Begin with the business, not the share price

Buying a share means buying a small ownership interest in a business. Before looking at its price chart, ask what that business does, why customers buy from it, and whether it can continue earning money through good and difficult years.

A business that made an unusually large profit last year is not necessarily a good long-term investment. Its result could reflect a temporary shortage, a one-off contract, favourable exchange rates or the sale of an asset. What matters is whether the underlying business can repeat good results without constantly spending more money just to remain competitive.

An example: two imaginary manufacturers

Harbour Fasteners sells standard bolts. Customers can switch suppliers easily, and competitors frequently undercut its prices. Harbour may earn a decent profit, but it must continually defend every order.

Precision Seal Systems sells a specialised component built into customers’ production lines. Switching suppliers requires testing, documentation and plant downtime. If Precision maintains quality and pricing discipline, those switching costs may help protect its business.

Neither business is automatically a good investment. Harbour could be a bargain at the right price; Precision could be overpriced or lose its advantage if a better technology appears. Financial statements help us investigate the economic difference between the two.

Figure 1Two imaginary manufacturers, two different positions

	Harbour Fasteners	Precision Seal Systems
What it sells	Standard bolts	A specialised component built into production lines
Customer switching	Easy	Requires testing, documentation and downtime
Competitive pressure	Frequent undercutting; every order defended	Protected while quality and pricing hold
What to verify	Whether profit survives price competition	Whether results support the claimed advantage

Look for evidence, not a good story

A potentially durable advantage can come from reputation, cost efficiency, distribution, network effects, switching costs, patents or specialised know-how. Each has weaknesses. Brands fade, low-cost operators face new competitors, patents expire, and technology can make established products obsolete.

Ask whether the company’s reported numbers support its claimed advantage. Does it maintain profits when rivals struggle? Can it raise prices without losing customers? Does it generate cash after maintaining its assets? Does its debt remain manageable?

Figure 2Treat an advantage as a hypothesis

1. 1Name the claimed advantagereputation, cost, switching costs, patents…
2. 2Predict what it should showsteady margins, pricing power, returns
3. 3Check several years of resultsnot one exceptional year
4. 4Ask what could weaken itcompetitors, technology, customers

A clear explanation of a company’s strengths is the beginning of analysis, not the conclusion.

Where to find reliable information

Most of the information needed to understand a listed company is free. The most important source is the annual report, which contains the audited financial statements, the notes that explain them, the directors’ report and, for Australian listed companies, the remuneration report. Half-year reports add a reviewed, rather than fully audited, update. Companies listed on the ASX also publish market announcements, which include results releases, investor presentations and any information that could materially affect the share price.

Treat these sources differently. The audited statements and their notes have been examined by an independent auditor against accounting standards. Investor presentations and results commentary are prepared by management to explain the results, and they naturally emphasise the favourable parts. Both are useful, but when a presentation highlights an “underlying” or “adjusted” figure, look for the reconciliation to the statutory figure in the accounts and read what was excluded and why.

Begin with at least three to five years of annual reports where they exist. A single year can be distorted by an unusual event; several years show whether results are repeatable. Read the notes on revenue, segments and significant items early, because they explain where the headline numbers come from.

Understand how the business earns its money

Before calculating any ratio, write in two or three sentences how the company earns revenue. Who pays, for what, how often and on what terms? The answer shapes how every later number should be read.

Look at the segment note in the accounts, which breaks revenue and profit down by division or region. A company that appears to be one business may be several, with very different economics. Ask how much revenue recurs, through contracts, subscriptions or repeat purchases, and how much depends on winning new one-off sales each year. Check whether a small number of customers account for a large share of revenue; companies often disclose major customers, and losing one can change the picture quickly.

For the imaginary manufacturers, Harbour Fasteners might sell to hundreds of distributors in small orders, while Precision Seal Systems might sell to a handful of large manufacturers under multi-year supply agreements. Precision’s revenue may be steadier while those contracts last, but it carries the risk of depending on a few customers. Neither structure is better in itself; each changes what to watch.

Look at the industry, not just the company

A company’s results depend heavily on the industry it competes in. Some industries let most participants earn reasonable returns; others push profits down for everyone. A few questions help:

• How many competitors are there, and how do they compete? Many similar suppliers competing on price tend to keep margins thin.
• How strong are customers and suppliers? A business that sells to a few powerful buyers, or depends on a single critical supplier, may struggle to keep its share of the value created.
• How easily can new competitors enter? High start-up costs, regulation or specialist expertise can protect existing firms; low barriers invite new rivals whenever profits look attractive.
• Could a different product replace this one? A new technology or business model can make an established product less relevant.

Figure 3Industry questions that shape a company's results

• Industry conditions
  • Rivalrymany similar suppliers competing on price?
  • Customers and suppliershow much bargaining power do they hold?
  • New entrantshow hard is it to start competing?
  • Substitutescould another product do the same job?

Consider management and incentives

Management decides how profits are reinvested, whether to borrow, whether to buy other businesses and whether to return cash to shareholders. Over many years, those decisions can matter as much as the underlying business.

Read the remuneration report to see what executives are rewarded for. Incentives tied to revenue growth or acquisitions can encourage expansion that does not create value; incentives tied to return on capital, cash flow or long-term shareholder returns tend to align better with owners. Look at how earlier promises compare with what was later delivered: past annual reports are a good record of what management expected and what happened. Note whether directors and executives hold meaningful shareholdings of their own, while remembering that ownership alone does not guarantee good decisions.

Write down your reasons before you buy

A short written note, prepared before any decision, is one of the most useful habits an investor can form. In a few sentences, record why you think the business is attractive, what you expect its results to show over the next few years, what the main risks are and what evidence would tell you that you were wrong.

The last part matters most. If you believe Precision Seal Systems has a durable advantage, write down what would weaken that belief: falling margins as customers renegotiate, a major contract lost, or a competitor’s product being approved by a key customer. Later, when new results arrive, compare them with the note rather than with your memory. Memory tends to adjust itself to the share price; a dated note does not.

Stay within what you understand

There is no obligation to have an opinion about every company. Businesses whose products, customers and economics you can explain in plain words are far easier to assess than those that depend on specialised technology, complex financial products or regulatory decisions you cannot judge. It is reasonable to pass on a company simply because you do not understand it well enough, and to spend your time on businesses where your knowledge gives you a fair chance of reaching a sound view.

Keep the business and the share price apart

A share price changes every trading day; the value of the underlying business usually changes slowly. On a given day, the price reflects what buyers and sellers are willing to trade at, influenced by news, interest rates, general market mood and the need of some holders to sell for reasons unrelated to the company. Over long periods, prices tend to be pulled towards what the business earns, but in the short term they can move a long way in either direction.

That gap is useful once you see it. A falling price is not, by itself, evidence that the business has deteriorated, and a rising price is not evidence that it has improved. Before reacting to a price movement, ask what has changed in the business. If the answer is nothing, the movement may be an opportunity or simply noise. If the business has changed, the price movement may be justified, or may not yet reflect the change. Either way, the analysis starts with the business.

Read management’s letter with care

Annual reports usually open with a letter from the chair and chief executive. It is worth reading, because it shows how management describes the year and what it chooses to emphasise. It is also written to persuade.

Read it alongside the numbers. If the letter celebrates record revenue, check what happened to profit and cash flow. If it explains a weak year as the result of temporary factors, look back to see whether similar temporary factors were cited in earlier years. Note what is not mentioned: a large write-down, a lost customer or a rise in debt that appears in the accounts but not in the letter. Letters that explain setbacks plainly, and that measure progress against goals set in earlier years, deserve more weight than those that describe only successes.

Avoid the common starting mistakes

Several mistakes are especially common when people begin analysing companies:

• Buying last year’s winner. A company whose share price rose sharply may already reflect good news. The question is what the business will earn from here, at today’s price.
• Following a story without numbers. An exciting product or market can be real and still produce poor returns for shareholders if competition, costs or dilution absorb the benefits.
• Ignoring the number of shares. A company that repeatedly issues new shares can grow its profit while each existing share’s portion shrinks. Chapter 6 returns to this.
• Relying on a single year. One strong year may be the exception, not the pattern.
• Acting on tips. A recommendation from someone else is a reason to investigate, not to buy.

Each mistake has the same remedy: return to the business, its numbers over several years and the price you are paying for it.

A first look at any company

The rest of this guide develops the tools for a closer analysis. A first look, before any detailed work, can be done with a handful of questions and the most recent annual reports.

Figure 4A first look at a company

• Avoid: What does it sell, to whom, and how does it get paid?
• Avoid: What industry conditions does it face?
• Avoid: Have revenue, profit and cash flow been steady over five years?
• Avoid: How much does it owe, and when is it due?
• Avoid: What do management's incentives reward?
• Do: x What would make the investment case wrong?

The aim of this first look is not to reach a decision. It is to decide whether the company deserves the deeper work described in the following chapters, or whether its business is too hard to understand, its numbers too erratic or its debts too pressing to justify the effort.

Compare a company with its closest rivals

Numbers mean more beside a comparison. A 12% operating margin might be excellent in one industry and poor in another. Before judging a company’s results, find two or three businesses that sell similar products to similar customers, and look at the same measures for each over the same years.

Comparisons answer questions that a single company’s accounts cannot. If every competitor’s margin fell in the same year, the cause was probably the industry, such as a rise in raw material costs, rather than the company’s own management. If one company kept its margin while others lost theirs, that may be evidence of the advantage it claims. If a company’s growth comes mainly from buying smaller rivals while the industry as a whole is flat, its growth rate says little about its competitive strength.

For the imaginary manufacturers, the useful comparison is not Harbour against Precision, because they sell different things. It is Harbour against other standard-fastener suppliers, and Precision against other makers of specialised sealing components. Each comparison tests the claim that matters: whether Harbour can earn a fair return despite competition, and whether Precision’s switching costs really protect its margins.

Be careful to compare like with like. Companies may use different financial year ends, present results in different currencies, or classify some costs differently. The notes to the accounts usually explain these choices. Where they cannot be reconciled, treat the comparison as a rough guide rather than a precise ranking.

Comparisons also help set realistic expectations. If the best-run businesses in an industry have rarely grown revenue faster than a modest rate over a decade, a forecast that one company will grow several times faster deserves careful scrutiny. That does not mean it cannot happen, but it should be supported by evidence about why this company is different.

Key takeaway

A durable advantage is a hypothesis to test using several years of performance, not a label to accept because management uses it.

Quick reference

• What does this company sell, and to whom?
• Why do customers choose it over alternatives?
• What could weaken that advantage?
• Do the company’s financial results support the story?