How to read a financial analysis report
The process of writing down an analysis can be instrumental in ensuring that as many stones as possible are turned over when looking for a business. Famous investor Peter Lynch, who is credited with coining the phrase, was also quoted as saying that “the person who flips the most stones wins the game. And that has always been my philosophy.Inasmuch asBelow is an overview of the main sections to consider when writing a financial analysis report on a company.
A report should start with a description of the business to help investors understand the business, its industry, its motivation, and any advantage it might have over competitors. These factors can prove invaluable in helping to explain why a business may or may not be a profitable investment. A company’s annual report, 10-K filing, or quarterly 10-Q with the Securities and Exchange Commission (SEC) are ideal starting points; it’s surprising how rarely industry experts refer to original company documents for important details. More valuable details can be obtained from industry trade journals, reports from major rivals and other analyst reports.
To also capture the key fundamentals for describing a business, watch Michael Porter. Porter’s five forces model helps explain a company’s place within its industry. Specifically, the factors include the threat to new entrants entering the market, the threat to substitute products or services, the extent to which suppliers are able to influence the business, and the intensity of the rivalry between existing competitors.Inasmuch asInasmuch as
The motivation for a bullish or bearish position on a company goes in this section. It may come at the top of a report and include parts of a company overview, but regardless of its position, it should cover the main positives and negatives of the investment.
A fundamental analysis, which can also be split into its own section, contains research on the company’s financial statements, such as sales and earnings growth trends, cash flow generation strength, levels of leverage and overall liquidity, and how it compares to the competition.
No detail is too small in this section; it can also cover efficiency ratios such as major cash cycle components, turnover ratios, and a detailed breakdown of return on equity components, such as the DuPont identity, which will divide ROE into three five different measurements.
The most important part of analyzing past trends is synthesizing them into a forecast of business performance. No analyst has a crystal ball, but the best are able to accurately extrapolate past trends into the future, or decide which factors are most important in defining a company’s success in the future.
The most important part of any financial analysis is to arrive at an independent value for the stock and compare it to the market price. There are three main valuation techniques:
- The first technique, and arguably the most basic, involves estimating a company’s future cash flows and discounting them into the future at an estimated discount rate. This is generally referred to as a discounted cash flow analysis.
- The second is called relative value, where fundamental metrics and valuation ratios (price/sales, price/earnings, P/E/growth, etc.) are compared to competitors. Another benchmark is to look at what other rivals have been bought out for or the price paid for an acquisition.
- The third and final technique is to look at book value and try to estimate what a business might be worth if it were dissolved or liquidated. A book value analysis is particularly relevant for stocks in the financial sector, for example.
This section can be part of the bullish/bearish story in the investment thesis, but aims to detail the key factors that can derail a bullish or bearish position. The loss of patent protection for a blockbuster drug for a pharmaceutical company is an excellent example of a factor that can weigh heavily on the valuation of its underlying stock. Other considerations include the industry in which the business operates. For example, the technology industry is characterized by short product life cycles, which can make it difficult for a company to maintain its edge after a successful product release.
The above sections might prove sufficient, but depending on the stones uncovered during a financial analysis, other new sections might be warranted. Sections dealing with corporate governance, political environment, or short-term information flow might merit further analysis. Basically, every material thing that could affect the future value of a stock should exist somewhere in the report.
The performance of the underlying company is most certainly driving the performance of its stocks or bonds in the future. Other derivative securities, such as futures and options, will also depend on an underlying investment, whether it is a commodity or a company. Determining the key drivers of a stock’s performance and putting them in writing can be an invaluable undertaking for any investor, whether or not a formal research report is required.