“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.”Psychology Today
Comparisons in the investing world are not different; we have many forms of comparison, some flattering, some not. But comparisons to help you find the best investment equals 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 benchmarks. Those comparisons allow us to see what is important, trends, or 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, which is a great analysis. It helps see how his fund performs 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:
- What is Common Size Analysis?
- How Do You Calculate Common Size Analysis?
- How to Perform Common Size Analysis
- Pros and Cons of Common Size Analysis
Okay, let’s dive in and learn more about common size analysis.
What is Common Size Analysis?
Common size analysis according to CorporateFinanceInstitute is:
“Common size analysis, also referred as vertical analysis, is a tool that financial managers use to analyze financial statements. It evaluates financial statements by expressing each line item as a percentage of the base amount for that period. The analysis helps to understand the impact of each item in the financial statement and its contribution to the resulting figure.”
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:
- Income statement
- Balance sheet
- Cash flow statement
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, comparing line items on the income statement to their revenue is the most common. Likewise, comparing them to assets, liabilities, or shareholder’s equity on the balance sheet is common.
The above chart describes 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 the company is not creating income as efficiently relative to Firm B.
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:
- Revenue – $5,687
- Gross Profit – $4,533
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
- Horizontal analysis
Vertical analysis analyzes 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.
Net Income Margin
The horizontal analysis takes the same line items and looks at the results over a longer period, such as multiple years or quarters. Below is an example of looking at Visa’s profit margins over five years.
As we see above, looking at a more focused period can tell us some, but looking at longer periods allows for greater analysis. It can help give you questions to investigate why Visa’s gross and operating margins fall while the net income margin is growing. It may be a simple answer, but we would never think to look if it wasn’t for the above chart.
How to Perform Common Size Analysis
Let’s perform some common size analysis using both the income statement and balance sheet—the company I would like to use Paypal (PYPL) as our guinea pig. The first analysis we will do is for the year ending 2020.
Cost of Goods Sold
Income Tax Expense
The great takeaway from researching above is the ability to see each line item’s impact on its performance. For example, most would consider Paypal a tech company as it operates in the fintech sector, but it spent zero dollars on R&D in 2020, which is remarkable. You also see higher net income margins related to operating margins, which would lead you to find out how that occurred.
Let’s do the same with the balance sheet of Paypal.
Cash & equivalents
From the above analysis, we can see that receivables make up most of the current assets of Paypal and a large part of the company’s total assets. Also, notice that goodwill is a smaller portion of the assets, and many liabilities come from accounts payable.
As we work through these common size analyses, looking through these statements and asking questions is good. Those questions lead to a better understanding of the company’s financials, which we are all here to learn.
Next, let’s work through a common size analysis of Paypal’s income statement over many years.
Paypal Income Statement Common Size Analysis
Looking at longer periods of financials is always a revealing exercise. Look at the lack of R&D for the last two years, which is surprising, also notice that both costs of goods sold and administration costs have all remained the same over the four years.
This 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 looking at competitors to understand how Paypal is doing relative to its peers.
As we can see from the above chart, using common size analysis allows investors to identify sharp changes in their income statements or balance sheet. The drastic changes become much clearer when comparing financials over longer periods.
For example, any discernable movements in the income statement can help investors decide whether to invest in Square.
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 deeper dive would require looking at longer periods, such as three to five years, to detect 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 income or profitability increases across the board. 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 for companies of different sizes in the same industry, like the chart we created above. Looking at the financials can reveal their strategy and highest costs, which 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. Eventually, 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 Analysis
Common size analysis is a great tool for analyzing any company, but this analysis has some pluses and minuses.
Let’s look at a few of them, starting with the pros:
- Easy to understand – it is easy to identify different aspects of a business and create a model looking at the costs of goods sold and operating expenses to understand how efficiently the business creates operating profit.
- Helpful for analysis over time – it helps investors analyze performance over time and pick out any trends, good or bad.
- Comparisons at a glance – investors can quickly scan a company’s financials and see any trends, plus how it executes its operations.
- Helpful in comparing across financial statements – using common size analysis helps investors see how efficiently the company uses its assets to create revenue or how its liabilities drive its costs.
Now, let’s move on to some cons of using common size analysis:
- Changes in prices – Common size analysis doesn’t account for any price changes and their effect on price-based ratios such as P/E. Or the impacts on inflation or historical changes in pricing and market cap.
- Consistency – Any accounting changes or not using the same terminology can make common size analysis difficult or unclear.
- Seasonal fluctuations – common size analysis doesn’t account for any seasonal fluctuations some companies might experience. For example, Walmart increases its sales in the fourth quarter of the year, likewise, Darden Restaurants. If comparing companies quarterly, those seasonal fluctuations might throw off the analysis.
- Qualitative – the use of common size analysis doesn’t account for customer service, quality of products, or any other qualitative effects that might drive company performance. For example, Costco has great customer service, but that doesn’t translate directly to an income statement.
- Liquidity and solvency – a company’s liquidity and solvency cannot be measured by common size analysis. It doesn’t measure the current ratio, debt to equity, capital ratio, and liquid ratio. All of which are used to measure the strength of the balance sheet.
Common 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 what drives those trends. Creating a spreadsheet that allows you to conduct a common size analysis on your investigation is a great practice. Analyzing Paypal and its performance relative to its peers is helpful.
Remember that, like any analysis, common size analysis is not perfect. Common size analysis will not likely give us a clear company picture. 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, as we tried with Paypal, excluding the cash flow statement.
The bottom line common size analysis helps investors and analysts make better decisions.
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.
If I can further assist, please don’t hesitate to reach out.
Until next time, take care and stay safe out there,