The performance of a company can be analysed by researching its financial information and judging that company’s potential future share performance based on the numbers it discloses to its investors. This is usually referred to as fundamental analysis.
Company analysis needs to be comprehensive, this is not something that can be carried out on a cursory basis as it involves a wide range of data and can be time consuming but highly valuable. Below are some of the key areas of a company’s reporting that you should be paying attention to in your analysis:
Company income statement
A company statement is where a firm reports its revenues, costs and net earnings and it includes various calculations of a company’s income. Both quarterly and annual reports are important, as they will help you to see whether the company is meeting expectations and how it is performing on a year-to-year basis.
An income statement is usually made up of the following:
All the sales the company has generated, before any costs are subtracted.
- Cost of goods sold
How much the company has spent on actually selling its products or services.
- Gross margins
How much money the company is making from its sales before you subtract operating costs. The gross margin ratio is a percentage figure that can be calculated by dividing gross profit by net sales. The higher it is, the more efficient the company is in making sales.
- Interest payments
Payments on short and long term interest. This can be used to calculate the interest coverage ratio – dividing earnings before interest and tax (EBIT) by interest expenses will provide an idea of how likely it is a company will go bankrupt. A low ratio means that a company is having problems meeting its debt repayments.
Company balance sheet
The company balance sheet provides you with a snapshot of a company’s assets and liabilities at a particular point in time. This includes:
Everything a company owns
Debt or any other claims on a company’s assets made by its debtors
- Shareholder equity
All the claims made by owners or shareholders of the company
- Assets vs liabilities
The balance sheet is called this because a company’s assets and liabilities should balance one another. Assets and liabilities will be listed on a balance sheet according to their level of liquidity – so current assets, those that are most disposable, would include cash and anything else that the company can quickly turn into cash.
Analysts frequently use ratios to analyse companies in an effort to gauge their financial health. Here are some of the most useful financial ratios which you can use to measure performance:
Price/earnings ratio: Compares a stock’s earnings with its share price, the price/earnings ratio reflects how much you are paying for each dollar/pound of a company’s earnings and is a measure of how expensive a share price is relative to corporate earnings. Generally, a PE ratio of 10-15 represents a reasonably priced stock, but the market has been known to tolerate higher ones.
Price/book ratio: Compares the market’s valuation against the value that is illustrated by the company’s own valuation via its financial statements. The higher the ratio, the more the market is willing to pay for a company above and beyond its tangible assets (e.g. buildings, machinery, inventory). This also accounts for intangible assets – e.g. brand, customer loyalty.
Return on assets: Like the PE ratio, the return on assets (ROA) is a percentage measure and it looks at earnings after taxes, i.e. how well a company is currently performing for shareholders.
Return on equity: The ROE looks at how much profit the company is generating for its shareholders, again expressed as a percentage.
Note: It is often worth comparing companies in the same sector to get a feel for how well they are performing against each other.
Beyond your analysis of the company’s financials, you should also be looking at the business itself. Here are some questions you should be asking:
- Does this business own any copyrights or patents? This can be particularly important for companies where intellectual property is important to the overall value of the company, for example in software development or biotechnology.
- How has the business been performing over time? A year’s worth of figures won’t show much – by assessing a company’s figures over a number of years, you will get a better idea of how a company is performing vs its competitors.
- How are expenses faring compared to a company’s gross profits? If they start increasing at a faster rate than gross profits, this can mean that a company is having problems controlling its costs, which will hurt future profit growth.