Shareholders' Equity

The balance sheet is basically an elaborated display of a simple equation.

Assets - Liabiilities = Shareholders' Equity or simply Equity

What this means is that whatever assets that a company owns, subtracting whatever the company owes, gives you what's left for shareholders. This is also known as the book value of the company.

Shareholders' Equity is usually at the bottom right of the balance sheet (Assets on the left side, Liabilities on the top right) and is usually broken down into the following sub components:

Common stock
Paid in capital
Retained Earnings
Preferred stock
Treasury stock
Others: there are actually a lot more complicated stuff but I will just lump it under others and we will talk about that on another day.

Common stock and paid in capital are usually thought of as the original capital of the company. Common stock is the no. of outstanding shares multiplied by its par value which is usually some arbitrary no. like $1 and paid in capital is usually the proceeds received during IPO or subsequent secondary equity financing.

Retained earnings would be the impt sub-segment to know. Needless to say, retained earnings comes from net profit (from the P&L statement). So what this means is that retained earnings should be as big as possible. If you see a company that has an original capital of say $1mn but retained earnings is like $80mn or some big no. then you know this co. has created tons of value for shareholders. And conversely, if paid in capital is bigger than retained earnings, either this firm is still very young, or it has continously raised new money from shareholders ie old shareholders keep getting their stake diluted and the business model's sustainability is questionable

Preferred stock is basically a stock pays dividend forever and is usually not a big sub-segment. Thus it pays to find out why a co. might have a huge preferred stock capital.

Treasury stock is a negative entry (ie the $ amt here is negative not positive) in shareholders' equity and it arises only when a company does share buybacks. This is a good sign bcos it signifies that the company has its shareholders in mind and is using share buyback as a way to return capital to its shareholders.

Step-By-Step Company Analysis

This is an expansion of a previous post on how to do a detailed company analysis.

Company CheatSheet

The zero-th step for company analysis is actually a quantitative stock screen. Poems have a good system to come up with a list of stocks. As for what criteria to use, the post mentioned above has a list which I would recommend pple to use. The screen should include both company specific financial ratios and valuations.

So you put in the criteria, the the system churns out a list of companies. Then you can select any co. that has a nice sounding name or maybe it is in a good industry and study it. It will probably take you 3-4 days (if you have a full-time job and can only spare limited family time to do this ECA) to read the annual report and broker's reports try to understand its business.

Ratios: when doing the screen, you would have included a few financial ratios, but the trick is to actually look at all other ratios, if something bothers you, ie this co's interest coverage ratio or asset turnover is too low. Then perhaps its not wise to invest in the stock.

Next is to focus of qualitative stuff. Some things that I would look for are:
1) Whether the company is in the right regional markets / right industry ie places where there is still a lot of growth, less competition and co. has pricing power.

2) Market share of its products, it is better to be either No.1 or No.2 in its field bcos anything else, it has no pricing power nor the competitive edge over its competitors. Of course, all industries are different, sometimes, the market is such that there is no mkt leader and can never have one.

3) Its business moat / competitive advantage / barrier to entry of its business, the company needs to have that edge where no one can ever get close to them. For Toyota the edge is its manufacturing capabilities, it can make a cheap, reliable and fuel efficient car targeting the mass affluent, and no one else can do that. But the European cars fight with another edge: branding and image. Think Porsche, Ferrari, Lamborgini.

4) Its management, their compensation scheme and their past actions. Has the mgmt been friendly towards shareholders? Have they issued options or other means to dilute shareholders' stake indiscriminately? Any directors resigned?

5) Clarity of its annual report. Sometimes, the annual report of the company can be very flashy but it does not tell you the impt things. ie. the company is trying to hide. It then pays to avoid these co.s.

Of course, the list goes on and on. And as you gain experience as an investor, you refine your thinking, and know what to look out for: the warning signs, the best practices, the business moats and whether the businesses are sustainable.

There are really so many things that you should look out for and even after that it pays to let things cool for a while, re-visit the company after some time, or after when the stock has fallen a lot. Especially in the Ra-Ra markets of 2006-2007.

So when I have decided that this is a company that I should own, I will wait for a good time to buy. When valuation gets cheap enough. Usually I only look at PER. So if the sustainable forward PER is cheap enough, I will buy. This is the most important step as a wrong entry price will decide if this stock is a 10 bagger or just a 1.5 bagger (after 10yrs).

It's not easy but it's rewarding when you get it right.