Last week, I shared the first five of 10 questions that you must be able to answer before you decide whether or not to buy a share of stock in a particular company. If you missed that guidance, I encourage you to check it out. You may want to review those questions because the next five build on their answers. The questions answered in that article are:
1. What does the company do?
2. What are its key products or services?
3. At what business unit or units does the company make most of its profits?
4. Who are the key competitors and how are they impacting the market?
5. What is driving growth at the company?
The gist of these 10 questions is to help you understand the company you are investing in and items to pay attention to when sizing up what’s on the horizon, both good and bad. After all, how do you know how to gauge a company’s business and the competitive landscape if you don’t have a firm understanding of what the company does and how it makes money for itself and its shareholders? These are some of the tools I use each time I look at a new opportunity that I may share with subscribers to my Growth & Dividend Report newsletter.
Okay, let’s get to questions 6 and 7.
6. What is driving the company’s profit picture and, if it’s not improving, why is that?
The answer to this two-part question hinges on what is happening with a company’s profits. I tend to look at a company’s operating margin: operating profit divided by revenue. There are several parts of the income statement that come into play calculating a company’s operating profit. Here’s the formula I use:
To calculate a company’s operating margin, use
And just to be sure we have things crystal clear:
Generally speaking, a company’s profit picture can improve when it earns more per dollar of revenue. If Starbucks raises its prices on a cup of coffee or Apple is benefitting from higher prices on its latest iPhone models, then odds are that such a company’s margins will be rising. If, however, Starbucks initiated that price increase to fend off the pain of higher coffee prices, the company’s margins may improve, but maybe not as much because the benefit of the price increase is offset by higher costs to the company.
Companies also can see margin improvement due to something called “economies of scale,” which means the more a company builds a product, the more efficient it will get. Hand in hand with that robust product volume may go more favorable costs associated with key parts or ingredients that go into the product. Also look for when a company initiates a new manufacturing technology or improves its materials to lower its production costs.
It is pretty simple. Another way a company can see its profitability improve is through lower costs. Take the Starbucks example above. If coffee prices drop and Starbucks keeps its coffee prices intact, its operating margin should benefit from the fall in coffee prices. If Starbucks was enduring the pain of higher coffee prices, then hiked prices on its coffee drinks and incurred a fall in coffee prices, that situation would bring a one-two benefit to Starbucks. The benefits of a price increase and falling coffee or input costs equals cha-ching for Starbucks!
Of course, coffee is one input among many at Starbucks. But that’s why you need to read the company’s financial filings to determine which inputs are critical. The same goes for other companies and other parts and ingredients.
7. What does the company’s balance sheet look like?
Up until now, most of the answers can be found in and around the company’s income statement. But we also want to examine its balance sheet. There are a number of line items on a balance sheet, but the ones I am immediately drawn to like a moth to a flame center on cash and debt positions.
How much cash does it have on its balance sheet? Is the cash position growing? Is it higher than it was in the prior quarter? Is the company’s cash higher than it was a year ago?
The same questions apply to a company’s debt level, but we have to introduce some math to determine if the company’s business can handle the amount of debt it has. The first thing we look at is its debt ratio. To do so, I use the following:
When confronted with formulas like the preceding one, I find it best to use a quick example to remove any math-related fear. After all, it’s basically some simple addition and division.
Let’s look at consumer product company Procter & Gamble (PG). I suspect you have heard of the company, and odds are that you have at least one of its products in your home.
Perusing the company’s balance sheet for the March 2015 quarter, we find it had $15.075 billion in short-term debt, $17.364 billion in long-term debt, and shareholders’ equity of $63.38 billion. Let’s caluculate:
Generally speaking, the lower the total debt to capital ratio, the better. But we have to remember that dynamics differ from industry to industry. That means acceptable total debt to capital ratios for a consumer products industry will be very different than a defense contractor. The smart thing to do is to compare a company’s total debt to capital ratio with those of its competitors and peers that we identified in the first five questions. If you find one that is substantially higher than the rest, it could be a red flag.
On the other hand, don’t be alarmed if you see companies without any debt on their balance sheets. I can verify that even after the explosion in debt-fueled corporate share buyback programs that have resulted from the low to no interest rate environment that there still are companies out there that are debt free.
This column explains how to analyze a company’s all-important operating margin and its debt load. My next column will build upon this one by focusing on assessing a company’s net cash position per share and how it relates to its stock price.
In case you missed it, I encourage you to read my e-letter column from last week, the first five questions to answer before you buy any stock. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.
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