Harry Domash's Winning Investing


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.

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 


Dividend Detective: If you like dividends, you'll LOVE Dividend Detective

Questions or comments about this site:

Winning Investing   199 Quail Run Road Aptos, CA 95003

(Aptos is 'the beach' for Silicon Valley)

(800) 276-7721 • (831) 685-1932