How to analyse a company, in a sensible order

Step 1. Understand the business

Before any number, answer these in ordinary language. If you cannot, the honest response is to stop, and that is a legitimate outcome.

• What does this company sell, and who buys it?
• How does it actually make money? Volume, price, subscription, interest spread, commission.
• Who are its competitors, and why would a customer choose this one?
• What would have to happen for this business to be in trouble?
• Is the market it serves growing, flat, or shrinking?

That fourth question is the one people skip and the one that matters most. If you cannot describe how this business fails, you have not understood it, you have only admired it.

Step 2. Check the numbers, over years

One year tells you almost nothing. Look at five to ten years and read the direction and consistency, not the latest figure.

The single most useful check on that list is the fifth. Reported profit involves judgement. Cash does not. A company where profit rises steadily while cash from operations does not follow is telling you something, and it usually becomes visible in the accounts long before it becomes visible in the share price.

Include at least one bad year in your window if you can. How a business performed in a downturn tells you more about its resilience than three good years tell you about its quality. See financial ratios for how to read each of these.

Step 3. Judge management

This is the part that cannot be automated and, over a long holding period, may matter more than the numbers. You are asking one question: can these people be trusted with money that is partly yours?

• Do they do what they said? Read three consecutive annual reports and check stated intentions against outcomes.
• How do they describe a bad year? Responsibility or excuses. This is highly informative.
• Are related party transactions small and explainable, or large and growing?
• Is promoter holding stable, and is any of it pledged?
• Has the auditor ever qualified the accounts or resigned?
• How is capital allocated? Reinvested well, paid out sensibly, or spent on unrelated acquisitions?

That last one deserves attention. A business generating cash has to decide what to do with it, and those decisions compound over decades. A management team that repeatedly buys unrelated businesses at high prices will destroy value no matter how good the core operation is.

Step 4. Only now, the price

Price comes fourth deliberately. Judging price first is how people end up owning cheap bad businesses, which is the most common way beginners lose money slowly.

At this stage you know whether it is a good business. The remaining question is whether today price is reasonable for what you now understand.

• How does the PE ratio compare with this company own history, not just with peers?
• What growth rate is the current price implicitly assuming, and is that plausible given the last decade?
• If growth turned out to be half what is expected, what would the share be worth?
• Where is the margin of safety? What can go wrong without you losing money?

A useful discipline: decide what price you would be happy to pay before you look at the current price. It stops you working backwards from the number on the screen to a justification for it, which is what most of us do by default.

And accept the most common honest conclusion in investing: a good business at too high a price is not a buy. It is a watch. There is no rule requiring you to act today.

Step 5. Write it down

This is the step that turns analysis into something you can actually use later, and it is the whole idea behind AlphaVik.

Before buying, write down four things. Three sentences will do.

• Why I am buying. The two or three specific reasons.
• The evidence. The numbers or facts those reasons rest on.
• The risks. What I already know could go wrong.
• What would change my mind. The specific events that would make this no longer worth owning.

Eight months later the price will have moved and you will feel something about it. That note is the only thing that can tell you whether the business changed or only the price did. Without it, you are relying on memory, which quietly rewrites itself to match how you currently feel.

The honest limits of this

Two things worth saying plainly, because most guides on this subject do not.

Doing this well is a lot of work. Properly analysing one company takes hours, and a portfolio of fifteen needs ongoing attention every quarter. Most people who intend to do this end up not doing it, and then hold individual stocks with no current view on them. That is worse than not picking stocks at all.

You are competing with professionals. Analysts with teams, databases and direct access to management are studying the same companies. You are not going to have an information advantage. Where an individual can have an edge is patience, because you have no quarterly performance to report and can wait years for a view to play out.

None of this means do not learn it. Understanding how a business is judged makes you better at every financial decision you make, including choosing funds. But if you are not going to do the ongoing work, an index fund is not a lesser choice. It is the honest one.