Fundamental Business Valuation Process
Everybody has a method of researching and analyzing companies. Whether we abide to our own set rules or not, the more important point is that we have a process that we adhere to. Whether you day trade, look at technicals or do it mechanically, a process which you can follow and continually improve is a definite requirement.
The following is a process I (usually) stick to except for special situations such as arbitrage, spinoffs and net nets.
Finding Investment Ideas
Business Valuation process
There are many sources of finding investment ideas. Ideas may come from the following:
- blogs and quality sites
- performing everyday duties (Smuckers, Midas, Safeway etc)
I’ve previously written about ways to find ideas.
Rundown of the Business
Once I’ve found a company of interest, I perform the following actions and try to answer a series of questions.
- What does the company do?
- Go through the latest 10-Q or 10-K statement and quickly review the financial statements. Can determine whether to pass or go on after 30sec -1 min.
- Quickly estimate an intrinsic value via DCF, Graham, PE, NNWC methods to get an idea of the buy price range
If the above information leans towards a favorable investment, the next step is to read up on the company.
Researching the Business – Business Valuation Process
- Competitive advantage (moat) to determine whether it is a short term, mid term or long term investment
- Management (compensation, company perks, previous performance)
- Business model
- Strategy compared to competitors
- Growth (I don’t place a heavy emphasis on growth)
- Risk (the company knows its risk better than anyone. 10-k’s provide a detailed list)
At this point, I know what the company does and how it intends to go about do it. The next step is to see whether they are doing it properly.
Analyzing the Business
- Detailed look at the financial statements line by line for the past 2 or 3 years of 10-K filings and then 10 years with the spreadsheet)
- View how to analyze a business via the income statement, balance sheet and statement of cash flows.
- You can tell whether management do what they say by analyzing the margins and other performance metrics such as CROIC, FCF, ROE.
- Competitor numbers (compare with spreadsheet)
- Come up with a buy price with conservative and realistic figures
Management can always talk the talk, but the numbers prove whether they have been walking it as well.
Coming up are important questions to ask yourself. But before that just click on the image below to download the best investment spreadsheet that will organize your thoughts and make things easier for you.
I’ve recently added a psychological section after some recent bad mistakes. I must admit this is by far the hardest section to answer but one has to be brutally honest.
- Am I giving more weight to recent data and events?
- Did I think a fact was obvious beforehand?
- Have I looked at the situation from different scenarios? (Company loses money, no growth, growth etc)
- Am I influenced by the way the data is presented preventing me to perform the required work?
- Am I overconfident in the analysis because I work in the industry or otherwise?
- Have I reviewed the negative factors?
- Am I over-weighing the negative factors creating too much loss aversion?
- Am I buying just to average down?
- Am I slow in changing my opinion?
- Am I ignoring potential risks because of the reward?
- Am I willing to purchase because I spent the time researching? Obligated to buy?
- Is there a bias because everyone else is recommending to buy?
- Am I refusing to sell for any reason? Attached?
- Is the information I am using a consensus that can be false?
- Do I have an exit plan?
How Much Data?
- 10 years of statements from spreadsheet to get an idea
- Detailed reading of annual reports – 2 or 3 years worth. Mostly going through the risks and management discussions and footnotes.
- Quarterly Reports – 1 or 2 quarters. Looking for any new changes. e.g. off balance sheet obligations, footnotes.
- Latest Proxy – looking at compensation, stock options, the board members, company perks such as jets or cruise ships.
This is how you do the proper Business Valuation Process. Do you have a process of your own?