Value Investing: How to Read and Analyze Financial Statements

stock market value investing series Mar 25, 2021
Value Investing

In this article series, you will find everything needed to start your path as an investor. Unlike most investors (beginners) who begin to invest based on speculation and news, we will approach investing the proper way. Through this article series, you will learn to invest based on value and not on news. 

After I introduce you to the material that we're going to study, we will go in-depth and do a ratio analysis of the company I chose. We will analyze the company by four ratio categories, giving you a complete picture of the company you're researching. The ratios will tell you whether the company is:

  • Profitable
  • Managing its debt properly.
  • Efficiently utilizing its debt and assets.
  • A cheap or expensive buy, based on the assets they own

After you learn how to do this ratio analysis, you can, without a doubt, do the right thing when it comes to investing. Unlike most investors, you won't have to panic if a company's price per share is declining because you know the fundamentals are good, and you can hold without hesitation.

Without further ado, let's dive into it!

1. General Information

In this article series, we will analyze ExxonMobil (NYSE: XOM). Exxon Mobil is an American oil company, and it's one of, if not the oldest oil company around the globe. For the past 135 years, ExxonMobil was considered the gold standard of oil companies. Without proper management, a company cannot survive for that long. In the past 10 years, the health of the company gradually worsened. Many of its smaller competitors overtook it and are now standing above it. Could we say in the present that ExxonMobil is the same company that it was before? We will answer this question with the information you're about to learn from this article series. 

Before we start, I must state that stocks are subject to speculation, so if you plan to invest short term, this analysis won't be of any use to you. The first thing you should ask yourself is what kind of investor you are? Are you a short-term or long-term investor?

If you're a short-term investor like most retail traders (trying to scalp stocks), you'd be better off gambling in a casino. Why? As retail traders, most of us don't have access to massive capital; therefore, most of the time, to scalp anything, you would stick to low market cap penny stocks. There is not enough fundamental data to do anything but speculate about future growth with such a low market capitalization. The problem with speculative investing in low-cap stocks is that any piece of positive or negative news can have a tremendous and immediate effect. If, for instance, positive news comes out all of a sudden, and a vast price spike is caused, the retail investor would stumble in a mass of confusion to figure out whether to cash out, compound his gains, or do nothing. Instead of continuing upwards as most would hope, that stock plummets quicker than it rose, and the retail investor is stuck with an 80% loss. Why do we not see any big professional investors being caught in this situation? Unless a professional investor sees immense value in that stock, he would have never even invested, to begin with. This leads us to the long-term investor.

Unlike short-term investors, long-term investors look at the fundamentals behind a company. Those fundamentals include different categories, based on which you could set yourself some guidelines on what to expect in the near term. Based on data from the financial statements released by a company, you can check the profitability, liquidity, utilization of income, and many more parameters, which draws a complete picture of the company's future growth potential. The data presented in the financial statements will be turned into ratios via mathematical formulas. We will review the ratios under four categories:

Liquidity Ratios - Current Ratio and Quick Ratio

Valuation Ratios - P/E Ratio and P/B Ratio

Profitability Ratios - Return on Equity and Gross Margin

Solvency Ratios - Debt to Equity and Total Debt to Total Assets

2. Ratio Overview and Categorization

This section will discuss and preview the ratios that we're going to study in this article series. We will not go in-depth here, so if you don't understand anything or some term is not explained, don't worry we got you covered! In future articles, we will go through step by step for every ratio, which will be more than enough to answer all of your questions. 

Other terms like Cost of Goods Sold (CoGS), Book Value (BV), or any other similar term you will find inside this section will be explained step by step in future articles. All formulas that we used to calculate and every parameter in the formulas that need a calculation will also be reviewed to learn where everything is coming.

The data that we used for these ratios is not fake and is 100% accurate. For your further studies and ratio analysis, all this data can be extracted from the financial statements. To find them, go to the company's official site that you're researching and look for the financial statement, which can be either quarterly or annual. The most common and widely used format of the statement is the 10-K. 

This format is issued by the U.S. Securities and Exchange Commission (SEC) for any publicly-traded company and is probably the most comprehensive one out there. The SEC issued this format to make the investors fully aware of the company's financial condition and help them make a rational choice based on the data that they will find in the 10-K financial statement.

The other way to acquire the data from these financial statements is to get it from any third-party site. If you decide to take this path, use only a well-trusted provider. There are many sites where the data feed is entirely false, thus misleading you in your calculations. For example, a slight difference in the long-term or short-term debt won't be crucial, but if the site you're using took all the liabilities under either long-term or short-term debt or both, then that makes a huge difference.

For example, let's take the value for 2019 (all values are in millions). In 2019 the long-term debt was $26,342, while the total liabilities were $163,659. As you can see, as I pointed out above, the difference is vast, and that is why the data should be extracted only from either the official financial statement or a very trusted third-party site. With that said, let's dive into the ratio overview!

2.1 Current Ratio and Quick Ratio

While both ratios measure liquidity, the concept behind them is very different. 

The current ratio measures a company's ability to pay its short-term liabilities (up to 12 months) with the balance sheet's current assets. The quick ratio measures the same thing, but it uses only assets that can be turned to cash in less than 90 days. Looking at both ratios' specifications, we see that the quick ratio is more conservative. It is conservative because it uses high liquidity assets, which can be turned to cash in a short time frame. The current ratio includes all assets, even very slow ones such as inventory because these assets can take a while to get turned into cash.

2.2 P/E Ratio and P/B ratio

These ratios fall under the valuation category and are used to determine a company's true value. 

The Price to Earnings (P/E) ratio is used to value the current price per share of the company (market price) compared to the Earnings per Share (EPS). The EPS can be found inside the financial statement under the income statement tab. There are two types of P/E ratio which are forward and trailing (TTM). 

We will review only the TTM version since it represents the P/E ratio in its most accurate form. It is the most accurate because we calculate the P/E ratio based on final data, which is released after a quarter or year ends. The forward P/E ratio is based on future estimates, making it less reliable. The only way to interpret the forward P/E ratio is to get an idea of where we could be heading. 

The Price to Book (P/B) ratio is used to value a company's market price to the book value. The book value is the amount of assets that the company owns per share. Checking that ratio is always good because the book value is always lower than the market value. That will give you an idea about the investment you are making.

2.3 Gross Margin and RoE

The gross margin represents the total revenue minus the cost of goods sold (CoGS). Sounds confusing? Let's break it down with an example. 

First, let's divide the cost of goods sold to manufacturing supplies and labor costs. Now let's say a company has a total revenue of $200k, manufacturing supplies of $50k, and labor cost of $100k. With $200k total revenue and CoGS of $150k, the gross margin would be 0.25 (25%). So, in essence, the gross margin represents how much gross profit a company retains per one dollar. Why is the gross margin ratio important?

If we take the same total revenue of $200k and manufacturing costs of $190k, that means we would have only 0.05 (5%) in gross profit. Profit is profit, but the background speaks otherwise. If you only retain $0.05 per dollar, this means that you are either buying over expensive manufacturing supplies or your labor costs are too high. 

The return on equity (RoE) is a ratio that is part of a branch of ratios named "Return on X". The X represents other ratios that involve assets or investment. In our case, we will only review the equity part. Without going too much in detail in this chapter, this ratio will tell you how much return you will get from your invested capital.

2.4 Debt to Equity and Total Debt to Total Assets

The debt to equity (D/E) ratio is a financial leverage ratio. It is comparing a company's total liabilities to the total shareholder's equity. What does that mean? Often to support growth, companies finance the growth through debt; (leverage) therefore, the ratio measures how much leverage a company is using. 

High leverage more times than not possesses more risk for the shareholders. Some industries operate with higher D/E ratios between 1 and 2, e.g., the automobile industry. Most industries, however, work with values below 1. When we talk about total liabilities, we should consider short-term and long-term debt. If you look at a company for the next 5-10 years, which debt would you consider? The answer is simple: long-term debt. Why? Short-term debt tends to be paid within 12 months, therefore not leading to stacking  of debt (less risky). Conversely, if you continue to add more long-term debt on a yearly basis (riskier), at some point, the company will operate with capital, the majority of which is funded by leverage (debt). 

To make it easier to understand, let's review an example. We will have two companies with the same shareholder's equity but mirrored short-term and long-term debt. In the end, the value of the D/E ratio will be equal because the total of the debt will be the same. However, there is one crucial difference. A company with more long-term debt will be considered riskier than the one with more short-term debt.

The total debt to total assets ratio also measures leverage, but it uses different parameters. Unlike in the D/E ratio, where some parameters are excluded from the debt calculation, all debt-related parameters are included. The other difference is between the type of assets used. While in the D/E ratio, we consider only shareholder's equity (most of the time, that is, cash), in this ratio, all assets are considered (even intangibles and inventory). 

With that said, we put an end to this article. If you feel lost after reading this, don't worry! In our next article we will start to review everything in-depth! Catch you there!

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