Is it a good company?

My checkboxes before buying shares of a company.

I am not a financial advisor, and the points listed below are only influenced by past investing experiences and various books I’ve been through. Furthermore, choosing an investment vehicle is pretty much a personal endeavour, as everyone has their own risk tolerance and time they are able to dedicate to company research.

Make sure to understand the current business

Before buying shares in a company, you have to at least understand how the company is making money, and what key factors will contribute to better earnings in the future. This is generally quite simple. If its’ CocaCola, you know that the company selling more soft drinks (for example to a wider market) would increase earnings. For Tesla Motors, we know that selling more cars at a higher profit margin would mean more profit. If you find it difficult to understand the business model, avoid the company. There are a virtually unlimited amount of investing opportunities. Do not go for ones you do not understand.

Company Level of Debt

Companies need financing to help spearhead growth. Financing can either come from

  1. Debt - loaning money at a negotiated interest rate, or
  2. Equity - giving a percentage of the company to new owners by selling shares in the company (hence we are here looking to buy shares).

When a company is in debt we just need to make sure that the company is able to cover interest payments. If it is unable to cover interest payments, we typically do not want to be anywhere close to it due to a risk of default. And that is only the most glaring worry for a company unable to meet interest obligations. Credit rating downgrades will make it more difficult for the company to get financing in the future, and if it does, this will be done against unfavourable interest rates.

One important concern for companies in high level of debt is employee, supplier and customer concerns. Financial distress may encourage the better employees to leave the company and in turn this may effect customer and supplier relationships.

Formulas to care about:

  • Debt-to-Equity Ratio: Lower is better. It means that the company is less leveraged, hence less risky.
  • Interest coverage ratio: The length of time (in number of fiscal years) for which interest payemnts can be made with the company’s currently available earnings. = EBIT/Total amount of interest expense. For example if a company’s earnings before interest and tax is $10,000 and total interest due is $2,000 the coverage is 5x. We’re looking for at least 2 here, but anything below 1 is very problematic.
  • Debt-to-asset Ratio: How much of the company assets are covered by Debt. A lower ratio means the company is less leveraged.
  • Current Ratio: Current Assets/Current Liabilities. Above 1 suggests that the company can cover its’ short-term liabilities with short-term assets.

What new business will improve company earnings going forward?

And how large will this new endeavour be as a % of total income?

This is an important question to answer, and albeit we can never be exactly right on the amount of money a business endeavour will bring in, we must be sure that a best case scenario would be a high percentage of what the current earnings are. Tesla motors started selling ther Autopilot and Full Self-driving (FSD) Capability software at a cost of $12,000. Their average car sale is slightly above $45,000. This means that if in the lifetime of the new customers (buying the car), if half of them buy FSD Software, Tesla will push its’ average earnings per car to around $51,000, a good percentage improvement. If on the otherhand Tesla started selling a new $20 toy with every car they sold, the improvement is not worth any of our attention.

Can Shareholders be diluted?

Dilution refers to the reduction in the percentage ownership of the given company when it issues new shares.

This is considered a major risk. Shareholder dilution occurs when there is an increase in the number of shares on issue that is not proportionally distributed between all shareholders. Often due to the company raising equity capital or some options being converted into stock (think Employee Stock Options). All else being equal, if there are more shares outstanding then each existing share will be entitled to a lower proportion of the company’s total earnings, thus reducing earnings per share (EPS). While dilution might not always result in lower EPS (like if the company is using the capital to fund an EPS accretive acquisition) in a lot cases it does, along with lower dividends per share and less voting power at shareholder meetings.

In Q4 last year I bought Greenwave Technology Solutions (GWAV), a company operating 13 recycling facilities averaging $2.04 per share. The prospects looked good. Management planned to open new facilities and expand to 20+ locations, upgrade technologies and sell directly to consumer to improve margins, install a new automotive shredder, essentially doubling the companies’ output and more. However, the stock tanked to $0.48c per share at the time of writing. The reason? The company needed to raise equity, and there was a 55% increase in outstanding shares.

Note that this was only one of the reasons. The company has run into financial trouble where its’ debt ballooned from $6m to $37m, resulting in company liabilities exceeding its’ assets (negative shareholder equity).

Current P/E and PEG ratios when compared to similar companies

When all is said and done, we care about the number of years it will take to get our investment back. Compare to similar companies to get an understanding of what is expensive for the industry.

Is it in a Hot Industry?

This one is directly taken from Peter Lynch (One up on Wall Street). If everyone is talking about it, you’re probably not going to have any advantage you can profit from and institutions are all over the industry.

Does the company rely on one (or a few) big customer/s?

With one or a few customers the company is vulnerable to decisions made outside of its’ control. That is, if the customer decides to go elsewhere, the company will be in trouble and you will, in most cases, lose a big chunk of your investment.