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Morningstar.com's Interactive Classroom

Course 202
Analyzing a Company

Introduction

Once you understand a company and its industry, it's necessary to evaluate whether the company has been performing well. To do that, there are a few important areas that you should always look at: growth, profitability, financial health, and valuation. In this session, we'll take a quick look at these four topics. We'll dig deeper into the specifics in subsequent sessions.

First Quality Check: Growth

Every company goes through stretches of poor performance--slumping sales, maybe even negative profits--but a quality company will have a proven record of long-term growth. One good standard is to look for companies with growth above that of the overall economy over the past five years. Not a high hurdle, to be sure, but one that eliminates stagnant firms and firms lacking long-term records (and most stocks touted by stock-market hucksters). Dell Computer DELL, for example, has generated annual sales growth of about 50% over the past five years. Few companies can do that every year, but a record of reasonably solid growth (say 20%) over a reasonably long period of time (say five years) is a definite plus.

Second Quality Check: Profitability

More important than rapid growth is high profitability--and that doesn't just mean positive net profits. Rather, it's the return on capital a company generates that matters over the long run. For every $1 invested in a company, how much does the company earn? That is the key question. A company that earns only $0.05 on each dollar invested year after year is a pathetic company; after all, better returns are available in money-market funds--with less risk. The figure to emphasize in assessing a firm's true profitability is return on equity, or ROE. This is the percentage a company earns on the money shareholders have invested in it. Microsoft MSFT, for example, earns more than $0.25 on each $1 of shareholders' equity, and it does so just about every year. That's an excellent return. But most companies have a bad year now and then, so it's a good idea to focus on average ROEs over several years rather than just the most recent ROE.

Third Quality Check: Financial Health

Is paying off credit-card debt a high priority for you each month? If the answer is yes, you probably want the companies you own to be burdened with as little debt as possible, too. That way, you can be sure they'll still be around after the next recession. When times are good, a company can plump up its ROE with debt leverage. That way, it generates a higher ROE, but at the (sometimes hidden) cost of greater risk. That's why it is preferable for companies to sport conservative financial-leverage ratios. Clothing retailer Abercrombie & Fitch ANF generates returns on equity of more than 50% and does so with very little debt leverage. Its financial-leverage ratio is a sparkling 1.7, meaning that for every $1.70 in assets on its balance sheet, it has $1 in shareholder equity backing it up. Abercrombie boasts that other characteristic of a financially sound company: positive free cash flow, or the amount of cash a company generates after capital spending. A company can either redistribute this cash to shareholders (through dividends or share repurchases) or use it to fund growth opportunities. Free cash flow is therefore a proxy for how much wealth a company is generating for its owners.

Fourth Quality Check: Valuation

Would you pay $100,000 for a car that might not start, that might lose a wheel after a few miles, or that might lose its door if you slam it too hard? Of course not. Yet people will pay extraordinary prices for firms managed by people who have little experience in their industry, that have yet to launch a product, or that could be out of business in a few years' time. That's where stock valuation comes in. Valuation tells you the relationship between what people are willing to pay for a stock (its price) and its underlying business, as measured by sales, or earnings, or something else. There are all kinds of valuation measures that you can use to determine how expensive a stock is; some of the most popular are price/earnings (P/E), price/sales (P/S), and price/book (P/B) ratios. We've also developed our own valuation measure, called the Morningstar business appraisal, which will be discussed in a later session.

Put Them through the Wringer

A company doesn't have to shine in each of these four categories; few companies would pass such a test. Rather, think of these as the quality checks necessary to make an informed purchase--the due diligence of stock-picking. By checking out how a company measures up in each area, you'll spot its weaknesses, and you'll certainly avoid buying a piece of junk. And don't stop with these four quality checks. Before buying a stock, read its latest 10-K and 10-Q reports and its annual report, which we described in the first level of our stock classes. These reports are jam-packed with useful information and are the sacred scriptures for stock enthusiasts.

Quiz 202
There is only one correct answer to each question.

1 What is a reasonable characteristic to look for in a company's growth?
a. Annual growth of 100% or more over a period of at least 10 years.
b. Annual growth of 20% or more over a period of at least five years.
c. Annual growth of 2% or more over a period of two years.
2 Return on equity measures:
a. Profitability.
b. Financial health.
c. Growth.
3 Which of the following is <em>not</em> true of high debt leverage?
a. It pumps up return on equity.
b. It decreases profit margins.
c. It makes a company a riskier investment.
4 What are two key characteristics of a financially sound company?
a. Low debt leverage and low free cash flow.
b. High debt leverage and high free cash flow.
c. Low debt leverage and high free cash flow.
5 Stock valuation measures how expensive a stock is relative to:
a. Its price one year ago.
b. Some measure of the underlying business, such as earnings.
c. The number of people buying and selling the stock at a given time.
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