Drilling Underneath the Numbers with Qualitative Analysis
The most widely used approach to identifying investment opportunities for those investors committed to picking stocks on their own is fundamental analysis.
The goal of fundamental analysis is to identify the “holy grail” sought by investors of all stripes – a company’s intrinsic value. Company fundamentals begin – and for some investors end – with the numbers gleaned from the company’s financial reporting outlined in three statements:
- Balance Sheet
- Income Statement
- Cash Flow Statement
Retail investors are not left to their own devices to analyse these three statements. Financial analysts glean through financial reporting to construct a series of ratios designed to get to the heart of a company’s intrinsic value.
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At the top of the list are the valuation ratios:
- Price to Book (P/B)
- Price to Sales (P/S)
- Price to Earnings (P/E)
- Price to Earnings Growth (P/EG).
In addition there are ratios for gauging a company’s leverage and liquidity as well as profitability and operating efficiency.
Ratios have two things in common.
- First, they are all based on numbers.
- Second, not a single ratio tells the investor anything about what it is the company actually does, who are its competitors, and the people that work there.
What is Qualitative Analysis
Qualitative analysis looks beyond the “hard” numerical data gleaned from a company’s financial performance to the “soft” qualitative data that extends beyond the numbers.
Quantitative analysis by the numbers is an essential first step, but common sense suggests there is more to learn about a company that can be uncovered by the story lying under the numbers, starting with what it is the company does to earn a profit – its business model.
The challenge facing investors is that “soft” data most often represents intangible issues that cannot be represented numerically. Assessing intangibles may be considered more art than science but it remains an essential step in determining the prospects of a potential investment.
Of the host of intangibles that merit analysis, including brand recognition, customer satisfaction, competitive advantages, management competence and trustworthiness, and corporate culture, the starting point is the company’s business model.
Understanding the Business Model
What the company does to make money is a simple, common sense statement of a business model. Companies offer products or services, or both. To dig into a business model retail investors have multiple starting points. For recent entries into publicly offered share purchases, the Prospectus accompanying the company’s IPO (initial public offering) contains a detailed description of its business model and most of the remaining issues needing answers in qualitative analysis.
In the absence of access to an IPO Prospectus, investors turn to the annual report issued to its shareholders, the company website, and announcements made to the ASX community.
Even the most trustworthy of managements strive to put “their best foot forward” in their own documentation, some “spruiking” can creep in. Investors can turn to analyst reports and independent financial websites for a view from the outside.
A business model includes the target customers and the benefits they derive from the company’s products and services, how what the company does is distributed to its customers, how revenues are generated, how products or services are created and the cost of production.
Quantitative analysis will not point out the risk of investing in a company offering a small number of products and services to a small customer base. Their numbers may be outstanding but fail to identify the inherent weaknesses competition and economic downturns can pose to such businesses.
One of history’s greatest investors – US based Peter Lynch – offered this advice about the need to understand a company’s business model:
If you don’t understand a company, if you can’t explain it to a ten-year old in two minutes, don’t own it.
Understanding the Competition
Investors need to know what the competition for whatever the targeted company does is doing. Is the company under analysis gaining a competitive advantage through unique features or its current product line or pipeline of future products. Does the company have a competitive advantage in the way it distributes its products. Does the company serve global markets or is it focused exclusively on the domestic market.
Investors also need to consider potential competition in the future. US investor Warren Buffet coined the term “economic moat” to describe competitive advantages making it difficult for new entrants in the market. Brand dominance is one, along with cost advantages and switching costs.
Technology that can be copied or improved provides no barrier to entry nor does market dominance. A company with 60% or more market share with no economic moat will see its market share erode as competitors enter the market. Successful companies breed rivals.
Understanding the People
Assessing the quality of the people in a company begins with top management but doesn’t stop there. Company websites include biographies of the executive team. Although it is reasonable to look for technical expertise in whatever the company does – mining professionals in mining companies and doctors and researchers in biotechnology companies, do not ignore the need for financial professionals who can keep expenditures under control. This is essential in start-up biotechs where the scientists can bun through company cash at a dangerous pace without a watchdog at the cash register.
Most financial releases contain a section entitled Management Discussion and Analysis, where top executives offer a rationale for the company’s performance and a look toward the future. The ASX website includes financial reporting going back years so it is a simple matter to check the prior year’s reporting to see whether management followed through on its future commitments.
Finally, there are the people in the company who actually do the work. Companies develop cultures over time, with inclusive cultures that support employee engagement contributing to solid customer service, productivity, and low turnover. Many companies today post Mission Statements on their websites, often claiming their employees are their most important resources.
The digital world provides retail investors with checks to see if companies are living up to their Mission Statements when it comes to employee treatment. Both Glassdoor and Seek have employee review sections about the Australian companies where they work.
Qualitative analysis is the second leg of the most used method for evaluating potential stock purchases – fundamental analysis. The first leg – quantitative analysis – targets hard data about a company’s financial performance and operating efficiency. From the three financial statements released by all ASX companies, analysts calculate an array of ratios used by investors to assess potential investments.
Qualitative analysis goes beyond the numbers, focusing on intangible issues not subject numerical analysis. These include the company’s business model and its competitive environment. In addition, qualitative analysis looks at the people who make up the company, starting with its executive leadership and going beyond that level to assess the corporate culture that impacts all employees.
Retail investors have multiple sources available to perform qualitative analysis, including company websites, annual reports, announcements to the ASX community, analyst reports, and articles appearing on financial websites.
