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After identifying the right industry to park your money, you should lay your
hands on the right company. Some parameters that will help you analyse a
company.
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the right industry to park your money, you should lay your hands on the
right company. As Peter Lynch says, "Identifying the right industry but the
wrong company, is like marrying into the right family but the wrong girl."
Here are eight financial and three non-financial parameters that you should
look into when you invest in a company.
*Return on Capital employed*: This refers to the amount earned by the
company on the total funds employed in business. The capital means both
equity capital and loan capital. Equity capital would, of course, include
reserves as well. Return would mean profit after tax plus interest on
long-term funds, adjusted for tax. This measures the productivity of money
and is the closest measure of finding out the underlying economics of the
business. Higher the ROCE, better for the investor. At minimum, ROCE should
be equal to the Weighted Average Cost of Capital (WACC) of the company. The
WACC is the rate of return that equity shareholders and debt holders put
together want to earn.
*Return on equity*: The return on equity measures the total return earned on the shareholders fund invested. It is the ratio of profit after tax to
shareholders funds. Over the long term, the value of a company would move in lock step with the return on equity. Higher the ROE, better for the
investors. Generally, ROE is higher than ROCE since the cost of debt is
generally lower than ROCE, thus resulting in equity holders enjoying a
higher share in the total returns pie.
*Historical sales growth*: This indicates how the company has been able to
grow its business over the long term. Compared with the industry growth
rate, this would give an indication of whether the company is increasing its market share or not. Also, it would help in finding out whether the business is in the growth or maturity phase and in understanding the seasonality of the business and, interpreting growth of the recent past, accordingly.
*Free cash flows to shareholder*: Business is not about booking accounting
profit; hence cash surplus is more important than accounting surplus. Free
cash flow is found out by deducting the upcoming maintenance capital
expenditure from the cash from operations.
A business might be earning lots of profits, but if a large portion of it
are to be spent in maintaining the fixed assets, then the "real returns" to
shareholders will be less. Thus, higher the free cash flows, better for the
investor.
*Debt/equity ratio*: This compares the debt employed in the business
relative to the equity component. Also called leverage, this can help
magnify the return to the shareholder and is invariably used for that
purpose. However, high leverage would create problems for the company,
especially when there is a business slowdown. Though there is no hard and
fast rule of what is the ideal debt/equity mix, a debt/equity ratio of
higher than two is considered risky.
*Working capital*: In simple terms, working capital refers to the amount of
cash required by the company to run its day-to-day business. The need for
working capital arises since there is a time lag between business expenses
and realisation from customers. Higher working capital means that cash is
locked in unproductively. The ratio of sales to working capital is
important. Higher this ratio, the better, because it implies that there is a bigger bang being got for every rupee of working capital.
*Profitability margins*: Margins refer to the difference between sales and
cost. Margin is an indicator of the value add provided by the business to
the customer. Consistently higher margins imply that the business has the
ability to pass on the hike in cost to the customers. Some of the crucial
margin numbers are gross margin, EBIT margin and net margin.
Gross margin is the ratio of gross profit to sales where gross profit is the difference between sales and manufacturing cost. EBIT margin is the ratio of operating profit to sales where operating profit is profit before interest and taxes. Of course, ultimately, it is the ratio of net profit to sales that is crucial.
*Degree of exposure to macro factors*: An investor should be aware of the
exposure of the company to macro factors such as exchange rates, interest
rates, inflation etc. For instance, depreciation of the rupee is good for
exporters, whereas it increases the cost of imported goods for importers.
Similarly, a company with high amount of borrowing at floating rates would
see an increase in interest cost if the PLR is increased.
Non-financial factors
*Quality of management*: Management is the trustee of the shareholders
funds and is responsible to run the business in the best interests of the
shareholders. A good management consistently displays two traits. One,
employing the shareholders funds in "high return" projects after careful
analysis. And, two, linking the rewards of the management closely with that
of the shareholders. Investors should carefully study management guidance,
managerial remuneration policy etc to see whether management actually acts
in the interest of the shareholders.
*Competitive advantage and its durability*: You should carefully understand
the unique selling proposition of the company that will help it sustain in
today's highly competitive environment.
This can be in the form of established brands (for FMCG, fashion
businesses), patents and intellectual property rights (for pharma,
technology companies), location (for hotels, retailers), cost of funds ( for banks, NBFCs), quality of manpower (for software companies). If the company does not enjoy any unique advantage, then it becomes highly vulnerable to competition and is likely to make compromises such as price cut to ensure its sustenance.
*Accounting policies*: You should understand key accounting policies to find out if they are reasonably conservative. A very aggressive accounting policy is not good as it might temporarily inflate the profits and cause
fluctuations in earnings.
A few common accounting manipulations include capitalising expense; making
inadequate provisions; non-disclosure of off-balance sheet commitments (like contingent liabilities, hedging contracts etc); big bath accounting (booking fictitious expenses when PE multiple of the company is low and reversing them when it improves; not routing expenses through income statement (directly adjusting losses against reserves).
Now that you have a clue to how company analysis is done at a broad level,
you should be able to pick stocks.
*Sources of information*
*Annual report*;
*Financial statements*;
*Accounting policies*;
*Management discussion *and analysis;
*Investors meet*/call by the management after the announcement of quarterly
results;
*Announcements/intimations* to stock exchanges;
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