A Business Analysis Framework
My goal in writing this is to give you a bird’ eye view of getting to a buy decision. I want this to be a road map.
Please Note: I tried to keep this very brief. I am noticing a trend of investing blogs just putting out a wall of text. I have no problem with that, but I want this to be something that can be consumed quickly. Please reach out if you want to dive into one of the steps in more detail. I am always happy to chat.
Step 1. What am I looking at?
So, you stumble across a company. It may be through a screener, or you read about it in the Wall Street Journal. Whatever the case may be, it caught your attention. At this point, you should focus on learning what the company does from a high level. You may not grasp the whole value chain, but you understand the product they deliver to customers. You also may want to check out any recent news on the company.
Step 2. What sticks out?
At this point, you break out the financials. You are looking for trends. I like to start with the income statement and work my way to the cash flow statement. I typically start with 3 years of financial and switch to quarterly as needed. I try to keep in mind a few things
a.) Operating trends: Revenue growth (shrink), Margin expansion (contraction), etc.
b.) Capital Structure: Debt to Equity, EV, Net Cash or Net Debt, Debt to EBITDA.
c.) Capital Allocation: This depends heavily on the nature of the business. If it is a mature business, I may try to figure out how they are returning capital to shareholders. (Buybacks or Dividends) If it is still in the growth stage, I am trying to figure out where they are investing in growth. Are they doing a lot of M&A or investing internally?
d.) Free Cash Flow: How much cash is being produced to put into debt and equity holders’ pockets?
Remember, you will revisit the financials. You are just trying to get a feel of the goals and trajectory of this business. You learn what the core economics of the business is. Assuming you see something attractive, you should move forward.
Step 3. Time to dig deeper.
It may be an attractive growth story with improving unit economics or an older company getting cash back to shareholders. Whatever the case, something stuck out to you. Now it is time to dig in! You should probably think about this process as an extended job interview. The first pass was like the resume screening, and the high-level financial analysis was the 20-minute phone interview. You should filter out most companies in step 2. Companies that make it to step 3 must catch your eye. I like to start with the most recent investor presentation. Many investors go straight into the 10-K. I go for the presentations first; more so, to learn the company’s lingo and goals. The 10-K can get the uninitiated bogged down. When flipping through the presentation, you are looking for business segments and key operating metrics. I know the investor presentation is the best version of the company and a lot of flaws can be masked, but you are just trying to learn the company. Once you feel confident in your understanding of business, dive into the 10-K and quarterly reports. At this point, you feel good about the business. Through the 10-K, try and get a feel of the value chain. Who are the suppliers? Who are the customers? Are customers being retained? Look for structural business characteristics. I like to use the seven powers framework outlined in the book 7 Powers by Hamilton Helmer. After reading a few of the 10-K’s you should understand what risks exist, what are management’s goals, and how the business is run. You want to listen to earnings calls as well. Pay attention to the questions asked by the analyst on the call. You want to learn what those guys and girls are looking at. They have likely covered the stock a while and know what matters.
Step 4. Build the story
Now, you go into investigative journalist mode. You are trying to understand the industry dynamics. What is the industry ecosystem like? The ecosystem means everything the company touches and affects. Dennis Hong has a framework called “Ecosystem Control.” You can no longer access the paper, but he talks about it in a Podcast that I will link. In my opinion, a great example of ecosystem control is John Malone in the TCI days. He had full control of the value chain. His horizontal scale allowed him to produce material operating synergies. His scale also allowed him significant bargaining power amongst networks. He often bargained his way into equity ownership of networks. Everything flowed through TCI and other cable cowboys. When looking at the company ecosystem, you are trying to use some version of the Porter 5 Forces Framework. You want to determine market share and bargaining power amongst customers and suppliers. At this point, the food chain should be well-established in your mind. Aside from ecosystem analysis, you want to look internally. Do some deep research on management. Is the CEO the founder? If not, what is his or her background? Did they come from operations or banking? How long have they been around? You also want to understand who your partners would be if you invested. Look at the other major investors are. You will likely see Vanguard and Blackrock, but you are looking for active managers who own them. Let’s assume Third Point is a major shareholder. You can then go on the Third Point website and read Dan Loeb’s investor letters to understand his thesis. You now have a feel for the external and internal dynamics of the business. You know the ecosystem pecking order and understand the business history.
Step 5. Build the model
In step two, you may have built a 3-statement model or something, but now you are trying to determine the valuation. I like to use the expectations investing framework highlighted in the book Expectations Investing by Michael Mauboussin. You are trying to determine the market expectations for the business. (Not your own) You can base it on analyst expectations and historical results, but you are trying to determine how long the market believes the business can return > than its cost of capital. I am not going to go into the dynamics of expectations investing. I highly recommend you check out the book. To me, it is the greatest contribution to investment theory in the last 30 years. The model is built by reverse engineering a DCF. You ask, “what is priced into the stock’s current price?” You can check out the expectations investing website for a free excel model. At some point, I will publish a basic reverse-engineered DCF model that you can download.
Step 6. Make Revisions
By building the model, you now know what the market expects. In this step, you use your time spent researching to revise expectations. Maybe the market believes sales growth will be 5%, but your research leads you to believe that it will be closer to 7%. The winning investment theses have two characteristics: 1. Correct 2. Contrarian. You can be right, but if every other market participant believes the same thing, you are destined to underperform. In this step, you are stating your difference of opinion to Mr. Market.
Step 7. Look for optionality
This step involves much more speculation. I do not suggest making investments based on this, but if you determine the business is undervalued based on the core operations, you get any additional optionality for free. This may be the growth of a new business line or a great M&A deal.
Step 8. Make a move
This framework is about as high-level as it gets. There are layers and layers of nuance within each step. With each step, the difficulty increases. By buying this business, you are confident that you are contrarian and right.
Closing
I hope this gives you a mental model as to how to filter down the investment decision. Many books could be written on how to do each step effectively. I wanted to present a process/checklist to get you to a buy decision. Most ideas will die in step 2 or 3. Wait for the perfect pitch. Do not fall into the sunk cost fallacy and buy just because you made it to step 6. You want to stay alive in this game.
Helpful Links
https://25iq.com/2014/11/02/a-dozen-things-ive-learned-from-john-malone/
https://25iq.com/2013/06/12/wholesale-transfer-pricing-and-the-free-parking-business-model/
https://read.amazon.com/kp/embed?linkCode=kpd&ref_=k4w_oembed_Zee12fE7ayi5i6&asin=0231203047&tag=bingshoppinga-20&amazonDeviceType=A2CLFWBIMVSE9N&from=Bookcard&preview=newtab
https://www.expectationsinvesting.com/