|
How
to Analyze
a Company's Business Model
Don't buy a stock before you
analyze the firm's business plan
If you were
considering buying a local business, say a bicycle shop, would you base
your purchase decision entirely on how much money the seller said he or
she made last year, or on the seller’s profit forecast for 2002?
I’ll bet
not. Instead, you’d probably want to know where the shop gets its
bicycles, how much it pays, and whether the competition is paying the
same prices.
You would
probably see if there are alternative sources in the event that an
important supplier goes out of business, or worse, decides to let Costco
sell its brand. You’d probably also want to know something about your
customers. Are they mostly individual consumers, or did one or two
bicycle courier services account for a big hunk of last year’s
purchases?
You’d
probably be interested in the industry outlook. Are sales steadily
increasing year after year, or are they trending down?
Taken
together, this information describe a firm’s business model (business
plan),
competitive position, and the outlook for its industry, in essence: its
profit potential.
Probably,
most folks would evaluate such topics if they were, in fact, thinking of
buying a bicycle store, yet few investors spend much time thinking about
them when they’re analyzing a possible stock purchase. That’s
unfortunate, because they’d make more informed investing decisions if
they did. So, from time to time, we’ll present some ideas for
evaluating a company’s profit potential. We’ll start by gathering
basic information about the company and its industry.
The Business
The first step is
finding out what the company does, that is, the products and services
that it sells. That’s a no-brainer if you’re talking about Wal-Mart,
but how many shareholders know what Lucent Technology or Network
Appliance do for a living?
Surprisingly,
few investing sites do a good job of presenting such basic information.
One that does, however, is Multex Investor (www.multexinvestor.com).
Its Company
Overview offers a concise but readable paragraph describing a
company’s products and services.
Multex’s Business
Description goes into more detail, describing each of the company
major products and services, probably more detail than you’ll want to
know at this preliminary stage of your analysis. Access either report by
first getting a quote, and then selecting the desired report from the
left-menu.
Morningstar (www.morningstar.com)
also offers a concise company overview. Morningstar’s description is
different, although not necessarily better than Multex’s Company
Overview. I suggest reading both to gain a better understanding of the
company’s operations. Access Morningstar’s version by getting a quote
on its homepage, and then selecting Snapshot.
Industry Outlook
Most investors I meet prefer the growth style to value investing,
meaning that they seek out firms with above average sales and earnings
growth prospects.
If you’re
in that camp, you’ll find your best prospects in fast growing
industries. Otherwise, your picks will have to grow their earnings by
cutting costs, by taking market share from the competition, or by
acquiring other industry players. Although many firms have successfully
practiced these strategies, those tactics are inherently riskier than
participating in a high-growth industry.
Ideally
we’d like to see an industry’s long-term sales growth forecasts, but
those are hard to find. Instead, we’ll start with industry earnings
growth forecasts, which are readily available, and then adjust the
results.
Analysts’ Forecasts Are
Good Enough
You can see the analysts’ consensus earnings growth forecasts on
Microsoft’s MSN Money Central (moneycentral.msn.com).
Market analysts have been under fire for failing to foresee the tech
industry implosion, and more recently, for advising us to buy shares in
Enron Corporation shortly before the energy trader filed bankruptcy.
However, we’re looking for gross numbers, not estimates accurate to
decimal points, so despite the shortcomings of their buy/sell ratings,
analysts’ growth forecasts are close enough for our purposes.
Find the
industry earnings growth forecasts by first getting a quote
for any company in the industry on MoneyCentral’s home
page, then select Earnings
Estimates (left-menu), and finally click on
Earnings Growth Rates. When I looked up Network Appliance, the
analysts’ consensus five-year average annual growth forecasts were 27
percent for the company, and 20 percent for its industry: computer
storage devices.
While there,
I also found five-year growth forecasts of 11 percent for regional banks
by looking up Bank
of America, 12 percent for retail department stores (Federated
Department Stores), 26 percent for drugs (Pfizer)
and 27% for semiconductors (Intel).
Convert to Sales Growth
The next step is to convert the earnings growth forecasts to get a
handle on industry sales growth. By looking at historical data, I’ve
determined that on average, long-term industry earnings growth outruns
sales growth by around 15 percent. Also, analysts’ forecasts typically
run high, I’m not sure by how much, but I’ll hazard a guess and add
10 percent to cover that.
Taking those
two factors, together, I discount the consensus five-year earnings
growth forecasts by 25 percent to come up with my industry sales growth
forecast. I know that I’m making all kinds of assumptions, but so do
the analysts, so my figures are probably as close as anyone’s.
Applying my
25 percent discount factor, I came up with estimated industry sales
growth figures of 8 percent for regional banks, 9 percent for department
stores, 15 percent for computer storage, 19 percent for drug companies,
and 20 percent for semiconductors.
Based on that
analysis, it looks as though growth investors will find better prospects
in the tech and drug industries, than they will by looking for regional
banks or department stores.
Competition
The estimated industry growth rates are just a starting point.
Naturally, you want to find companies that will outpace their industry.
To do that, you have to first identify the major players, an easy task
if you know where to look.
Hoover’s (www.hoovers.com)
is a good place to start, listing each company’s three top
competitors. The competitors are listed below Hoover’s Company
Profile, accessed by entering the company name or ticker symbol on
Hoover’s main page. Hoover’s top competitor’s list is generally
accurate, but it isn’t infallible.
Multex
Investor is another good source, often providing an extensive
competitors list in the last paragraph of its Business Description.
Identify Strongest
Competitor
Once you’ve identified the players, your next step is to pinpoint the
strongest competitors. These are usually the companies with the largest
sales, the highest sales growth, or possibly the biggest profit margins.
Often, you’ll find that the company that you started analyzing isn’t
the best. If so, consider discarding your original candidate in favor of
the better competitor.
Of course,
there's more to do. We’ll continue the analysis in a future column.
published 1/13/02
|
