“People constantly evaluate themselves, and others, in domains like attractiveness, wealth, intelligence, and success. According to some studies, as much as 10 percent of our thoughts involve comparisons of some kind.” Show
Comparisons in the investing world are not different; there are many forms of comparison, some flattering, some not. But the use of comparisons to help you find the best investment is called common size analysis. Common size analysis allows us to compare our company across many years of performance, plus comparing one company to others in the same/different industry, or to benchmarks. All of those comparisons allow us to see what is important, trends, or any other items that might help us make the best decision. One of my favorite shareholder letters is from Chris Bloomstran of Semper Augustus. He uses common-size analysis to compare his fund’s performance against the S&P 500, and it is a great analysis. It helps see how his fund is performing relative to important metrics and gives you a sense of the direction the fund is going relative to the market. In today’s post, we will learn:
Okay, let’s dive in and learn more about common size analysis. What is Common Size Analysis?Common size analysis according to CorporateFinanceInstitute is:
Creating common size financial statements allows investors to make it easier to analyze Visa over time and compare it to Mastercard. Using common size financials helps point out trends we might not see looking at raw financial statements. Common size analysis allows the use of all three major financial statements in this format:
The easiest way to do this is using spreadsheets that can easily convert the statements into percentages based on each separate line item or the ones you want to analyze. An online resource can do this for you, Mergent Online, although it does come with a cost. The two most common uses of common-size analysis are on the income statement and balance sheet. For example, when comparing line items on the income statement, it is most common to compare them to the company’s revenue. Likewise, it is common to compare them to assets, liabilities, or shareholder’s equity on the balance sheet. The above chart lays out a before and after scenario when comparing different companies. Firm A has higher revenues and income than Firm B, but when putting in percentages, we can see that relative to Firm B, the company is not creating income as efficiently. How Do You Calculate Common Size Analysis?To calculate a common size analysis, we need to convert the income statement’s financial data, for example, into percentages. The way we do this is simple: To put that into practice, let’s use the latest quarterly report for Visa:
Percentage of Base = $4,533 / $5,687 x 100 = 79.71% Pretty simple, huh? Common size analysis can be done in several ways:
Vertical analysis is analyzing specific line items to a base item within the same financial period. For example, looking at the gross margin, operating margin, and net income margin of the first quarter of 2020 for Visa. Gross Margin 80.82% Operating Margin 67.17% Net Income Margin 52.68%
Gross Operating Net 2017 82.31 66.25 36.49 2018 81.29 65.8 49.98 2019 81.87 67.03 52.57 2020 79.35 64.51 49.74 TTM 79.04 64.81 49.91
How to Perform Common Size AnalysisLet’s perform some common size analysis using both the income statement and balance sheet—the company I would like to use is Paypal (PYPL) as our guinea pig. The first analysis we will do is for the year ending 2020. Revenues 21,454 100% Cost of Goods Sold 11,453 53.38% Gross Profit 10,001 46.61% SG&A 6,573 30.63% R&D 0 0% Other 0 0% Operating Income 3,428 15.97% EBIT 5,274 24.58% Income Tax Expense 863 4.02% Net Income 4,202 19.58%
Let’s do the same with the balance sheet of Paypal. Cash & equivalents 13,083 18.58% Receivables 36,374 51.68% Current Assets 50,995 72.45% Investments 6,089 8.65% Net PPE 1,807 2.56% Goodwill 9,135 12.98% Total Assets 70,379 100% Accounts Payable 38,447 76.41% Current liabilities 38,447 76.41% Long-term debt 8,939 17.76% Long-term liabilities 11,869 23.59% Total Liabilities 50,316 100% Retained Earnings 12,366 61.77% Paid-in capital 16,644 83.24% Treasury Stock 8,507 42.49% Shareholder equity 20,019 100%
As we work through these common size analyses, it is good to look through these statements and ask questions. Those questions lead to a better understanding of the company’s financials, and that is what we are all here to learn. Next, let’s work through a common size analysis of Paypal’s income statement over many years. 2017201820192020Revenues100%100%100%100%Cost of Goods51.13%53.47%55.06%53.38%Gross Margin48.87%46.53%44.94%46.62%SG&A31.62%30.32%29.24%30.63%R&D7.27%6.93%0%0%Operating Margin17.3%16.2%15.7%16%Taxes3.09%2.06%3.03%4.02%Net Margin13.7%13.3%13.8%19.6%
Using this type of analysis will give you a better idea of the company’s performance and any additional investigation areas we might need to dive deeper into. Another great example of this type of analysis is to look at competitors to get a sense of how Paypal is doing relative to its peers. PYPL MA V SQ FIS FISV Rev 100 100 100 100 100 100 Costs 53.38 24.75 20.96 71.10 66.51 52.6 Gross 46.42 73.25 79.03 28.90 33.49 47.40 SG&A 30.63 18.10 10.58 19.65 28 38.05 R&D 0 0 0 10.48 0 0 Operating 15.98 53.34 64.97 -0.20 12.32 9.35 Taxes 4.02 8.81 13.24 0 0.7 1.31 Net 19.59 41.90 49.91 2.24 1.26 6.45
For example, comparing the net income margins of all the Paypal peers gives you an idea of the company’s overall profitability. The above chart is only for the TTM (trailing twelve months) and is only a snapshot. A much deeper dive would require looking at longer periods, such as three to five years, to detect any trends. Those longer snapshots can tell you if the company is going through some financial struggles or a rare event. Of course, suppose you see increases in income or profitability increases across the board. In that case, that might indicate the company is expanding its operations and taking market share from its peers. They are making it more attractive to investors. Common size analysis is also a great tool to use across companies of different sizes in the same industry, like the chart we created above. Looking at the financials can reveal their strategy and their highest costs that might give them a competitive edge over their peers. For example, Square might be sacrificing margins to gain more market share, which would increase its revenues at the expense of profits. Many companies embrace this strategy to attract investors to the big revenue increases, which helps increase their market size. At some point, they will have to move towards profitability, but the growth strategy does work. A great exercise to see how a company grows from a growth strategy to profitability is to look at the early days of Amazon. Looking at the company’s common size analysis will give you insight into the company moving from serious growth to merely amazing growth. But kidding aside, you can see them move from gross profits to operating profits to bottom line profits. It is an amazing journey, and cool to see it progress. Pros and Cons of Common Size AnalysisCommon size analysis is a great tool to analyze any company, but there are some pluses and minuses to this analysis. Let’s look at a few of them, starting with the pros:
Now, let’s move on to some cons of using common size analysis:
Investor TakeawayCommon size analysis is a fantastic tool to use when analyzing any company. It allows you to compare vertically across different financial statements, for example, analyzing the cost of goods sold and operating expenses. It also allows for horizontal analysis of companies across multiple years, allowing investors to see any trends, good or bad. And when using common size analysis across the different financial statements, we can see how efficiently the company uses its assets to drive more revenue. One of the biggest benefits is the ability to compare different size companies across a sector, such as property-casualty insurance or fintech. Using common size analysis helps investors pick out any trends, good or bad, and further investigate to uncover what is driving those trends. It is a great practice to create a spreadsheet that allows you to conduct a common size analysis on your investigation. Not only analyzing in Paypal, but its performance relative to its peers too as a helpful measure. Remember that, like any analysis, common size analysis is not perfect. Common size analysis is not likely to give us a complete, clear picture of a company. Rather, it is a tool in our toolbox to help us find a clearer picture. Investors should use common size analysis in the context of complete financial statement analysis, such as we tried to do with Paypal, excluding the cash flow statement. Bottom line, common size analysis helps investors and analysts make better decisions. With that, we will wrap up our discussion today concerning common size analysis. As always, thank you for taking the time to read this post, and I hope you find something of value in your investing journey. What is the best way to compare two companies?One of the most effective ways to compare two businesses is to perform a ratio analysis on each company's financial statements. A ratio analysis looks at various numbers in the financial statements such as net profit or total expenses to arrive at a relationship between each number.
Why is making a comparison across stocks important?It is a quick and efficient way to find out stocks that are overvalued and those that can be included in the portfolio. While a stock can be evaluated in several ways, comparing with other stocks in the sector, is a preferred way to find quality stocks in which to invest.
Is useful in making comparisons of companies of different sizes?Vertical analysis is useful in making comparisons of companies of different sizes. 15. Meaningful analysis of financial statements will include either horizontal or vertical analysis, but not both.
What can you use to compare companies in different?Return on Equity is the best tool for comparing companies across industries because it is a type of ratio that informs investors about how well a company, or more specifically, its top management, manages the money that shareholders have contributed to it.
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