Behind Every Ticker is a Business
If you wouldn’t buy a business without looking at its books, why would you buy a stock without looking at its books? If one had $10,000 to put into a non-publicly traded company, one would audit that business like $10k was on the line, because it is! But for some reason, if it were a stock, and the average investor saw a catchy headline with that ticker in it, all audit bets are off.
One of the most forgotten things for investors is the raw business behind the stock. As much as we wish it weren’t the case as consumers, businesses operate solely on the movement of money. The financial statements reveal the true health of a business; an undeniable metric that can only be altered by highly illegal, highly immoral, and highly unlikely fraud. Investors who understand basic financials separate winners from stocks drowned in hype.
The Three Core Statements
The three key financial documents that I recommend to always review are the following:
Income Statement
Cash Flow Statement
Balance Sheet
I assure you that by the end of this article you won’t be an accountant, but you will understand the gist of financial statements—likely more than you already do. Quick note before we start: no metric gives a perfect read on where a stock is headed. Trust me—there are plenty of stocks in the market that would still look overpriced even if their price got chopped in half. Financials are simply a value machete—cutting through all the non-sense, hype, FOMO, FUD, or any other news that stretches a stocks price.
1. Income Statement
Income statements measure the profitability of a company. Through all of the super fancy business terms you probably learned in 8th grade: revenue, expenses, and the bottom line—net income. While those business terms are valuable, more often than not the business is bringing in an astronomical amount of money. Making it very difficult for us non-accountants to piece together the companies outlook when dealing with hundreds of millions, billions, or more. So, to make this easier I look at earnings per share, or EPS. Beyond this, I would just ensure that the numbers make sense. For example, has the EBITDA (Earnings Before Interest, Debt, and Amortization) grown consistently? Does the total revenue out-grow the cost of revenue? Any other logical check you can think of, I encourage you practice it.
2. Cash Flow Statement
A cash flow statement tracks the actual cash movement without the accounting news. Cash flow has some of the most important metrics across the board of analyzing stocks. For a breakdown of the big three cash flow metrics, check out a prior article over ‘Following the Money’. But one key metric I will go over quickly is the Free Cash Flow (FCF). This is the margin of cash left after operations and expenses. Therefore, if this number is low, it shows that the company is essentially operating paycheck to paycheck.
3. Balance Sheet
I purposefully left this financial statement for last. This is Warren Buffett’s favorite financial statement, saying: "I read the balance sheet more than the income statement”. Also Peter Lynch, a professional investor with a CAGR of 29.2% once said “The biggest losses in stocks come from companies with poor balance sheets.”. So it’s fair to say that the balance sheet is crucial to understand for value investing. Simply put, the balance sheet shows what the company owns and owes. What assets the company has, the return on those assets; the liabilities and the amount those liabilities are costing the company. Like the income statement, we only need to do some logical puzzle piecing for stock purchasing. Ensure that the total assets of the company is growing—and outpacing the total liabilities. Also, you may want to take a look at the debt and know that the company isn’t taking on more than they can handle, and is likely able to pay off what they are borrowing.
Conclusion
Financials are likely one of the most boring topics when discussing the analysis of a stock; but by far the most necessary, as proved by the most highly regarded investors saying so. You don’t need to be an expert level accountant to be an independent investor; you just need to understand when a company is functioning as a normal company versus when it’s going through a time that is much higher risk to invest in it. Blindly trusting analysts, news headlines, or other opinions is simply noise compared to simplified analysis of a company.