level, who wouldn’t want an increasing salary year-on-year, isn’t it?

It is the actual money that a company uses to do the following endeavours:

1. To Pay Dividends
2. To Buyback Shares of the company
3. To Pay Debt
4. To Acquire another company
5. To Reinvest the money back to the company

A good management manages and allocates the company’s free cash flow to increase further its intrinsic value and in turn their shareholder’s value.

Let’s see Meta’s Free Cash Flow.

The Management’s Plans

• Meta platform’s management is currently investing in the Metaverse, a network of 3D virtual worlds focused on social connection, this is where they plan to slowly pivot their business operations in the future.
• Currently they are strengthening and improving their reels in both Facebook and Instagram. An answer to the rising competition with TikTok.
• They are also adding advertisements in their reels now.
• They are continuing to improve their algorithms for both the image ads and most especially their reels, for it to be more efficient in targeting and connecting the ads to its proper potential and existing customers.
• They are looking for ways to further monetize WhatsApp.

• Their push to selling their hardware devices such as Meta Quest 2, Ray-Ban Stories and Portal, are one of their ways to stray away from the clutches of Apple’s iPhone devices. This is due to Apple’s privacy changes last year 2021, where the amount of data harvested by Meta substantially became lower because of it. Meta Platforms said that they estimate to lose approximately $10 billion USD for 2022 because of Apple’s privacy changes.

Meta Platforms Quick Financial Check based from the previous paragraphs and slides above

• Revenue Growth: ✔️
• Income Growth: ✔️
• Profit Margins (Not decreasing): ✔️
• Debt to Equity (lower than 100%): ✔️
• Free Cash Flow Growth: ✔️

To Sum It Up

I practice this simple approach, to look for a potential company to own, and invest. If the company pass my simple method, then I’ll do the next step which is to dig deeper and immerse myself into the company’s past reports. This is where it would takes me days, weeks, and even months to do the deep dive research of a company.

As you’ve noticed, what active fundamental investors do is reading. The plus here is, information is widely accessible and available in the digital space for free. Additionally, there are tools that can make our research faster to save us more time, and most of these online investment research tools initially can be used for free, but then it will require subscription from their users when accessing their advance tools.

Value investors enjoy the process, the hunt for a wonderful company.

I am not the type of investor who is obsessed to look for the next Apple or Amazon, I only search for companies that will grow, compound and do great over a long period of time. If the company I own or plan to own, eventually becomes the next Apple or Amazon, then that’s just a plus for me. That’ll be like hitting the jackpot, luck just played its hand and not because of my investing skills. I just want to make my money work for me over the long stretch of time, and if learning more will help me achieve my goals, without needing any physical labour and effort, then that’s a path I am absolutely willing and gladly to do for the rest of my life.

<—See Part 1 – Understanding a Public Company from Scratch – MD&A & Financials

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.