Value Investing Part II: Investment Analysis

Be sure to read Part I of this series.

The analysis of an investment must be thorough. We should strive to understand the company in all material respects. Without a solid understanding of the business (its capital needs, the competitive nature of its industry, etc.) we will not be able to value the business with any level of confidence. The first question you must ask yourself before beginning an analysis is: Is this business simple and understandable? If the answer is no, forget about it and look for a different company to research.

Simple and understandable means different things to different people. Larry Ellison's (the founder of Oracle) understanding of Oracle is second nature. I, on the other hand, couldn't begin to understand how Oracle makes money. I would not attempt to research Oracle because the effort would be futile. As Charlie Munger would say, "that one goes in the too hard pile."

To ensure my research is thorough I like to use two checklists, the Preliminary Workup and the Final Workup. The two checklists are as follows:

Preliminary Workup

Where do I expect to find value in this company?
Balance sheet?
Income/Cash Flow?
Intangibles?
Others?
A combination thereof?
Is the company heavily dependent upon human capital, e.g. investment banking?
What risks does the company face that could impair its value?
What factors influence the balance sheet values?
How sensitive is the balance sheet to those factors?
What are the risks to income/cash flow?
Factors?
What is the competitive structure of the company's industry?
Is the industry in decline?
What is the company's position in its industry?
Does the company have pricing power?
Is the company a slave to its suppliers?
Is there a risk/history of unethical or criminal behavior within the company?
Others?
Does the company have negative exposure to, or benefit from, commodity prices?
Explanation.
What is management doing with free cash flow?
Does it make sense? Is it in the best interest of shareholders?
Or is it stupid?
What are the risks of financial distress?
Look at various metrics, e.g. Cash Flow to Debt, Debt to Equity, Net Current Asset Value
Other risks.
Other positives
If the price is right, would I want to own this company?
If the answer is yes, perform the Final Workup.

Final Workup

What is the company's normalized cash earning power?
What is the intrinsic value of future earnings? Provided in a range, not one absolute number.
List and explain assumptions. Are they reasonable?
Is there excess capital?
What is the value of excess capital? Provided in a range, not one absolute number.
What is the range of total value?
The range should be the "reasonable scenario" (neither best case nor worst case).
What events, actions, etc. could permanently impair the value?
What is the probability of these events happening?
What is the total value under a worst case scenario, given reasonable assumptions?
What is the probability of the worst case scenario?
I do not consider a best case scenario.
What is the market price? How does it relate to value?
What is my margin of safety?
Non-existent? Not sufficient? Neutral? Sufficient? Excellent?
At what price would I commit 10% of my net worth to this company?
At what price would I commit 50% of my net worth to this company?

Decision: After performing your thorough analysis you have a decision to make. It comes down to 3 choices: Start a position, Wait for a better price, Throw it in the trash.

The Thesis

If I decide to buy, I like to write a little statement in which I answer two questions: Why am I buying this security? Under what circumstances would I consider selling?

It should be clear that you have to put forth a significant amount effort before you can begin the workups. You should be able to answer all these questions with the 2 or 3 most recent annual reports of the subject company. Find the reports on the company's website and start reading.