In today's era, with more and more data being available, how do we know if a company is healthy? In order to decide whether to invest in a company, there are two ways to evaluate its potential.
Having studied the wider context in which a company operates, your next step is to examine the business itself. When you're performing fundamental analysis on an individual company, it's advisable to take into account a number of qualitative factors. Let's have a look at them in detail:
First, it's important to ask:
How does the company make its money?
This seemingly straightforward question can be surprisingly hard to answer in some cases. Although many companies do have a very simple proposition at their heart, such as selling groceries or clothing, others may have complex or unconventional business models that take time to understand.
For example, there are many niche technology companies that supply hardware or software to fulfil a very specific purpose. Their markets may be unfamiliar territory for you, unless you're actually involved in selling or using the product concerned.
Can you explain the company's business model?
There are many notable traders who follow a rule of thumb: if they don't fully understand the product made by a company, the methods used to sell it or the market that buys it, they simply won't trade on the share.
Test yourself by explaining the company's business model to a friend in the simplest possible terms. If you struggle to do this, you probably haven't got the full measure of it yet.
A company will normally have competitors. And even if it's offering something completely new and unique, the chances are that imitators will soon enter the market.
You might want to consider:
Once a company has firmly established its competitive advantage, perhaps by becoming a household-name brand or having a product that dominates the market, its position may seem unassailable. In these conditions, the company can often flourish and maintain profitability for a sustained period, and as an investor you can reap the benefits. But don't get complacent - all good things usually come to an end eventually.
When the FTSE 100 reached its 30-year anniversary in January 2014, only 30 of the original constituent companies were still members of the index. The other 70, despite having been the industry-leading titans of 1984, had either gone bust, been taken over, or simply slipped into obscurity, to be replaced by new contenders in the top 100.
Can the company maintain its advantage?
A successful company will generally need to evolve to stay ahead of the competition. If it appears to be resting on its laurels or running out of new ideas, these are warning signs that trouble could be imminent.
Take the example of HMV. In this case, a leading high-street retailer struggled to adapt as the marketplace changed. With consumers increasingly downloading or streaming music rather than making physical purchases, HMV's core business was eroded. Apparently lacking a back-up plan, the company was destined for terminal decline.