A practical pass over one listed business - what it earns, what it owes, what cash it keeps, and what the current price is already assuming.
14 min read · Level 2
Almost all the value in appraising a company comes from the falsification work, and almost all the time goes into the model - which is the wrong way round and persists because the model is pleasant and falsification is not. A spreadsheet is where you record a view you already hold; every cell in it was chosen by someone who had already decided roughly what the answer should look like, and the discipline of the format does nothing to counteract that. The part that actually changes decisions is the sentence naming what would make you wrong and where it would show up, because it is the only component of the appraisal that can be checked against the world later and found to have been right or wrong. The practical implication is uncomfortable for anyone who enjoys modelling: a one-page appraisal with a real falsification test and a diarised check date is worth more than a forty-tab model without one, and the second is far more commonly produced. If you finish a company and can state its implied growth rate but not what would change your mind, you have built an artefact rather than made a judgement.
Appraising a listed company is a sequence, and the order is what makes it useful. Read what the business earns. Read what it owes. Read what cash it actually keeps. Then, and only then, look at the price, and work out what the price is already assuming.
The reason for that order is anchoring. A price seen early becomes the centre of gravity for every subsequent judgement, and the result is a set of assumptions reverse-engineered to justify a number you have already accepted. Doing it in this order costs nothing and is the single highest-value habit in this lesson.
This lesson does not re-teach how to read a set of accounts or how to build a discounted cash flow - Reading Financial Statements and Valuation Methods are where those live, and an appraisal that skips them is a guess with arithmetic attached. What it does is put them in sequence over one specific company, and add the step that most appraisals omit: turning the price into an implied assumption that you can then agree or disagree with.
Because the question 'is this a good company?' and the question 'is this a good investment at this price?' have different answers, and confusing them is the most common error in equity selection.
An excellent business at a price that assumes it stays excellent forever has no room in it. A mediocre business at a price that assumes it deteriorates faster than it will has room. Neither judgement is available until you have converted the price into an assumption - which is a small piece of arithmetic that almost nobody does, because the price arrives pre-formed and feels like a fact rather than a claim.
And because most of the work of an appraisal is falsification rather than construction. A model is where you record a view; the appraisal is where you go looking for the thing that would make the view wrong. If you finish a company and cannot state what would change your mind, you have written an advertisement.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
A listed industrial distributor. Every figure below is from its most recent annual report; the price is today's quote.
Revenue 2,400m Operating profit 288m (12.0% margin) Depreciation and amortisation 95m Net profit 205m Shares outstanding (diluted) 150m Share price 24.60 Operating cash flow 260m Capital expenditure 70m Gross borrowings 600m Cash 150m Shareholders equity 1,150m Interest expense 34m Dividend per share 0.55
Step one, what it earns per share, and what the price is as a multiple of that:
Earnings per share: 205m / 150m = 1.3667 Market capitalisation: 24.60 x 150m = 3,690m Price to earnings: 24.60 / 1.3667 = 18.0
Step two, what it owes, and whether the obligations are comfortable:
Net debt: 600m - 150m = 450m EBITDA: 288m + 95m = 383m Net debt / EBITDA: 450 / 383 = 1.17x Interest coverage: 288 / 34 = 8.47x
Both are unremarkable in the reassuring sense. Operating profit covers the interest bill more than eight times over, and the net debt is a little over one year of EBITDA.
Step three, the cash rather than the profit:
Free cash flow: 260m - 70m = 190m Free cash flow yield: 190 / 3,690 = 5.15%
Note that free cash flow (190m) is meaningfully below net profit (205m). That gap is where the questions live, and it is worth tracing rather than shrugging at.
Step four, the whole business rather than just the equity:
Enterprise value: 3,690m + 450m = 4,140m EV / EBITDA: 4,140 / 383 = 10.81x
Step five - the one people skip. What growth is the price already assuming? Take the free cash flow of 190m, a required return of 9%, and ask what perpetual growth rate makes the enterprise worth 4,140m:
4,140 = 190 x (1 + g) / (0.09 - g) solving: g = 4.22%
So the current price implies free cash flow compounding at about 4.2% a year forever, at a 9% required return. Whether that is demanding depends on the business: for a distributor in a mature market growing with nominal output, it is a real assumption rather than a formality.
For contrast, price the same cash flow on a 2.5% perpetual growth assumption:
190 x 1.025 / (0.09 - 0.025) = 2,996m of enterprise value
against the 4,140m the market is asking - 38.2% more. That difference is not a valuation; it is the size of the disagreement between the market's growth assumption and a cautious one, expressed in money. Your job is to decide which of the two assumptions you would defend, knowing that the answer depends on two inputs you chose.
The rest of the figures round out the picture:
Return on equity: 205 / 1,150 = 17.8% Payout ratio: 0.55 / 1.3667 = 40.2% Dividend yield: 0.55 / 24.60 = 2.24%
The main mistake is looking at the price first. Everything after that is reverse-engineered, and you will not notice it happening.
The second is comparing price-to-earnings ratios between companies with different balance sheets. Earnings are struck after interest, so a heavily borrowed company shows a lower ratio for a reason that has nothing to do with cheapness. EV/EBITDA exists precisely because it puts two differently financed businesses on the same footing.
The third is accepting profit without checking cash. In the example free cash flow is 190m against 205m of net profit - a 15m gap that might be growth in working capital, might be a timing difference, and might be the first visible edge of an accounting problem. The three-statement work in Reading Financial Statements is how you tell which.
The fourth is treating the implied-growth figure as the answer rather than as a question. The 4.22% depends entirely on the 9% required return you chose; at a different required return it moves substantially. The value of the calculation is that it converts a price into a sentence you can argue with, not that it produces a verdict.
The fifth is a margin of safety applied to the output rather than to the inputs. Taking your valuation and knocking 20% off it is arithmetic theatre. A real margin of safety comes from using conservative inputs - a lower growth rate, a higher required return, a margin that reverts - and then seeing whether the price still leaves room.
The sixth is finishing without a falsification test. 'What would have to be true for me to be wrong, and how would I see it in next year's accounts?' If you cannot answer that in one sentence, you have not appraised the company.
Three years, not one, because one year is a snapshot and three is a direction. Note revenue, operating margin, net profit, operating cash flow, capital expenditure, borrowings and share count for each. Cover the price with your hand; you are establishing the facts of the business, and a price seen now will contaminate every judgement that follows.
Net debt over EBITDA tells you how large the obligations are relative to what the business produces; interest coverage tells you how comfortably the current bill is met. In the example, 1.17x and 8.47x. Then ask the stress question: if operating profit fell 30%, what would coverage be? Here 288 x 0.7 = 201.6 against 34 of interest, still 5.9x, which is the answer you want.
Free cash flow is operating cash flow less capital expenditure - 260m - 70m = 190m here, against 205m of net profit. A persistent gap in the same direction over several years is the signal. Growing receivables, capitalised costs, and repeatedly excluded 'one-off' charges are the three places it usually hides.
Price to earnings of 18.0 and EV/EBITDA of 10.81 say different things, and the difference is the balance sheet. Use the enterprise multiple whenever you are comparing this company with another, because it is the one that does not silently reward borrowing.
Solve for the growth rate that makes the current enterprise value work at a required return you would actually accept: EV = FCF x (1 + g) / (r - g). Here 4,140 = 190 x (1 + g) / (0.09 - g) gives g = 4.22%. Now you have a sentence rather than a number, and sentences can be disagreed with.
Rerun it with assumptions you would defend in a bad year. At 2.5% growth and the same 9% required return the business is worth 2,996m of enterprise value against the 4,140m asked - 27.6% less. That gap is the margin you do not have, stated in money rather than in adjectives.
One sentence: what would have to be true for this to be wrong, and which line in which future report would show it. 'If the operating margin falls below 10% for two consecutive years, the growth assumption is not supportable.' Then diarise the check. This is the step that separates an appraisal from an opinion, and it takes two minutes.
For any individual listed company you are considering holding directly, and as a periodic re-examination of something you already hold, where the same sequence applied to new accounts is what catches deterioration early.
Avoid this whole exercise where the business is genuinely outside what you can assess, and avoid it as a substitute for a decision - an appraisal that always concludes with more research is a way of not choosing. Do not apply it to a company whose accounts you cannot reconcile; that is a reason to walk away, not to model harder.
A pattern that turns up repeatedly in the post-mortems of accounting failures is that the warning was visible for several years in the simplest possible form - reported profit consistently exceeding cash generated from operations, with the difference accumulating in receivables, inventory or capitalised costs. It rarely appears as a single dramatic year. It appears as a modest gap in the same direction, each year explained by something reasonable, until the cumulative amount is too large to explain. The signal is not the size of any one gap; it is the direction persisting.
Track the profit-to-cash gap as a series across several years, not as a single-year check. A gap that alternates is timing; a gap that always runs the same way is a question.
When investors revisit a holding that disappointed, a common finding is that the original case rested on an assumption nobody recorded - a margin holding up, a contract renewing, a competitor not entering - and that because it was never written down, its failure was never noticed as a failure. The position was reassessed only when the price moved, by which time the assumption had been quietly wrong for several reporting periods. Writing the falsification test at the time of purchase converts a vague conviction into a testable claim with a date attached, which is the difference between noticing deterioration in a report and noticing it on a chart.
Record the load-bearing assumption and the line item that would reveal its failure. An unrecorded assumption cannot be checked, and therefore will not be.
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