The following article is a walkthrough of how a layman can analyze a company's financial statement. When analyzing a company, you don't need anything more advanced than some basic algebra; so, we aren't going to be getting into any crazy math that is difficult to understand. As Ben Graham said -
In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra.
A few weeks ago, I picked up a 10-K from Coach, Inc. (NYSE:COH). I had come across the stock a while ago, but saw that it was flying high with a P/E ratio somewhere near 20. As a value investor, I try to find lower P/E ratios, so I moved on. However, when I saw the 10-K, I decided that it never hurts to analyze a company's financials. At best, I may be surprised and decide to invest. At worst, I will know more about the industry and have something to which to compare other apparel companies, which may help me one day identify a good investment in the apparel industry.
When analyzing a company, I never look at the trading price. I figure that if I want to value a company, I should try to do so without anything pulling me to any specific number. I also don't read anyone else's analysis on the stock until I'm done with conducting my own, albeit much less robust, analysis.
Before we get started with my analysis, let me just give a quick overview of Coach. (The following information is taken from Google Finance)
Coach, Inc., is a marketer of fine accessories and gifts for women and men. Coach's product offerings include women's and men's bag, accessories, business cases, footwear, wearables, jewelry, sunwear, travel bags, watches and fragrance.
As you can see from the description, Coach isn't involved in the manufacturing of any of the items they sell. Although they don't manufacture their own products, they are fully in charge of design, which includes picking raw materials used.
Coach has over 350 retail stores in the USA, and they hope to bring up that number to 500 over the next few years. They also have 90+ stores in Japan as well as stores in China. They expect to be expanding the number there, and in other emerging markets as well.
Coach boasts a gross margin of over 70% and an operating margin of 31%. What's really good is that although they are a luxury brand they were not affected in any major way by the recession. This is an interesting point. Logic tells you that luxury brands like Coach would be hit hard by a recession. Yet Coach, as well as other luxury brands, seems to have not been affected as much by the recession.
A look at the balance sheet tells us how the company's finances look, and they look great. Not only are current assets over 2x's the current liabilities; they are greater than their entire liabilities. This is always a good metric to look at when seeing what shape the company is. Along with the debt/equity ratio, which is 0.012.
As a value investor, I like getting stocks that are close to their book values. As of July 2012, Coach's book value was $6.99 per share. If we take out intangibles, we are left with $5.03.
Of course, it is always possible to have a business that calls for a lot less physical assets, and I believe that Coach is one of them. Coach's biggest assets are their designers. All other assets can be marked down for whatever reason, and Coach would still thrive. But if they lose their top designers, then they could potentially experience some really bad years. They may have real physical products, but without the creative geniuses to keep it going, they may as well close shop. For this reason, I am okay with valuing the company at a higher price than their book value.
Now that we've got a good sense of the company, we can start doing some basic math. I am willing to pay up to 15 times earnings of the most recent year. With this multiple, we get a share price of about $54. However, if I take the average income of the last 3 years and use a 15 multiple, I get a share price of $45. Using averages is usually better, as it gets rid of some noise in the data.
Assuming the higher share price of $54, I work out what the enterprise value of the company would be as of and get $15.67 billion. (Enterprise value is based on the market cap plus debt minus excess cash. Learn more at investopedia.com.) Based on this value, the earnings yield of 2012 is 10.5%. In this economy, that is a very good yield, especially based on the <2% yield of the 10-yr. treasury bond. (The reason I used the higher share price of $54 is to create a higher hurdle rate for the earnings yield. The higher the denominator, the lower the yield will be, and with a higher share price, we are causing a higher denominator.)
However, all these numbers are based entirely on the 10-K, which was put out in June 2012. To catch myself up on current events, I look at S&P Capital IQ's Report (which I get free through my brokerage). I see that Coach missed S&P earnings estimates. I don't bother myself with such short-term problems. From what I see, and from what S&P is reporting, we can expect good number to come out of Coach in the long-term.
According to S&P Capital IQ's Stock Report, Coach has grown their sales over the last 9 years by 18.29% and their net income by 20.09%. This tells me that they have grown their net income at a faster rate than their sales by cutting costs and being an altogether more efficient company.
It's interesting to note that, while we came up with a price of $54, S&P analysts have their "fair value calculation" per share measured at $54.80. (Not bad for an analysis done on the back of an envelope.)
As S&P points out Coach's biggest competition comes from Michael Kors Holding LTD (NYSE:KORS), and Kate Spade, which is a subsidiary of Fifth & Pacific Co. Inc. (FNP). While I haven't read much on these companies yet, S&P analysts seem to feel that Coach will be able to hold its advantage over the competition. As an investment, both KORS and FNP are both selling at multiples far above COH, and give no dividend. I would therefore not recommend buying those stocks.
Coach is a good company with a conservative balance sheet. Its income is strong and consistent, with a large share of the accessories market. I believe that their shares have an intrinsic value of approximately $55. With the current price of $50, I don't think there is much room for growth in the short-term. If you are looking for long-term value, this may be a good investment for you. As Buffett is quoted as saying:
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
With this in mind, $49 is a fair price for Coach's stock, which leaves us with the question of whether Coach is a wonderful company. I believe it is. However, Graham was quick to warn investors to have a margin of safety; I would caution investors to determine how big a margin they are looking for. If you like a margin that is more than 10%, I would advise against buying Coach.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in COH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.