Your Definitive Guide to Researching Stocks
Dear Rich Lifer,
In one of Warren Buffett’s first televised profiles, the “Oracle of Omaha” explained what makes a good investment.
He said to “Money World’s” host, George Goodman back in 1985…
“Most of the professional investors focus on what the stock is likely to do in the next year or two. And they’ve all kind of arcane methods of approaching that, but they do not really think of themselves as owning a piece of a business.
“The real test of whether you’re investing from a value standpoint or not is whether you care whether the stock market is open tomorrow,” says Buffett.
“If you’re making a good investment in a security, it shouldn’t bother you if they closed the stock market for five years.”
This mindset can be traced back to Buffett’s first teacher: Benjamin Graham.
Considered the father of security analysis and value investing, Graham documented his methods in two books, “Security Analysis” (1934) and “The Intelligent Investor” (1949), both essential reading for any investor.
If you’ve picked up one of these seminal texts, you know they’re not easy reading. In fact, it might take you several years to reread these books before you grasp all the wisdom being shared.
When it comes to picking stocks, Graham and Buffett take a similar approach using fundamental analysis to determine the true intrinsic value of a company.
Today we’re going to show you how to research companies like some of the greats so you can make better investments.
Here are the 8 steps to researching any public business you’re considering taking up a small stake in. As Buffett says, “Buy into a company because you want to own it, not because you want the stock to go up.”
Step 1: Read the Business Section of the 10K
The first step to researching any company is reading their annual 10K report. 10K reports are required to have certain information in them and one requirement is to have a business description.
So, whenever you start researching a company, reading the business description in the 10K report is usually the best place to start. This will breakdown different segments of the business, explain the industry the company is competing in, and tell you what the business does and how it makes its money.
If you’re researching several companies at once, simply reading the Business Section of the 10K report might be enough to weed out certain businesses and save you time.
For instance, if after reading the Business Section, you’re still not clear how a company makes its money, or whether you think it’ll have enough customers in the future, you can stop your research here and move on to another company.
This is an important point since you don’t need to own hundreds of stocks or companies to be successful. You only need a handful of good companies to deliver above market average returns, so don’t waste any more time than you have to researching companies.
Step 2: Read the Most Recent MD&A
The second step is to pull up the most recent Management Discussion & Analysis (MD&A). This can be found either in the annual report (10K) or in one of the most recent quarterly reports (10Q).
It’s important to pull the most recent MD&A since what was presented in the Business Section of the 10K report could be outdated once you read the latest quarterly report.
Therefore it’s a good idea to read both the Business Section and the most recent MD&A to compare any changes in numbers or strategy. The MD&A should cover management’s plan, any industry trends, or news about competitors, offer a breakdown of segment performance, and the overall performance of the business at that particular point in time.
Step 3: Review the Financial Reports
Here’s where most investors get lazy and simply pull financials from websites like Yahoo Finance and MSN Money. While these websites are great tools to complement your research, we don’t recommend you rely on these sites for the financial analysis portion of your research.
We highly recommend you pull the latest financial reports from the most recent annual and quarterly reports because these financial statements come with footnotes and the footnotes can be the key to understanding a business’ financials.
Often, companies will do something unique with a particular line item, and in the footnotes, they will explain what they’re doing and why they’re doing it this way. For example, if a company adopts a new accounting rule, you can simply Google what that new accounting rule is to understand how it affects the financial statements.
This of course requires more work, but over time you’ll become exposed to different kinds of financial statement analysis and gain a deeper understanding of what’s actually going on behind the numbers.
Step 4: Download Company Presentations and Earnings Calls
This fourth step can be done before or after you go through the financials. In fact, you might end up going through steps 2-4 simultaneously.
Up to this point, we haven’t tried to value the company. We’re just getting to know the business and how they make money, where their margins lie, if they have free cash flow, and what is their growth rate, etc.
Reading company presentations and earnings calls will give you an idea of management’s plan for the future.
Step 5: Competitor Analysis
Now we need to find competitors. In the MD&A section, or Business Section, or earnings calls, you will likely have come across something about the industry and its competitors. Ideally, you want 2-3 competitors to compare.
Up to this point, you should already know what the plan is for the company you’re considering buying shares in. You should know its growth rate, revenue over the last 5 years, and its plans for the future.
With this information, you need to do a bit of research on the 2-3 competitors you’ve identified and compare what their plans are and what kind of growth rate they are projecting. If you notice a big difference in margins, you should ask why. Sometimes you might identify a competitive advantage that one business has over others in the industry.
Step 6: Determine the Intrinsic Value of the Company
If you’ve made it this far, you must think the company has some kind of competitive advantage or believe the business will perform well into the future. Now it’s time to figure out how much the company is actually worth.
There are several ways you can value a business: Discounted Cash Flow, PE multiple, EV/EBITDA, are just a few.
Whatever method you choose will depend largely on the company you’re valuing. As you become more comfortable with different valuation methods, you’ll learn which ones are appropriate based on the type of company you are researching.
This is also where you want to compare the company with its competitors. Compare ratios and compare the company with itself from prior years.
If the company says they have a particular plan in mind, ask how long has that plan been in place? Is the plan working? Can you see it in the numbers?
Also, if you have access to analyst research, this is a good place to pull it all down. You can see what valuation methods they are using for this industry and see what they’re saying about revenue and earnings. Read their investment thesis and decide whether you’re more bullish than they are or less.
If you have access to several analyst reports, compare them all and see where your valuation stacks up. But don’t place too much confidence in the “pro’s” reports, however. Use them as a tool to identify areas you might have overlooked in your own research.
Step 7: Identify Drivers of the Stock
This next step is critical since you should now have your fair value of the stock figured out. Once you have an idea of what the intrinsic value of the stock should be, compare that price to what the stock is trading at today.
Look at the last 12 months and circle any peaks and valleys in the share price. You want to try and understand what moves the stock up or down. To do this, pull up news headlines at those particular points in time when the stock price either went up or down significantly.
For example, maybe whenever a headline comes out about rising interest rates, the stock plummets. This could be one driver you identify that moves the stock. The goal is to identify certain drivers so you know what to look for in the future.
Step 8: Look for a Buying Opportunity
Now you know what the company does, how they make their money, and some drivers of the stock, it’s time to determine what your personal margin of safety is for this particular stock.
If you like the company, but maybe you think there’s a lot of risks, then you’ll want a larger margin of safety. A great buying opportunity is when a company misses earnings by a few cents. If the price drops dramatically, this could be a great way to get in at a level within your margin of safety.
If your research shows this miss in earnings won’t change the fundamentals of the business, then you know over the long haul, this dramatic dip will correct itself. Don’t let everyone selling off, scare you away from buying. Be confident in your analysis.
And if the price isn’t right, keep that company in your “bullpen” until the price reaches your margin of safety to buy. When you finish your research, don’t keep going. Set it aside and move on to researching the next company.
The more research you do, the better and faster you will become at valuing different businesses.
Remember, “Buy into a company because you want to own it, not because you want the stock to go up.”
To a richer life,
The Rich Life Roadmap Team