The process of putting an analysis down in writing can be instrumental in making sure as many stones as possible have been turned over when researching a company. Famed investor Peter Lynch, who's credited with coining that phrase, has also been quoted as saying that “the person that turns over the most rocks wins the game. And that's always been my philosophy.” Below is an overview of the major sections to consider when writing a financial analysis report on a company.
A report should start with a description of the company in order to help investors understand the business, its industry, its motivation, and any edge it might have over its competitors. These factors can prove invaluable in helping to explain why a company might be a profitable investment or not. A firm’s annual report, 10-K filing or quarterly 10-Q with the Securities and Exchange Commission (SEC) provide ideal starting points; it is surprising how rare it is for industry experts to refer to original company filings for important details. More valuable detail can be obtained from industry trade journals, reports from key rivals, and other analyst reports.
To also capture key fundamentals to describe a company, look to Michael Porter. The Porter’s Five Forces model helps explain a company’s place within its industry. Specifically, the factors include the threat for new entrants to enter the market, the threat for substitute products or services, the extent to which suppliers are able to influence the company and the intensity of rivalry among existing competitors.
The motivation for a bullish or bearish stance on a company goes into this section. It can come at the top of a report and include parts of a company overview, but regardless of its position, it should cover the key investment positives and negatives.
A fundamental analysis, which can also be broken out into its own section, contains research on the firm’s financial statements, such as sales and profit growth trends, cash flow generation strength, debt levels and overall liquidity, and how this compares to the competition.
No detail is too small in this section; it can also cover efficiency ratios like the primary components in the cash conversion cycle, turnover ratios, and a detailed breakdown of return on equity components, such as the DuPont identity, which will break ROE into three to five different metrics.
The most important component of analyzing past trends is to synthesize them into a forecast of the company’s performance. No analyst has a crystal ball, but the best ones are able to accurately extrapolate past trends into the future, or decide which factors are the most important in defining success for a company going forward.
The most important part of any financial analysis is to come to an independent value for the stock and compare this to the market price. There are three primary valuation techniques:
- The first and arguably most fundamental technique is to estimate a company’s future cash flows and discount them back to 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 the fundamental metrics and valuation ratios (price-to-sales, price-to-earnings, P/E to growth, etc.) are compared to competitors. Another comparison analysis is to look at what other rivals have been bought out for or the price paid for an acquisition.
- The third and last technique is to look at book value and try to estimate what a company might be worth if broken up or liquidated. A book value analysis is especially insightful for financial sector stocks, for instance.
This section can be part of the bull/bear story in the investment thesis, but is meant to detail key factors that may derail either a bullish or bearish stance. The loss of patent protection for a blockbuster drug for a pharmaceutical company is a great example of a factor that can weigh heavily on the valuation for its underlying stock. Other considerations include the sector in which the firm operates. For example, the technology industry is marked by short product life cycles, which can make it hard for a firm to keep its edge following a successful product release.
The above sections could prove sufficient, but depending on the stones uncovered during a financial analysis, other new sections might be warranted. Sections covering corporate governance, the political environment or nearer-term news flow, might be worthy of a fuller analysis. Basically, anything important that can impact the future value of a stock should exist somewhere within the report.
The Bottom Line
The performance of the underlying company is most certainly to drive the performance of its stock or bonds in the future. Other derivative securities, such as futures and options, will also depend on an underlying investment, be it a commodity or a company. Figuring out the key drivers to the performance of a stock and putting it down in writing can be an invaluable endeavor for any investor, regardless of if a formal research report is needed.