The Research Process
How to dig into just about any stock...
After I find a stock that I’d like to dig into further, I’ll usually go through most / all of these steps. Sometimes I’ll do a few of them and put the idea back on the shelf for a while only to pull it down again later.
Here are some basic steps in the research process for me…
Check out the latest investor presentation — This is distinct from a quarterly earnings presentation. If available, they usually have some pretty thorough slides that ideally give you the quick pitch on the stock and some high level stats on the industry/markets/competitors the business is focused on. You can also get a glimpse at good KPIs for the business (and peers). I usually start here to get the graphical layout of the key figures over time and the quick pitch (from management) on why own their stock. Technically, there are 2 types of investor presentations outside the normal earnings presentation:
Conference presentation — hosted regularly by most investment banks, 1 or 2 members of management will give a quick overview of the business and an outlook… these can be more informative than your typical earnings presentation because they’ll bring you up to speed on where the company’s been and where they’re going very quickly
Analyst or investor day — typically a full day (or 2) presentation on all aspects of the business from each member of the management team… these presentations will give you excellent details on industry dynamics and a multi-year outlook for the business
Form 10-K — I’ll pull up at least the last 2 10-Ks to get a comparison and a full 4 years of coverage (SEC filers typically give you 3 years of comparative income statements and 2 years of balance sheets / cash flow statements… bummer!).
All sorts of items to cover in the 10-K… There are plenty of good posts out there on how to break down a 10-K. I tend to gravitate toward a few sections in particular —
Business description and revenue recognition — is it easy to understand what the business does and/or how they make money?
Selected financial data to get the multi-year look (update: SEC no longer requires this disclosure, super bummed)
Financial statements especially balance sheet and cash flow statement
Segment results or information — find the crown jewel
MD&A — what is the company saying or are there other KPIs not listed in the financial statements or notes
Footnotes — segment results is my favorite but the debt section is a close second… looking for terms, maturity, favorable fixed rates, or any other “gotchas” that might exist
Subsequent events — did anything meaningful happen after results were reported?
Acquisitions or divestitures — it helps to skim over recent M&A activity to get a feel for major changes in financial statements (i.e. that major drop-off in revenue might be explainable after all)
Latest earnings call transcript — I typically don’t go back too far on these but, at a minimum, I like to hear what management is focused on right now. Occasionally, you’ll get some good tidbits from analysts on near-term risks… Maybe there’s a piece of the business not well covered in the 10-K that is deceivingly profitable and about to run into a pothole. Also, I love it when management teams help you bridge EBITDA to cash flow… It’s a simple exercise, start with EBITDA, then take out cash taxes and interest, adjust for working capital impact and capital expenditures… Voila you have free cash flow! Good management teams help frame this out for their business.
Most earnings calls can be incredibly unhelpful. Others might have potentially good information but reading into it doesn’t pan out the way management indicated (i.e. they are always going to be optimistic).
Cash sources and uses — I like to grab at least 5 years of cash flow statement data and line it up. Then take the cumulative impact for that 5 year period. There is no better way to gauge capital allocation policy than to see how management has actually been spending cash. This worksheet will always trump what someone says on an earnings call.
Financial statement analysis — My tendency is to take key financial information and drop it into multi-year vertically-oriented tables. I’ll build 3-5 of these tables for various aspects of the business depending on how complex it might be (i.e. multiple segments, complicated accounting policies, history of M&A, etc.).
Press release / earnings presentation — If I’m digging into a business mid-year, I want to quickly skim the latest earnings press release or 2. Something very simple that’s easy to overlook — is the business growing or declining? Both revenue and earnings. Specifically, I like to see the progression from unadjusted to adjusted. Is the business really growing?
Non-GAAP reconciliations — I tend to build my spreadsheets using my own calculation of earnings, EBITDA, free cash flow, etc. Most of the time, my figures won’t line up with what’s in the press release. I like to see how companies bridge from earnings to adjusted earnings but I don’t always bank on their adjustments being reasonable. Intangible amortization is usually the one I’ll allow depending on the M&A strategy / usage…
Old prospectus / Form 10 / merger proxy — These documents are chock full of detail on both carve-out financials, industry information, pro-forma financials, projections, 3rd party valuations, etc. If I’m looking at a company that came public within the past 5-10 years, I’ll definitely take a look at the IPO docs.
Valuation — This isn’t exactly a formulaic approach for me. I love all sorts of metrics and use them in different situations. For instance, one of my favorite screens is EV/Sales and looking at just about everything near the 0.1-0.2x mark… In theory, a business doing 10% margins trading at 1x EV/Sales would also be trading at 10x EBITDA… If I can buy a business at 0.1x sales and the business is truly capable of 5% margins, then I’m getting a bargain price of 2x EBITDA! (Obviously very very dependent on the business but it’s easy to toss out the obvious non-starters.) As you might have guessed, I’m very cash flow focused. I like to see businesses generating healthy cash flows and understand how they use them. Profits without cash can sometimes make me nervous (both in the public markets and private).
Catalyst — I don’t require having a “catalyst” in anything I own. The term may even be a bit loose as few stocks have true, actual catalysts. When I own something, especially if it’s cheap for cheapness sake, then I’d like to have at least a rough idea as to what would cause the cheapness to change. You can’t just say that a stock will go from 9x earnings to 12x earnings — something needs to lead it there.
This isn’t a comprehensive list and there are many more nuances to it than this. But it’s a good starting point and helps me frame the things I like to focus on… May update this post down the road as more things come to mind…
Leave a comment with your favorite metric or a part of your research process.