Three tests form a good guide when investing in shares.
As a finance professor who teaches equity analysis, I am all too often asked by my students for stock recommendations. I am not a financial adviser, so I will not give specific stock picks. However, I do provide the three questions necessary to make an investment in an individual stock.
What is the historical performance of the company?
Let’s start here. Past performance sets a baseline for a company. It is important to remember that a company is worth the sum of its future cash-flows – not its historical cash-flows. Understanding the past, however, may give us a useful guide as to how a company will do in the future.
For publicly traded companies, examining the last five years is helpful. Financially, what are the growth rates, what are the margins, what is the level of return on investment? These are all important in understanding how a company generates cash-flow.
It is also important to do what is called an EIC analysis, standing for economy, industry and company. The economic analysis looks at the macro environment to understand how it is affecting the industry and the specific company that is being analyzed. Industry analysis focuses on market attractiveness. Approximately 50% of the performance of any company will be impacted by its external environment. Evaluating sources of competitive advantages over time is a key part of a company analysis.
Take Tesla, which announced a 10% workforce reduction in April 2024. A glance at the industry for electric vehicles suggests a slowing market. The transition to electric vehicles is taking longer than expected. Even Tesla is unable to escape the market challenges, which are suppressing its growth rate and its sales margins. Specifically, its first-quarter sales of 2024 are expected to decline year over year between 2023 and 2024.
What is the expected performance of the company?
A company is worth the sum of its future cash-flows, and it is important to understand what will drive those cash-flows. We start with the industry or market and its expected growth rate over time, and then estimate the company’s growth rate. We then look at the company’s margins, so that we understand how much cash will be generated on an average sale. We then look at investments the company is expected to make over time in working capital and capital expenditures, to help us better understand return on investment.
Value is based on the future growth of a company and its future return and investment. That is what must be estimated when we look at the future performance of a company. Generally, the next five years are the most important for an evaluation. If the company is in a cyclical business we must look across the entire cycle. To understand why Nvidia saw its share price skyrocket in 2023, it’s useful to know that the company’s revenue is expected to grow to over $150 billion and its operating profit to over $92 billion by 2027.
Does the current price accurately reflect the expected performance?
If a company is expected to do well, and the price reflects it, then there won’t be much upside to the investor. For more than 40 years, Warren Buffett has invested in what he calls ‘broken stocks’ – that is, companies where the price does not accurately reflect future expectations. Buffett exploits this, and that allows him to earn above average returns.
In early 2024, Nvidia’s stock price reached $900 per share. At that price, the full expectations of Nvidia’s improved performance were built into the stock. From an investor standpoint, returns above $900 per share would mean that Nvidia would have to do even better than the current expectations of the company. As such, Nvidia may not be a great investment at its current price. It is not that it is performing poorly or even that it did not have improving expectation for the future. It is that the market had appropriately priced those expectations and that would limit the upside in the near term.
