How to analyze a stock from scratch, in seven steps and no shortcuts

Analyzing a stock is not predicting the future. It is building a thesis out of explicit assumptions, so that you know exactly which one broke when the result comes in different. Here is the route we use.

1. Understand how the company makes money

Before any multiple: where does revenue come from, who writes the check, and what would make that customer stop. If you cannot explain the business model in three sentences to someone outside finance, you are not ready to judge the price.

2. Read revenue backwards

How much did it grow over five years? How much came from price and how much from volume? Price-driven growth in a regulated industry has a short life; volume growth in an expanding market has legs. Be suspicious of growth by acquisition — it shows up in revenue and disappears in cash flow.

3. Margins and what they reveal

Gross margin shows pricing power. Operating margin shows cost discipline. Net margin shows what survives interest and tax. A company with a 60% gross margin and a 3% net margin is handing its profit to lenders — and the problem is the balance sheet, not the business.

4. Debt, in two calculations

Net debt to EBITDA above 3 times needs an explanation; above 4, it needs its own thesis. But the more revealing number is interest coverage: EBIT divided by interest expense. Below 2 times, the company is working for its lenders. Check the maturity schedule too — cheap debt that all matures next year is expensive debt in disguise.

5. Return on capital

ROIC is the central question: what does each dollar put into the business come back as? If ROIC is 6% and the cost of capital is 10%, the company destroys value by growing. Growth is only good when the return clears the cost of capital; otherwise it is an elegant way to burn shareholder money.

6. From profit to cash

Earnings are opinion, cash is fact. Compare net income with operating cash flow over three years. If profit grows and cash does not follow, look in inventory and receivables — the two accounts where revenue that never became money likes to hide.

Then subtract maintenance capital expenditure to get free cash flow. That number, not the one in the press release, is what pays dividends.

7. Only then, the price

With free cash flow in hand, valuation is arithmetic. A worked example: a company with a $10 billion market capitalization, $900 million of free cash flow and 3% expected real growth. The cash yield is 9%; adding growth, the expected return lands somewhere near 12% a year.

Compare that with a 10-year Treasury around 4.5%. The equity risk premium in this case is roughly 7 percentage points — which is a conclusion, not an opinion, and one you can argue with on its own terms.

Risks and counterpoints

Everything above looks backwards. A company in structural change — new regulation, technology that resets the industry — breaks the extrapolation, and the historical numbers look best precisely in the year before the problem.

There is also the risk of false precision. A model with fifteen tabs still rests on two or three assumptions. Move perpetual growth from 3% to 4% and the fair value jumps roughly 20%. Work in ranges, not in a single magic number.

What to do with it

Write the thesis on one page, with the three assumptions holding it up and the price you would be willing to pay. Revisit it every earnings report. If an assumption breaks, the thesis is over — and selling on a broken thesis is process, not defeat.

This piece does not recommend buying or selling anything.