How do you analyze any company on the stock exchange? Start by understanding its economic engine.

When an investor decides to buy a stock on the stock exchange, they often start in the wrong place. They open the financial statements, look at the earnings, and then begin comparing the price-to-earnings ratio (P/E ratio) and return on equity (ROE), along with other financial ratios, with other companies. Only then do they try to decide whether the stock is cheap or expensive. But company analysis doesn’t begin there. Before asking about the stock price or the P/E ratio, there’s a much simpler and more important question: How does this company make its money?

The question may seem basic, but it’s actually the starting point for analyzing any economic activity. Every company has a different way of making money, and what makes one company successful may be completely different from what makes another successful. Therefore, you can’t analyze a bank in the same way you analyze a real estate company, or a telecommunications company in the same way you analyze a retail company.

The basic idea is to view a company as an economic machine . Money and resources flow into this machine, the company uses them in its operations, and ultimately generates revenue, profits, and cash flow. Your task as an investor is to understand how this machine works, what makes it perform well or poorly, and then use financial figures to measure its efficiency.

Let’s say you’re studying a clothing retail company. The company buys merchandise from suppliers, stores it, and then displays it in stores, after which customers come and buy it. In this case, several factors directly influence the company’s profitability: the amount of inventory, the number of stores, the sales volume of each store, and the profit margin on each sale. Therefore, when analyzing a retail company, it’s not enough to simply know that its profits have increased. You need to understand why they’ve increased.

Have sales increased in existing stores? Or has the company opened dozens of new stores? Are the new stores generating a good return on investment? Is the company selling its inventory quickly, or is merchandise piling up in warehouses?

For example, there’s a ratio that measures inventory turnover, which simply tells you how quickly a company’s stock is converted into sales. If a company buys large quantities of goods but can’t sell them, a lot of money is tied up in inventory. If the goods move quickly, the company can recoup its investment and reinvest it in new stock. So, the number itself isn’t important. What’s important is understanding why that number is significant for that particular company .

Take a bank as another example. A bank doesn’t buy products and put them on shelves to sell to customers. Its business is fundamentally different. A bank receives money from depositors and other sources, then uses a portion of it to lend to customers and businesses and invest in various assets. In return, it receives returns and interest. Therefore, one of the primary drivers of a bank’s profitability is the difference between the return it earns on its money and the cost it incurs to acquire it. But that’s not all. A bank can appear very profitable on paper, then face significant problems later if the loans it granted to its customers were of poor quality. Ultimately, a bank is dealing with a customer’s promise to repay the money with interest. If the customer defaults, a portion of these loans becomes potential losses for the bank.

Therefore, when analyzing a bank, you must look at more than just profits. You want to know the quality of loans, the non-performing loan ratio, the bank’s ability to absorb losses, and how much capital it has to protect itself. This is where certain ratios specific to banks become important. For example, the net interest margin helps you understand how much a bank earns from its core lending and borrowing business, while the non-performing loan ratio helps you understand the quality of its loan portfolio. Note the difference here: the same ratios that might be very important for a bank might be almost meaningless when analyzing a clothing company. The reason is simple: the economic drivers are different.

When you move into a real estate company, the way of thinking changes again. If the company owns a shopping mall, for example, the primary source of value is not the number of products sold, but the property itself and its ability to generate income. Therefore, you will start with different questions: What percentage of the space is leased? How much do tenants pay? Do rents increase over time? Are tenants able to continue paying? And how much money does the property generate after its operating expenses? This is where the importance of a concept like property operating income comes in—that is, the amount of income the property generates from its core business after deducting its associated operating expenses.

The value of the property itself also becomes very important. A company might be generating reasonable annual profits, but at the same time, it might own a substantial real estate portfolio whose market value could be much higher than what appears in some accounting figures. Therefore, when analyzing a real estate company, don’t just look at profits. Look at the properties themselves, their income-generating capacity, their occupancy rates, the size of their associated debt, and the value of the company’s assets. Again, we don’t start with financial ratios. We begin by understanding the business , and then we look for the numbers that can measure that business.

A telecommunications company has a completely different model. The company builds and invests in a network, then uses that network to provide services to millions of customers. Therefore, the number of customers, what each customer pays, and customer retention become key factors in determining revenue. If a telecommunications company has ten million customers, the question isn’t simply: have they grown to eleven million?

You should also ask: How much does each customer pay? Are new customers profitable? Do existing customers stay with the company or switch to competitors? Therefore, investors pay attention to metrics like average revenue per customer , as it helps them understand how much the company earns from each customer. They also care about the customer churn rate, because a high rate could indicate that the company is facing problems with pricing, service quality, or competition.

Then comes another very important issue: investment in networks. Telecommunications companies need to constantly spend large sums on towers, networks, and technology. Therefore, it’s not enough to simply see profits rising. You also need to know how much money the company needs to spend to maintain and grow its operations. This is where we start looking at cash flow, because accounting profit alone doesn’t always tell us how much money actually remains within the company.

There’s no single number that tells you if a company is good, and this is one of the most important points an investor should understand. There’s no magic financial ratio that can tell you whether a company is excellent or bad. If I tell you a company has a 25% return on equity, that number alone isn’t enough. You need to know how the company achieved that return, how much debt it uses, the nature of its business, the risks it takes, and how much capital it needs to continue growing.

Saying that a stock is trading at 8 times earnings doesn’t automatically mean it’s cheap, just as a stock trading at 25 times earnings doesn’t automatically mean it’s expensive. Perhaps the first company is experiencing a long-term downturn, while the second has the potential to grow for many years. Therefore, your task shouldn’t be to find the lowest number . Your task should be to understand the economics behind the number .

There’s a big difference between a company that can increase its profits using its existing funds and one that needs to inject huge sums every year just to achieve modest growth. Imagine two companies, each achieving 20% profit growth. The first company needs to invest a relatively small amount to achieve this growth, while the second company needs to invest huge sums in factories, equipment, inventory, and new debt.

On paper, both companies are growing at the same rate. But economically, the first company might be far more successful. This is where a crucial concept in company analysis comes in: return on investment (ROI ). Simply put, this metric attempts to answer the question: when a company invests money in its operations, how much return can it generate? This question is vital because growth has a cost. It’s not enough to simply say, “The company is growing.” You must ask, “How much does this growth cost?” And can every new pound the company invests generate a healthy return?

If the answer is yes, then growth can be a powerful source of shareholder value creation. However, if a company is constantly injecting money but the return on that money is weak, then growth itself may not be beneficial.

What do you do with the profits you make?

Another question that reveals a lot about the quality of management is this: After a company makes a profit, what does it do with it? It can distribute a portion to shareholders, use it to open new branches, build factories, acquire other companies, pay off debts, or keep it as cash. Here we must ask: Is management using these funds in a way that generates a good return for shareholders? An excellent company isn’t necessarily the one that makes the most profits today. The best company might be the one that can take its current profits and reinvest them in a way that will generate significantly greater profits in five or ten years.

For this reason, understanding how a company uses its capital is just as important as understanding how it generates profits. This is where you begin to read financial statements differently. When you understand the company’s economic engine, you’ll start reading financial statements in a completely different way. You won’t see inventory as just a number on the balance sheet, but will ask: Is this merchandise moving quickly? You won’t see bank loans as just a huge number, but will ask: Are these loans good? Are the customers able to repay them? You won’t see real estate as just an asset on the balance sheet, but will ask: How much income does it generate? What is its true value? You won’t see the capital expenditures of a telecommunications company as just a large number, but will ask: Are these investments necessary? Are they generating a good return?

Here, financial statements transform from a collection of difficult numbers into a story about the company itself .

Once you understand the company, how it makes money, what drives its profits, what risks it faces, how much capital it needs to grow, and how it uses its profits, the final question arises: What is the value of this company? Only then does valuation become meaningful. You can then use the price-to-earnings ratio, cash flow analysis, or any other method appropriate to the nature of the business. But you are using these tools now after you have understood the company, not before.

This is a crucial difference. Valuation isn’t simply about finding a stock trading at a low price-to-earnings ratio. Valuation is about determining whether the price the market is paying today makes sense compared to the money the company can generate in the future and the risks it takes. The best way to begin analyzing any company isn’t by asking, “What’s the price-to-earnings ratio?” and not by starting to memorize dozens of financial ratios.

Start with one question:

What makes a retail company profitable? Inventory, stores, and sales.

What makes a bank profitable? The money it manages, the difference between its returns and costs, and the quality of the loans it grants.

What makes a real estate company profitable? The properties it owns, its ability to generate income, and its value.

What makes a telecommunications company profitable? Customers, what they pay, their loyalty, and the company’s ability to provide service efficiently.

Only then do we use the numbers and ratios that help us measure this engine. And finally, don’t forget that a stock isn’t just a symbol moving on a stock exchange screen. Behind every stock is a real company, and behind every company is an economic engine. The better you understand this engine, the better you’ll read financial statements, and the more rational your ability to evaluate a company and make an investment decision will become. Always start with the business… then move on to the numbers… and only lastly look at the price.