Don’t you look at the neighborhood in which you plan to purchase a home in? You also probably look for answers to questions, such as: what was the average price for homes in that neighborhood over the past year. Or how long did it take to sell a home. Or how many homes are for sale right now. Or what is the typical size of a home. And is there a plan to develop a large amount of homes in the near future. Outside of the neighborhood, you probably speak with lenders and inquire about mortgage terms.

You intuitively know that the more information you gather, the better decision you will make.

Similarly, when I buy a stock of a company, I try to understand not only the company, but also the economics of the business in which it operates in. I research how much debt the typical company uses, the typical dividend yield investors can expect to receive, and the profit margins in the industry.

I typically start with four or five companies that share a similar business model. And, in this article, I will briefly go over the items I compare between companies.

Capitalization

I start by multiplying the current price of the stock by the number of the common shares outstanding. To that number, I add the market value of the bonds and preferred stock. For example, Seritage Growth Properties (SRG), a real estate company that traded for $35 when I bought its shares last week, had $37 million in outstanding shares (that number includes Class A, B, and C shares). So, the common stockholder capitalization was $1.3 billion.  Add to that $70 million of preferred shares outstanding and liabilities of $1.5 billion. Add all these numbers and you get a total capitalization of $2.87 billion.

Understanding the capitalization structure allows one to see how leveraged the company is. In the case of SRG, the company uses 55% leverage, which to me is reasonable. The rule of thumb is simple: the higher the leverage, the higher the risk of default. Or, as my mother often reminds me, bankruptcy is never declared by those who do not take debt. 

Balance sheet

I also like to look at balance sheet items, such as current assets, net current assets and book value per share. You would be surprised how much these simple balance sheets - publicly disclosed to anyone - can reveal about the economics of a business and the relative strength between companies. If we return to Seritage, as of year end 2017, current assets were $438 million, net current assets were $185 million (a positive number means that the company can pay off its short term liabilities without selling its long term assets) and a book value per share of $35.    

To know the book value per share is important because you immediately get a sense of how much you are paying for the net worth of the company. If we go back to SRG, you can see that the stock traded at about the book value per share of the company (I try to refrain from paying for stock that is priced over two times the book value per share). 

One thing to note is that the reported book value per share often needs adjustments. You can see an illustration of how I adjusted the book value per share of Colgate-Palmolive by clicking here.  

Income statement

Revenue is vanity, profit is sanity and cash is reality - but all three income statement items are worthwhile to look at. Observing trends in revenue gives a better overview of the company than its management’s statements. The profitability allows one to understand the economics of the business and to compare whether the trend reconciles with the revenue trend. For example, if you look at operations of Bed, Bath & Beyond, an American chain of merchandise, you will see that revenue over the past decade increased by 73%, or 5.65% compounded annually. And earnings per share increased from $2.10 to $5.10, 9.3% compounded annually, over the same period. When the two metrics reconcile, you reduce the chances of accounting shenanigans. 

Ratios

No matter how deep your pockets, no one likes to needlessly overpay. And just as you probably know the range of prices for homes in that neighborhood we discussed in the first paragraph, ratios allow us to understand how much we are paying for the stock.

Some of my favorite ratios are: price to earnings per share, price to book value per share, net income to sales, earnings per share growth over ten years and net income to book value per share. While I can easily think of additional ratios (such as enterprise value to EBITDA, or a comparison of every dollar of retained earnings to market value of the stock over a five-year period), starting with just a few ratios often illuminates most of the picture.

Next week

This is part one of a two-part essay. This week I wrote that understanding the financials of four to five companies in the same industry is a good place to start to understand the economics of a business. 

Next week, I will compare Simon Property Group, an American commercial real estate company, GGP Inc., a publicly-traded real estate investment trust that invests in shopping centers, Realty Income Corp., whose headquartered is across the street from where I work, and Seritage Growth Properties, a REIT with a portfolio of 235 shopping centers.