Introduction to Equity Analysis

11th Mar '19 by Damian Cannon

4 comments 1433 reads

Summary

I attended this half-day course in the afternoon of February 22^nd in Central London. The material here is definitely educational even if just to reveal the gulf between the research that I do and the research that I could be doing. The fact is that professional analysts can spend weeks digging into a single stock, with access to tools such as Bloomberg, and this isn’t wholly practical for individual investors.

Nevertheless Steve Clapham does a good job of showing how be approaches the analysis of a company and it feels like you’re getting to look over his shoulder as he goes about the task. Unlike his accounting course the material here doesn’t require you to be an expert in balance sheets or any other part of the accounts. Instead there’s an assumption that you have some familiarity with the tools used to value companies and assess their investment potential.

While on the course I made as many notes as I could as there’s too much to take in on the day. From these I’ve extracted the major points to try and provide a flavour of the material. In reality Steve covers a lot more content than these headlines suggest and I’m sure that he’s happy to answer any questions.

The structure of this course is available here and I’ve used this to lay out a selection of interesting points which came up on the day:

Enterprise Value

Ignore DCF, CAPM etc. as of little practical use to investors
EV is better for peer group comparison
Use debt at market value not face value

Stock Market Value

P/E – definition of EPS is the difficulty
EV/EBITDA or EV/EBIT – use at least one EV metric for balance
EV/CE – good for property companies and similar

Analysis Basics

Look at LFL revenue trends and vs peers
Working capital ratios – very important
Valuation per unit – very useful for certain sectors

Finding the Ideas - how to find winning stock ideas

News – temporary hits to profit are often extrapolated into the future
Thematic investing - can be structural or tactical
RNS – look for a more positive update than was expected

Testing the Hypothesis - check that this is an idea worth pursuing

A 30-60 minute quick check
Liquidity – can you really…

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Gromley

12th Mar '19

Hi Damian,

Thanks for sharing this. To be honest though I find it a little hard to glean to much at that quite high level – I guess the key question is how useful did you find it?

Anyway, there is one point of detail that I would pick up on is ‘Enterprise Value’ [EV].

I used to rely quite heavily on Enterprise Value, but I have actually concluded recently that I think it is often a misleading measure (as defined).

Just for the uninitiated, Enterprise Value is the Market Cap plus net debt.

The logic is good in the sense that this is the total value of the enterprise, for example to a purchaser. Think of all of those instances of companies being sold for a pound – the buyer has to stump up not just the £1 but also has to cover all of the company’s debts.

However, on reflection I believe that Net debt (Gross debt less cash at bank) is a false measure.

Firstly because ‘cash’ as a manipulated number – I’m not just thinking Patisserie Holdings (LON:CAKE) where the cash seemingly didn’t exist (or perhaps there were other debts in this case.) Rather I’m thinking about the extent that companies ‘window dress’ their accounts by delaying payment of bills but aggressively collecting cash from customers at the period end (been there got that T-Shirt).

And its not always just window dressing and can just be the nature and seasonality of the business. A classic example of this is GAME Digital (LON:GMD) which is often touted as being fantastic value because of its negative EV (its net cash is greater than its Market Cap). In this case I maintain that the cash is actually effectively deferred inventory, it will all be paid in due course to suppliers for goods held. I wont bore everyone by repeating my reasoning for that assertion, but I’ll just note that if they actually had that much unencumbered cash they would not need to have any debt.

Its my belief that in the majority of cases where a company has both cash and debt, the cash is encumbered in one way or another and that the best measure to determine (my version of) EV is to consider Gross debt.

There will be some exceptions to this; for example where a company is sitting on a cash-pile from a disposal which has not yet been distributed or utilised or potentially where a company has just raised funds for future investment (arguably the cash is unencumbered here until they actually commit to the investment).

On the other hand if the debt is backed off against a readily saleable asset (e.g. a mortgage seured against a freehold property – not against ‘plant’ whose resale value is usually much less than book) then it can be reasonable to ignore that debt for the purposes of my EV calculation.

So, for my purposes now I treat EV as being Market Cap plus Gross Debt – adjusted for any truly unencumbered cash and for any clear ‘mortgage like’ debt.

Of course, the trouble is that one cannot ‘screen’ for EV calculated this way as it involves some finer level analysis of the numbers, but when we are talking about a more forensic analysis of the detail of a company’s accounts it is something that can clearly be interpreted.

Did Steve Clapham touch on anything like this or does he just take the traditional view of Enterprise Value?

Damian Cannon

16th Mar '19

Hi Gromley,

Thanks very much for your detailed post. With the course(s) I did find them both interesting but Steve covered an awful lot of material at quite a pace. So I need to go back over the slides in order to get the most out of the courses. My plan is to do this, create a checklist and then incorporate some of these questions in my analysis. The caveat is that as an amateur investor I don't really have the scope to spend several working weeks digging into a company unlike professional analysts.

On your point regarding net and gross debt I totally agree. The published net debt figure is often somewhat useless and I'd much prefer to see an average debt figure along with values for maximum and minimum net debt throughout the year. On the whole though I try and stick to companies that have no debt or very minimal debt levels which implies that their interest costs should be zero or close to that level. If a company claims to have a lot of unencumbered cash and isn't using it for special dividends, buybacks or acquisitions then that's a red flag.

On the course Steve mentioned checking the claimed debt level against interest costs since there should be some correlation. In addition he pointed out that the P&L notional interest cost can be different to the interest charged and I found this recently with a company where high interest costs were simply being accrued rather than paid out. With regard to EV he covered adjusting this for minorities and associates and then moved onto the fact that the debt figure being used should reflect the market value of any debt rather than its face value (since old debt with a high coupon would be very expensive to buy back). So, yes, he did go in to the EV calculation in some depth since the simple market cap + debt figure is just a starting point.

Cheers,

Damian

Mark Simpson

Good point on the real cash/devt levels of a business. Personally I would like to see accounting standards force companies to declare their average net debt/cash over the accounting period and the highest net debt/lowest net cash position during the period. This would be very useful information to be able to assess the true investment case.

doug2500

While I accept I could do more, and more of better quality, I am encouraged by numerous articles which seem to point to information overload and accuracy of decisions NOT improving with extra info. Both for this reason, and the pressures of reality I now console myself that's it's better to be roughly right than exactly wrong.

So now if I'm looking at a company I only look to get comfortable with the balance sheet, cashflow and valuation rather than drilling into it in exacting detail. Once comfortable (for want of a better expression) I then revert to a bit of gut feel on when and what price to buy at.

Do I work out earning yield and compare it to bonds? No
Do I look at the cash adjusted P/E and see if I'm prepared to pay it? Yes
Do I have the ability to do better research? Yes
Do I have the time? No
Do I feel like it's holding me back? A little maybe, but not much and it's a compromise. This is real life after all.
Do I think my approach is better than offloading to a professional? Yes

I would estimate I spend 4 or 5 hours on a new holding plus whatever I knew in advance. I then take a modest position (sometimes I'll fill my boots) and build it as I gain confidence and knowledge in the company.

Hopefully this is of interest to people.

Doug

Introduction to Equity Analysis

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Damian Cannon

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