U.S. Markets closed

Strategic Value Investing: Company Analysis, Part 1

Want to analyze a company, to get a better understanding of it before you invest? Authors Stephen Horan, Robert R. Johnson and Thomas Robinson addressed that issue in chapter five of their 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors."

Analysis is a process in which investors, especially value investors, want to discover:

  • What is the business about?
  • How does it create profits?
  • How effectively and efficiently does it manage its operations?
  • How efficiently does it convert accounting profits to cash flow?
  • How viable will the company be in the future?



The answers to these questions can be found in a company's financial statements and other publicly-published documents.

The income statement

The first of the formal financial statements addressed in the book is the income statement, which displays the revenues that were generated from sales and the expenses incurred to produce those revenues.

To show how this document can help investors assess a company, the authors created a mini case study, starting with this enhanced income statement ("we provide additional columns to make the comparison of data from year-over-year more illustrative.") for Walmart (NYSE:WMT):

Strategic Value Investing income statement

The statement covered the financial year ending Jan. 31, 2011 and amounts were shown in millions of dollars. Looking at the bottom line, "Net Income Attributable to Walmart," we see that on a percentage basis, net income (profit) increased from 3.5% in the previous year to 3.9% for the then current year. That's a significant improvement in the highly competitive retail industry.

Analysts will want to know why this improvement occurred, and the authors begin by noting that sales (revenue) increased from $405 billion to $419 billion. In addition, net income increased from $14.4 billion to $16.4 billion.

At this point, they wrote it was necessary to remove "size" as an element, which means stating lines on the income statement as a percentage of revenue, rather than cash (this accounts for the extra columns on the income statement).

In fiscal 2011, Walmart had a net profit margin of 3.9%, meaning it generated $3.90 for every $100 of revenue. Further, the company increased its net profit by 14.1% despite revenue rising only 3.4%.

What drove the increase in net income? Turning to the management discussion and analysis section, we learn that same-store sales (covering stores open both years) declined 0.6% because of the economic environment. So the increase came from the opening of new stores, which increased store footage. Also in the management discussion and analysis section: Favorable exchange rates boosted non-domestic revenue enough to compensate for the decline in same-store revenues.

Getting back to the data, the authors observed that the cost of sales (spending needed to acquire merchandise for resale) increased from 74.6% to 74.7% and that meant the company was marking up its merchandise less than in fiscal 2010. In turn, that led to a small decline in its gross profit margin.

Next, they studied Walmart's selling, general and administrative costs. This category takes in everything except the cost of merchandise it bought. Big items include store rents, the salaries of store employees, insurance and depreciation. Selling, general and administrative costs declined in fiscal 2011 to 19.2% from 19.5% in fiscal 2010.

The authors called this a "significant" reduction in expenses, and follow up by defending that term: "You might quibble with our use of the term significant for a decline of this percentage magnitude. Remember, this is a decline of 0.3 percent of revenues that are now $419 billion, representing a costs savings of $1.3 billion!"

Turning again to the management discussion and analysis section, management reported the savings were the result of higher labor productivity and lower incentive payments because of organizational changes in fiscal 2011. While the saving is significant, it is a one-time event and likely won't happen again in future years.

Looking again at major changes on a percentage basis, we note that income from discontinued operations increased and made a positive contribution to the bottom line. The improvement came from a decision to exit one of its lines of business. Again, this is not likely to happen again in the future.

The news behind this improvement came in a footnote, which reported it involved the 2007 sale of its German operations and a settlement with the Internal Revenue Service. A loss on the sale of its German operations had become a tax benefit.

Summarizing, the authors wrote the increase in Walmart's profit margin was mainly a result of lower payroll costs and a one-time tax benefit. They continued by stating that if the one-time tax benefit was backed out from discontinued operations in 2010, the profit margin increase would have been just 0.1%, from 3.7% to 3.8%.

At the same time, the reduction in payroll and incentive costs were offset by a slightly higher cost of sales, and overall, "Management appears to have done a good--but perhaps not a great--job of controlling costs."

Conclusion

Using just the income statement, and a few bits of information from the management discussion and analysis, the authors were able to develop a good understanding of the company's financial performance. With this storyline in place, they were well placed to take on the data in the cash flow and balance sheet statements.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.