Overview – Starting Our Quantitative Analysis
After coming up with our investment ideas and performing qualitative analysis on them, we can now begin the final step of our investment analytical framework, which is to perform quantitative analysis on our remaining prospective investments.
During our previous steps of coming up with investment ideas and performing qualitative analysis, our goal was to gradually whittle down our list of prospects as we went along. Indeed, by the time we arrive at this stage of our framework, the potential investments we have remaining should be the ones that have the highest probability of ending up in our portfolio.
That being said, it’s entirely possible for a prospect to make it to this stage yet still be rejected after studying its numbers. This is bound to happen: just because a prospect looks good from a qualitative standpoint doesn’t necessarily mean its numbers are good too.
By the time we finish our quantitative analysis, we should now have enough information to make a final decision on whether to pursue a potential investment or not. So, let’s take a look at how we can go about performing our quantitative analysis.
Remember the Importance of Comparisons
Before doing any number crunching, it’s crucial to keep one thing front of mind, and that is the importance of making comparisons.
Numerical data on its own provides very little, if any insight. That’s because there’s no context to establish any sort of meaningful benchmark.
For example, say that a company you’re looking at posted a net income of $100 million in the previous year. Sounds good, right? This may sound impressive until you learn that all of its competitors netted at least $250 million in the same year. Numbers are only as impressive, or disappointing, as the context they’re placed in.
It’s no exaggeration to say that studying numerical data without making any sort of comparisons is nothing more than an elaborate waste of time.
If an investor wants to extract the most insight possible from their quantitative analysis, then it’s imperative they make good comparisons with the numbers they have.
The more comparisons that can be made, the more insight investors stand to potentially gain. Going back to our focus on equities, this can be accomplished by studying a company’s numerical data for the past several years. What counts as “several” will vary between investors, but having enough historical data to draw comparisons from can help investors identify trends in the data and detect any anomalies in it too.
Selecting the Appropriate Ratios/Metrics
Saying “perform quantitative analysis” is one thing, but how exactly will an investor go about doing that? By using the appropriate investment ratios and metrics of course.
Ratios/metrics are so powerful because almost all of them connect seemingly disparate pieces of data, and in doing so reveal important relationships investors would otherwise miss.
Net income and total assets seem like unrelated values. After all, they’re reported on separate financial statements and represent entirely different things. However, the return on assets (ROA) ratio creates a relationship between these two values, revealing how effectively companies use their assets to generate revenue, and by extension, their net income.
Knowing about investment ratios/metrics is one thing, but what’s more important is knowing the appropriate ones to use on a given company. Very few ratios/metrics can be applied to every type of company and/or industry.
This isn’t to say there are no common ratios/metrics that can be used across several companies because there certainly are. Rather, some ratios/metrics can provide more meaningful insight than others in certain contexts.
TD Bank and Shopify have entirely different business models, so the ratios/metrics that will need to be used when analyzing them will be very different.
Naturally, this may raise the question of “How do I know which ratios/metrics to use?”
There are hundreds, if not thousands of ratios/metrics in existence along with countless variants. So, the fastest way to answer this question would be to perform an internet search. Now, this doesn’t mean an investor will know every relevant ratio/metric after doing this, but it’s certainly a good start.
As an investor gains more knowledge about certain industries, and as they continue to accumulate more experience, in time they may discover more nuanced ratios/metrics that will help them with their work. Perhaps they may even come up with their own ratios/metrics they feel will provide the insight they need.
We previously discussed how studying numerical data without making any comparisons is a fruitless endeavour. That same idea is also applicable when using investment ratios/metrics.
Calculating a plethora of ratios/metrics in a given fiscal year won’t be of much help unless those same ratios/metrics are calculated on historical data and are then compared to try and spot any trends.
Performing Quantitative Analysis on the Financial Statements
After discussing the importance of making good comparisons and knowing which investment ratios/metrics to use, we can now turn to the three documents that contain the bulk of the numerical data we wish to study: the financial statements.
(If you’re unfamiliar with what the three financial statements are, it’s highly recommended you read more about them before proceeding.)
As you may already have surmised, the approach we take when performing quantitative analysis will vary on the prospective investment we happen to be looking at, which is to be expected. Therefore, there’s no “one-size-fits-all” approach when studying the numbers.
So, instead of going over every possible approach when analyzing the financial statements, we will instead go over a more general approach where we discuss numerical data of interest that investors may want to focus on, as well as some ratios/metrics they may want to calculate.
Financial Statement Analysis: Balance Sheet
As we know, the balance sheet reports what a company “owns” (assets) and what it “owes” (liabilities). We also know that the sum of assets is equal to liabilities plus equity. That is, there are two ways to acquire assets: by using funds contributed by the company’s owners (using equity) or by taking on debt (debt becomes a liability).
Focusing on that last point of using debt to acquire assets, one of the first things investors may want to check is to see how leveraged a company is (i.e., what percentage of their assets were acquired by taking on debt/liabilities). A very simple way to do this is by computing total assets/total liabilities.
This is a quick litmus test to see how much debt a company is taking on. Almost all companies take on debt to purchase and/or repair assets, but too much debt is a problem that cannot be ignored, especially if the total assets/total liabilities ratio starts to approach 1 (an increasing number of assets are being acquired using debt).
Keeping a close eye on liabilities is important, yes, but it’s also important to discern what portion of those liabilities are current.
If a large portion of total liabilities is current (i.e., are due in under a year), this may present an issue if the company has insufficient cash or assets on hand to pay for those liabilities, something that can be checked by using the quick ratio (current assets/current liabilities).
Investors may also want to extract the total assets and total equity numbers from the balance sheet. That’s because these figures will be used to compute certain ratios later on, namely the return on assets and return on equity.
Because balance sheets are a “snapshot” of what a company owns and owes, that is, everything being reported in it was on a given day, making comparisons with historical data is tricky.
However, assuming a company dates its balance sheet on the same day, or roughly the same day, every year, then investors can more or less see how a company’s balance sheet changes year after year.
Financial Statement Analysis: Income Statement
Next, we arrive at the income statement, or earnings statement.
Every income statement will look different, depending on the industry a company operates in and the types of products/services they offer. Although specific income statement arrangements may vary, they all must follow the same skeleton. That is, at their core, they all report the same things: revenues, expenses, and net income.
This may not be readily apparent for all income statements, but after a few minutes of review, the same skeletal format will be made apparent.
Looking first at the “revenue” section, investors may want to focus on how it’s broken down. Companies that have different business divisions usually report the revenue earned from each of them. If a company operates in multiple countries, then they may report how much they earned in each country.
Regardless of how this portion of the income statement is organized, investors will want to compare these figures to historical data to see if there are any trends, such as certain business divisions showing a steady increase in earnings, or a few countries showing continuously declining earnings.
Moving onto the “expenses” portion, we follow the same procedure: understand how expenses are broken down, compare these numbers with historical data, and try to detect any trends.
Amortization & Depreciation is commonly reported under expenses, which will be important to make note of when analyzing the cash flow statement.
Net income is found at the bottom of the income statement and is used to calculate a variety of ratios such as return on assets, return on equity, dividend payout ratio, and price to earnings, to name a few.
Financial Statements Analysis: Cash Flow Statement
Finally, we arrive at the cash flow statement.
It’s easy for investors to overlook the importance of the cash flow statement in favour of the first two, but it serves the critical role of reconciling the numbers reported in the income statement and balance sheet, as well as showing investors how exactly a company’s cash moves around.
Investors must remember that revenue and cash are not the same things. A company can post impressive revenue/profit figures but still be starved for cash, leaving the unattentive investor scratching their head. It doesn’t matter if a company consistently reports record profit yet struggles to have enough cash on hand. You can’t pay employees or cover other immediate costs with receivables.
So, the one metric investors will want to keep a close eye on is free cash flow.
Free cash flow is, arguably, one of the most important metrics for an investor to know, and is something an investor will almost always want to calculate.
That’s because free cash flow is what companies use to pay dividends, repay debts, and make future capital investments. Free cash flow also serves as the basis for valuation methods such as discounted cash flow.
Once we have free cash flow, we can also calculate the dividend payout ratio relative to free cash flow, which is dividends paid/free cash flow. Dividends are a portion of a company’s earnings, yes, but remember that earnings do not automatically mean cash.
As always, we’re always looking to make comparisons while trying to spot trends in historical data. If a company’s cash flow in any of the three major categories (operations, financing, investing) starts to show a noticeable trend, then investors will want to keep an eye on its future development.
Quantitative Data That Isn’t on the Financial Statements
While most of the relevant quantitative data that investors will need can be found in the financial statements, some of it won’t.
Most of the time, this additional data can still be found within the annual/quarterly report, but while some of this supplemental data can be found relatively easily, others may be tucked away deeper than expected.
For example, most large banks have a detailed breakdown of their loan portfolio, such as the clients they extend loans to (individuals, businesses, government entities), and the geographical locations they operate in. Knowing what a bank’s loan portfolio looks like is crucial to understanding its financial health, and by extension, its investment merit.
However, this data is tucked away in another part of the annual report, and the responsibility rests on investors to find it.
The type of supplemental data investors will need varies between industries and individual companies, which again, is not surprising.
While it’s tempting to skip this portion of quantitative analysis due to the difficulty in obtaining the data, it would be a mistake to do so. That’s because there are still important bits of data that, although aren’t easy to access, can still provide investors with important insight into investment merit.
Arriving at a Final Investment Decision
Let’s quickly review what we’ve done so far in our analytical framework: came up with a list of prospective ideas and narrowed them down, performed qualitative analysis and further narrowed our list, and then finally performed quantitative analysis on our remaining prospects.
After performing all of these steps, we wrap everything up by making a final verdict: after analyzing all of our remaining prospects, do we proceed to add them to our portfolio or not?
Regardless of the decision that’s made, the hope is that it’s made with full confidence given the amount of work that was undertaken to get to this point.
Wrapping Up
With this article, we now conclude our investment analytical framework, which began with coming up with investment ideas and ultimately making a final verdict.
Again, the framework we’ve gone over by no means claims to be the “perfect” one all investors should follow. Readers may wish to follow it step-by-step, take some bits for inspiration, or reject it entirely.
Regardless of what you wish to do with this, its purpose was to provide an in-depth example of how investors may want to go about performing their work and to show that the steps needed to go from coming up with investment ideas to making a final decision don’t have to be overly complicated.
