The Guide to Stock Picking, Part 2: Having Fun with Financials | by Kalan Karuppana | Sep, 2024

Breaking down Financial Analysis, Insider Trading, and Valuation Methods

Introduction

In part one of this series, I broke down how to understand the basics of a company: how the company generates revenue, who its competitors are, and at what rate the larger industry is projected to grow. All of these things are instrumental to a basic comprehension of the company; however, to make sure our position on a company is nuanced and detailed, we have to look into the company’s financial statements and possible future financial outlooks.

By first breaking down a basic financial statement, then looking at insider and Congress trading patterns, and finally using valuation tools to estimate a company’s future financials, I hope to make financial analysis more understandable and effective for determining the rating (buy/sell/hold) you give to the company.

Analyzing Financial Statements

There are three financial statements: the income statement, balance sheet, and cash flow statement. To find all of this information, you can use Yahoo! Finance or the company’s SEC filings, but I’d recommend using Yahoo! Finance though because the platform compiles years worth of data into one spot which makes it much more user-friendly.

First, the income statement. The main things to look at here to check the health of a company are revenue, expenses, and EPS. For total revenue, consistent growth over time (calculated in percent change) is extremely important. For the rest of this article, I will use Walmart, Inc. (NYSE: WMT) as my example. From 2021 to 2022, Walmart’s revenue grew 2.43% year-over-year (YoY); from 2022 to 2023, it grew 6.72% YoY; from 2023 to 2024, it grew 6.02%. This consistent YoY revenue growth hints that the company is steadily growing at a healthy rate, not relying on large fluctuations in demand for products or speculation. For looking at expenses, I like to look at operating income (income the company has after all operating expenses have been removed). Better than looking at gross profits, operating income reflects the true profits of the company, so growth in this department is also great. And finally, EPS growth. For example, Walmart’s EPS saw incredible growth from $1.43 to $1.92 in the past year, representing an amazing 34.2% YoY growth rate.

For the balance sheet, I like to look at current and long-term assets compared to liabilities, as the current difference and long-term differences illuminate the financial standing of the company on two different timelines. Looking at Walmart as of Jan. 31, 2024, it has $76.8 billion of current assets and $92.4 billion, showing how Walmart has negative net working capital (difference between short-term assets and liabilities) currently, which is usually a negative indicator of short-term success. However, the company has a large positive difference between long-term assets and liabilities, showing the company has lots of invested capital and longer-term growth opportunities. I also like to look at debt, as debt can either be seen in a positive or negative light given the company you analyze. For a Fortune 100 company like Walmart, debt can be leveraged to avoid paying taxes, but for a small company or one which has a high debt-to-revenue ratio, debt can be crippling and a negative force on the company.

Lastly, the cash flow statement. Here I like to look at two things: capital expenditures and free cash flow. Capital expenditures are important for investing in the future of a company, as spending money now as an investment in the business would hopefully help grow the business in the future. Free cash flows are also really important, as they give the company flexibility for whatever it plans to do in the future (e.g. share buybacks, capital investment, repaying debts, mergers/acquisitions, etc.).

Insider Trading

This one is pretty interesting, as looking at company insider’s trades and congress’s trades may illuminate unforeseen aspects of the company. The insider trading portion of the analysis is just to cover all bases and “confirm” your analysis with other informed investors. Looking at insider trading should NOT be your only source of analysis when deciding whether to invest in a company. That being said, my favorite website for looking at this is MarketBeat, as the website has insider trading and even more information on the website for any stock you can think of.

Valuation

For newer investors, valuation can be one of the most daunting parts of stock analysis. People always wonder what methods to use, so I’ll speak briefly about two different valuation methods: comparative analysis and discounted cash flow analysis (DCF).

For newer investors, comparative analysis is the easiest to learn. There are three ratios I look at during this process: the P/E (price to earnings), EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization), and P/B (price to book value) ratios. Essentially, by comparing these ratios to that of its competitors, we can gain a better view of the value of the company. If its P/E, EV/EBITDA, or P/B ratios are lower than those of its competitors, then the company may be undervalued; if the ratios are higher than those of its competitors, it may be overvalued.

For more experienced investors and those who know modeling, the DCF is one of the best ways to predict the company’s future price based on the production of the company’s future cash flows. If you want to learn about this for free, I recommend watching Rareliquid’s DCF videos. This more advanced tool can lead you to a more detailed and potentially more accurate prediction of the company’s future price, making it a great tool to use if you have the knowledge and time to create the model. My full Walmart DCF can be found in this article.

(Disclaimer: It’s important to understand, however, that any valuation tool is not a sole indicator of future financial performance. This is just another tool to help crystalize your view on the company.)

Conclusion

When people think about stock analysis, they normally imagine doing this part of the analysis, diving into the financials and valuing a company. While this part is super important to our analysis, this should be a complimentary section, helping prove your initial analysis and personal beliefs with numbers; this should not be a section where you play around with numbers until you find a valuation number you like and only analyze sections of the financials which align with your gut feelings. But altogether, financials, insider trading, and valuation are all super important for your analysis to be cohesive and well-put-together, so doing the due diligence and putting in the effort is essential for the success of your finished product.