122: Lemonade Stand Analysis or How to Analyze a Stock
Remove complexity to lay a solid foundation for understanding
Simplify Simplify Simplify
Spending a few moments thinking about the essence of a company can improve your understanding of the company and lay the framework for better analytical work.
Investors are blessed and cursed with a Library of Alexandria on each company. Pull up the investor relations page of any public company and you’re met with presentations, transcripts, quarterly and annual reports, proxy statements, and more. The sheer volume of material and information is overwhelming.
Where to begin?
Lemonade Stand Analysis
I find it helpful to take a step back and think about what you might term the Lemonade Stand Analysis.
What’s the essence of a lemonade stand? One purchases sugar, lemons, and cups (water is free) and sells cups of lemonade. Simple enough.
But if our hypothetical lemonade stand were publicly traded it would have a 100-page annual report and all sorts of details heaped on top of an otherwise simple business.
Unfortunately, investors must start with this heap and work backward to understand a business before proceeding forward.
Taking the time to step back and think about the company as if it were a single location, one-man shop, etc., rewards the analyst with a clear analytical framework to hang subsequent facts and information.
Starbucks
The closest thing I could find to a publicly traded lemonade stand is Starbucks. Amble over the IR page, pull up the latest 10K report and…
135 pages!?
A 135-page report for a company that roasts, markets, and retails specialty coffee. Sure they’re in 86 markets and serve some food too, but come on, this is a simple business at heart, right? Right!
In full disclosure I don’t own nor have I studied Starbucks in detail. Let’s take a quick walk through the 10K…
There’s a breakdown of company-operated vs licensed stores
We also see a geographic breakdown of stores
The next page lists details on beverage vs. food
There are pages and pages of risk factors
There are details of operating expenses
Details of operating results by region
Pages of audited financials
Details on debt, investments, and other assets/liabilities
Details on hedges and currency swaps
My point is all of this “stuff” — this complexity — comes from the simple business of roasting coffee beans, distributing them, and making people a cup of coffee perhaps with a scone on the side.
You can imagine a publicly traded lemonade stand having a similarly long annual report even though it’s one of the world’s simplest businesses.
But if you start with the complexity you run the risk of getting lost in the analysis or missing key pieces of information. In analyzing Starbucks you should always have in your mind the image of a modest one-store coffee shop.
That image of the single store is your latticework to allow you to sort, filter, and remember information better.
A Sample of Simple
Now let’s look at a few well-known businesses and the length of their 10Ks/annual reports. Of course these businesses (Starbucks too!) are complicated systems with lots of moving parts. But at their essence they’re really pretty simple.
Home Depot: 99 pages — HD buys building products and retails them from their stores. They hold some inventory and manage some distribution centers for fast movement of product.
American Water: 168 pages — The company moves water from fresh sources to customers (after some filtering, etc.), and moves and treats wastewater from customers.
AB InBev: 235 pages — Sure, ABI is the world’s largest brewer and this report includes a sustainability report. But still — 235 pages! They take a few inputs, brew beer, and distribute the product to consumers.
Waste Management: 162 pages — WM picks up trash and brings it to its own landfills. This is perhaps even simpler than a lemonade stand.
Old Dominion Freight Line: 78 pages — A simple (but not easy) business of moving things from Point A to Point B through a network of hubs and spokes.
Sherwin Williams: 122 pages — They make paint and sell it through a network of stores.
Apple
Now a counterexample. Apple. This is one of my favorite examples. The whole of the gigantic Apple company with nearly $400 billion in sales reports on 80 pages! The quarterly report is just 28 pages!
I don’t want to make it seem like analyzing companies is easy, because there’s a lot to it. Proper analysis of stocks involves understanding the business itself, how that business got to its present situation, the competitive environment in which it operates, assessment of long-term opportunities and threats, management incentives, and a lot more.
Grasping the essence of a business is within reach of just about everyone, however. And even seasoned analysts can benefit from stepping back from their in-depth research and detailed models once and a while.
Stay rational! —Adam
This is one of your best ones yet! This way of viewing companies is passed over once you get to B school, and yet so very valuable.