Comparative Analysis: Apples to Apples

If you have been following this blog over the last couple months, first, I would like to say, Thank you! It has been a pleasure writing for you. If you haven't, you can catch up by visiting a few of my other posts. We have been discussing how to find stocks of interest in your everyday life (here), a few tips on what to look for in a stock as a beginner (here) and some free online resources to dig up additional information (here) on a publicly traded company.

Today, I am going to discuss comparative analysis. It sounds intimidating but trust me, you are already familiar with the concept. You have probably heard someone say the phrase "compare apples to apples", "that's apples and oranges" or some other similar phrase. It just means that it is far easier to compare things that are alike.

Consider the following question; Which is a better movie, Braveheart or The Notebook? I personally think they are both great movies (yes, I have been known to enjoy a chick flick on occasion). But I like them both for very different reasons. If I watched Braveheart and I wrote down what I thought made it such  great movie and then judged The Notebook by the same criteria I don't expect I would consider it great or even good. Nearly everything I enjoyed about Braveheart was absent The Notebook. I simply cannot compare the two by the same criteria and come to an honest conclusion. The same is true for Stocks.

When you are doing your stock research you will come across a lot of number and ratios that won't make sense by themselves. How much debt is too much? What is a good dividend? What is a good Price/Earnings ratio?

There is no template for what a good investment looks like. Different industries or sub-industries should be judged by different criteria. To determine what criteria a company should be judged and to get some context for all of those numbers and ratios you should look at a few different things;

Revenues ~ Looking at the reported quarterly revenues is a good place to start. Revenue is the total amount of cash coming in from sales of the product or service the company provides. This is often referred to as the "top line". For this number obviously higher is better.

Net Income ~ Net Income is the revenues minus expenses and losses. This is commonly referred to as the "bottom line". Again, the higher the number the better but you also want to be mindful of the relationship between revenue and net income. If revenue goes up drastically but net income stay the same there may be issues that need to be investigated. There are many factors that can impact that relationship, some good, some bad. Perhaps raw material costs are going up (probably bad) or maybe the company has been investing in new equipment (probably good) but whatever the case, it is important you know why.

Gross Margin ~ The gross margin can help you define the relationship between the revenue and the net income. It is generally expressed as a percentage. That percentage identifies how much revenue is turned into profit on a per unit basis. It sounds complicated but conceptually it is not. Think of it like this; If I own a sandwich shop and I sell a foot long sub for $5 and the cost of the bread, meat, cheese, vegetables, condiments, paper wrapping and labor come to $3 my Gross Margin per unit is 40%. This is an indication of how efficiently the company makes money.

Debt ~ Not all debt is bad. In many industries you will find that a certain amount of debt (it varies) is appropriate. In fact, having little or no debt might actually be harmful to a company in a competitive industry. Debt is often used to expand a company. Having no debt might mean that the company does know how or has no desire to expand which can limit earnings potential. Of course having too much debt is bad as well. Finding a range of what is the appropriate amount of debt for a company can be difficult but comparative analysis can help.

Price to Earnings Ratio (P/E) ~ As I explained in a previous article (here) the P/E is a very important number that can signify the perceived growth potential (or lack thereof) or value of a company. This number more than all the others discussed above is only valuable when compared to other P/Es.

That is a few of the numbers you should be comparing but to what do you compare them? 

• Competitors ~ Always look at the competition, preferably the company's chief rival like Coke and Pepsi. 
• Past Performance ~ To know where a company is going it helps to know where it has been. What is the company's P/E ratio now and how does that compare to its highest and lowest over the last few years? Are they accruing more debt or paying debt down? Are revenues trending up? Is net income outpacing the trend in revenue or is it lagging? Identifying trends is an important part of Stock Analysis. Often companies have a seasonal cycle, so be sure to compare the 1st quarter of one year to the 1st quarter of the next, the 2nd quarter to the 2nd quarter and so on.
• Expectations ~ Company's often make statements in earnings reports or press releases that indicate how much they expect to earn or grow in the upcoming quarters. Financial Analysts do the same. How do their expectations compare?  Do they match your expectations?

When performing comparative analysis, context is king. The more context you have the more sense you can make of that great jumble of numbers you will find in earnings reports, financial statements and Yahoo! Finance pages.

I will break down those numbers in a future blog so stay tuned and as always, if you have any questions feel free to post them in the comments section. I would love to hear them.