Stock Analysis - Scoring System introduction
Updated: Jun 9, 2020
Before the first valuation will come online hopefully within the next days, I wanted to shine some light on how I will (usually) proceed
As I mention in the introduction page, I am taking a basic fundamental value approach to analyze most companies, prior to any possible investment. That doesn't mean I am taking a deep dive every time I am interested in a stock/brand which would probably also go beyond the scope for this kind of blog.
However, I would like to give an introduction on how I am proceeding with most of my valuations (besides the fundamental basics, which you can find in this post).
In order to give a proper overview as well as staying within some kind of limit, I will prepare each post on the basis of a scoring system to evaluate the companies’ overall attractiveness before calculating approximate company value based on several valuation methods.
Scoring will be split into 3 categories:
a) Company KPIs to evaluate financial strength
b) Five-Forces Analysis to assess the companies’ strength in the market and
c) Something I will call “other factors” that can play a key role for each company wanting to succeed in today’s fast moving market/economy
While over all categories a maximum of 40 points can be scored by any given company, I will give the final rating using a percentage scale for easier understanding and comparison.
For the input of financial KPI’s I will be using the likes of Finviz, Yahoo Finance or Bloomberg, depending on the stock and respectively will look at the latest full year financial report of the company itself, in case of not readily available key figures.
For the further fundamental analysis according to Porters Five-Forces as well as the “other factors”, please be aware that all included scores are of course highly subjective and reflect my own assessment of the situation. You do not have to concur with it, so please feel free to let me know if you have a different opinion, on one, several or all of the factors.
If you were shocked of hearing the word “subjective” you might want to skip this next part about estimating Company Value.
The general process I want to follow for most cases will be:
1) Calculating company value via standard Discounted Cash Flow method
2) Calculating company value via 2-3 different multiple approaches
3) Calculating company value via Dividend discount model (if it makes sense)
4) Using the average result to compare equity value against the current market cap
Using the latest reports of the company itself as well as current micro/macro environment as indicators and I will try to stay as objective as possible. Please bear in mind that though, that parts of this cannot be done without input from my side. You might therefore come to a completely different result, when you do your evaluation (which is fine). If you feel, I am being overly optimistic or pessimistic, you are free to give a thoughtful comment of course!
In this section I want to go into a little bit more detail about the factors used in the scoring approach, trying to provide a short explanation for each of the entries, starting with:
a) Financial key figures
First off, this will clearly be the most objective part of my analysis as most of the necessary data is readily available on various websites and only limited input/research is required on my side.
The higher a stock scores in this section the stronger it could be deemed financially and the lower it might be valued by the market at the moment compared to its’ intrinsic value. The evaluation is based on 10 different indicators which I will highlight below. Fulfilling a set requirement (subjectively set by me!) will award the stock 1 point per category. Being outside or far outside the set requirement will yield 0 or -1 points respectively.
The below are the indicators used and target ranges inside the scoring system:
1) EBIT/Enterprise Value (1 point if >5%; 0 points if between 1%-5%; -1 point if <1%):
Instead of applying the most widely used P/E ratio to give a first indication of a companies current valuation, I am using the less known EBIT to EV ratio to display the companies earning strength, taking into account their full capital (while the P/E ratio just considers a companies market cap, EV also takes into consideration the existing debt, which in recent times many companies have a lot of; EV = Market Cap + Debt - Cash).
2) Enterprise Value/Market Cap (1 point if <1,5; 0 points between 1,5-2 ; -1 point if >2):
Further utilizing the EV, I am comparing it to the current market cap of the analyzed stock to give an early indication whether the gross of a companies total value is derived from a high amount of debt. This would lead to a higher score in this category and might indicate a slightly more risky investment.
3) Cash Flow/Sales ratio (1 point if >5%; 0 points between 5%-1%; -1 point if <1%):
This key figure is not usually tracked by the most common sites across the web at the moment. It nevertheless provides a good insight as to whether a company is able to “turn good results into real money”. A lower percentage might indicate an issue with that. For reference, I will be using the Operative Cash Flow after investments out of the most recent companies filings, as not all companies disclose Free Cash Flow.
4) Debt/Equity ratio (1 point if <1; 0 points if between 1-2; -1 point if >2):
This is the first metric directly indicating the strength of a companies balance sheet. While it should never be relied on without any other context, it is obvious that a company with a higher amount of debt holds a higher risk for shareholders.
5) Operative Margin (1 point if >20%; 0 points if between 10%-20%; -1 point if <10%):
Operative Margin relates directly to how a companies’ business is performing in terms of profitability. Are revenues high enough to sustain the current operating cost? This metric will show it to you within a second.
6) Dividend Yield (1 point if >2%; 0 points if between 0%-2%; -1 point if 0%):
Companies paying dividends are mostly established in their market for a longer time, enabling them to generate constant positive cash flows that are sufficient to sustain not only further investments but also to reward the shareholders for their faith in their business. Of course most younger businesses will have a lower or zero dividend policy in order to enable further growth and investments, which will yield them -1 point here. But I will leave it that way as such company inherently would carry a higher risk for the investor.
7) Operative Cash Flow 5y CAGR (1 point if >10%; 0 points if between 1%-10%; -1 point if <1%):
The growth of cash flow available from the companies’ operating activities (also here, after investments), should be one of the main focus points of any management team, unless the business is in a steep ramp-up phase, requiring additional investments. If long-term Cash Flow
growth is evident, it is a good sign for the business as a whole.
8) Sales 5y CAGR (1 point if >10%; 0 points between 0%-10%; -1 point if <0%):
Having demonstrated continuous growth over the past 5 years can serve as a first indicator of further growth also in the following years. Annual revenue growth above 10% suggests that a company still has plenty of room to grow and/or is one of the leaders in its’ industry pushing for more market share.
9) EPS 5y CAGR (1 point if >10%; 0 points between 0%-10%; -1 point if <0%):
Same as for the long-term sales growth, continuously evolving (increasing) earnings per share can be an indicator of a stocks ability to convert top-line revenue growth into positive results. While significantly increasing sales are a good sign, especially in the early years of a newly founded company, at some point earnings will have to follow this development, to give shareholders a further proof-of-concept.
10) Effectiveness (1 point if 9) > 10; otherwise 0 points):
This metric is takes into account the long-term development of both, the top-line and bottom-line growth of a company. Has bottom-line growth exceeded top-line growth over the past years, it can serve as a first evidence/indication, that the company is making effective use of its’ cost structure and leveraging scale effects in order to grow its’ profit over proportionally.
The final result might look something like this:
For all indicators above I am reserving myself the right to adjust for any changes, I might see in the market, as a result of my evaluations or whenever it makes sense (i.e. in case of a REIT valuation I would switch to using FFO or AFFO instead of operating free cash flow and/or PE ratio as indicators).
To visualize the decision making process maybe a little bit better it looks something like this
With that being said, let’s move over to the
b) Five-Forces Analysis
For those not familiar, the concept of analyzing a business via the Five-Forces model (Wikipedia) is based originally on a framework published by Michael E. Porter (Harvard University) and attempts to determine the competitiveness of an industry by taking a detailed look at the 5 determining factors of the markets micro environment. The Forces identified by Porter are:
Competition inside the industry:
For a lot of established companies, this will be the main factor in determining possible growth opportunities and weighing new efforts against their expected benefit. The lower the threat of some of the other types of Forces (be it through high entrance barriers, superior bargaining power or others) the higher the rivalry inside a specific industry. Different organizations fighting for a competitive advantage may rely on innovation, advertising or increasing cost pressure to capture additional market share.
Threat of new entrants:
The threat of new entrants into an existing market is probably the factor which has seen the most significant changes over the past years. Entrance barriers to consider for new entrants would traditionally be existing patents, rights, regulatory requirements or high initial capital investments.
The inception of the internet has however made it easier than ever before to start a new business online, leverage the power of existing (3rd party) structures and break down so-called entry barriers into almost any market (including those previously thought save).
Threat of substitutes:
Substitutes in the context of the Five-Forces-Analysis do NOT refer to the obvious risk of a companies product being replaced by a cheaper one of a competitor (which would be a risk of new entrants or competition). Instead, a substitute will use a completely different technology to fulfill the same economic need. If you need to go from place A to B and have a car available, a substitute for it would be using the train, a plane or similar and not a cheaper car.
The risk of a variety of (possibly cheaper) substitutes plays right into the question whether an established company has a strong brand or other values that would retain customers to the prefer the existing product over an alternative.
Bargaining power of customers:
Customer bargaining power is prevalent in all markets that have an abundance of alternatives available. The higher the number of alternatives or substitutes available, the higher the customers price sensitivity becomes for a specific output, especially if no qualitative differences exist.
Considering that today a price comparison is usually just a few seconds away at the tip of your fingers, being able to retain pricing power within your market is a great show of strength for almost any company.
Bargaining power of suppliers:
Same as with the customer side, this Force is heavily influenced by the available alternatives on the supplying side of an industry. With only a few options available for sourcing a specific key component, material or service, a company can find itself dependent on one single supplier and might buy at any price.
Likewise the supplier in such situation can make use of its’ pricing power within his own industry to gain a competitive advantage.
Seeing the above, it becomes quite clear that the analysis itself as well as its’ result would usually be highly qualitative and dependent on the evaluators subjective thoughts.
I will nevertheless try to give a quantitative result by measuring the companies strength inside the industry for each of the Forces. A score between 1-3 will be given for each of the categories with 1 being the lowest (weak) and 3 being the highest (strong). Therefore the max score within this part of the scoring will be 15 points.
Last but not least the overall sum of the scoring shall also include
c) Other Factors
which is somewhat based on my own ideas of very well known factors that can have a significant impact on a companies success. To extend the reach of the traditional industry analysis I am including concepts that have become more important in recent times for any companies’ success.
Namely these are:
With reference to the commonly known “scalability” of a company in terms of increasing production while benefiting from decreasing fix cost, I am adapting this term which relates to the exponential growth effect that can be seen in some modern companies. New possibilities in the fields of data gathering, leveraging available infrastructure, and reaching customers quicker and more direct enable some companies to break into industries previously thought to have high barriers of entry. These factors enable aggressive companies to achieve not only strong but exponential growth, possibly at even lower cost than established companies. (Examples: Air BnB, Uber, Facebook)
Of course the benefit of intangible assets to a companies overall business is a well known factor for years and years. Be it a strong brand that people always return to, to buy their favorite coffee or clothes, a new technology, algorithm or an extensive data collection.
With basically anything being available to anyone, anywhere, standing out from the ocean of competitors means make or break in more markets than ever before. (Examples: Apple, Starbucks, Google)
3) Network Effects:
Companies or technologies that owe their success to the network effect (link) have significantly increased with the inception of the internet, even more so in recent years. In basic theory the network effect describes the impact that an additional user of a specific service/good/technology has on others already using it. Once a critical mass is reached the effect becomes more significant in a way that for each new used, the value achieved is higher than or equal to the price paid for the service/good/technology by each user. (Examples: The Internet (in the past telephones), Air BnB, Bitcoin).
In each of the above categories I will give a score of (once again) 1-5 based on my own analysis. Therefore a maximum score of 15 can be reached inside the “Other Factors” company.
The result would then be displayed in the following way (subject to changes, if I don't like it anymore):
Adding the points from all three categories, each analyzed company will receive a percentage rating based on the points achieved out of the maximum possible of 40. Having evaluated the companies financial strength, its’ position inside the industry as well as other influencing factors, what is left to do is assess and calculate its' possible current value.
Details on how I plan to approach the valuation, will follow in the next post!