Most of the people who invest in stock market rarely carry any research before investing and they normally depend on stock tips by others. The same person carries day and night research before buying a cell phone but when it comes to investing they are not willing to spend an hour. These are the people who blame that share market is a gamble. I would suggest everyone to please do your research before investing and if you can’t then please invest through mutual funds under the guidance of experts.
Before we jump into specific factors to analyze a public stock to invest in, there is one crucial aspect to consider
It plays a very important role in investing and in all aspect of life. No matter how wealthy or intelligent investor you are, money management is important.
I would like narrate a small story on Michael Gerald Tyson, former American heavyweight boxing champion and youngest man to have won boxing world title. He made huge money in his career but he was declared bankrupt in 2003 and the reason was indiscriminate spending. So one can understand the importance of savings, hence it is important to eliminate their unimportant expenses because it is going to help them in the time of need. Instead of following the traditional formula of savings which is the difference between income and expense, we should try to fix the savings say 30% of income and manage the expenses with remaining 70%, rather than saving the money left after blind spending.
I believe finding a favourable bet providing an edge is only 50% of the job while the remaining 50% is money management. The best person who fits the situation is George Soros and money management played a very significant role in his success though the success rate in his case was only 30%. George Soros said, “It’s not whether you are right or wrong that’s important, but how much you make when you’re right and how much you lose when you’re wrong”
There are ‘n’ numbers of factors involved in analyzing a company. Here are some of the important points which a beginner should look into, while selecting a stock to include in the equity portfolio:
Key Factors To Analyze A Public Company Stock Before Investing In It
It is one of the very important aspects to look into before investing in a company. The manager sits in a driving seat of a company and if he is a poor driver he is sure to commit an accident in future.
“Investing in India follows the same rule as elsewhere, there is one crucial difference- here the quality of management has to be considered closely. Abroad one can go by what is there in the books, but here you have to add an additional layer- the management” said Nemish Shah, Co founder and Director of Enam Holding.
It’s better to stay away from companies that constantly raise capital and dilutes equity and are also highly leveraged except in case where it is needed in short term to enhance its competitive edge.
Good management has the ability to generate excellent results even though the sector is suffering with problems. Piramal Enterprise, JSPL, TCS etc are few companies with an excellent set of management on the other hand DLF, Suzlon etc are examples of poor management.
Annual Report Analysis
An annual report is a report on company’s performance throughout the preceding year, intended to give shareholders and other interested parties information about the company’s activities and financial performance. It is a very valuable piece of information where company’s management, directors, auditors discusses about the prospect about the company, its vision etc.
It is important to go through the annual report by making comparison with its peer company for better understanding rather than reading on a standalone basis. Say if you are reading the annual report of Marico India, a leading FMCG company, it’s better to make a simultaneous comparison with its competitor say Hindustan Unilever.
You can read: “Annual Report analysis of Marico India” to get a better idea about reading and analysing an annual report.
Warren Buffett said he loves to curl up with companies’ annual reports. When asked how to get smarter, Buffett once held up stacks of paper and said he “read 500 pages like this every day. That’s how knowledge builds up, like compound interest.”
Few important areas to look into while reading an annual report includes –
i. Chairman’s letter
ii. Director’s report and MD&A section
iii. Action by top shareholders
iv. Auditor’s report
v. Financial performance
vi. Debt structure
vii. Salaries drawn by the key personnel etc.
Debt Or Leverage
It plays an important role in stock selection. Presence of debt has both positive and negative aspect. The probability of negative is higher as far as history is concerned. I believe instead of looking debt on a standalone basis, it’s always better to look at management quality as well because good management and leverage can result in deadly combination like Piramal enterprise in the last 25 years while poor management and leverage could be disastrous like Suzlon energy or DLF.
If you are a newbie and don’t have proper skill to judge the quality of management, it’s always better to look for a company with low or no debt level whether on or off balance sheet. More importantly, also track that the company takes low short term debt, especially during cyclical downturn.
Financial Statement Analysis
While the annual report helps you understand qualitative aspects of the company, financial statement analysis refers to the analysis of key financial statements like balance sheet, Profit & loss account, cash flow statement and footnotes. To get better understanding of the financial statements, it’s better to do both inter-firm and intra-firm comparison
Here are some key points to consider in financial statements,
- A liquid balance sheet
- Absence of encumbrances
- Low or no debt levels
Profit and Loss account
- Multiple source of earnings
- If the company is diversifying into new segments, the core activities remain intact
- Pricing power
- Low interest cost and sufficient earnings to meet the situation
- Bigger the size of revenues as the large businesses has more strength to face the economic turmoil than smaller ones
- Adjust for any extraordinary item (if any)
Cash Flow Statement
- Low working capital to improve operating cash flow
- Low dividend payout to fund growth with company’s internal resources
Taking financial statement analysis further, it is also a good idea to analyse following key financial ratios by comparing with its peer companies. These are often also termed as Key Financial Indicators
- Inventory turnover ratio and inventory days
- Debtor turnover ratio and receivable days
- Payable turnover ratio and payable days
- Cash conversion cycle
- Debt equity ratio
- Interest coverage ratio
- Debt service coverage ratio ,etc
Margin of Safety
It involves buying stocks at deep discount to its intrinsic value so as to reap the maximum benefit out of it by holding it for long term. It provides a cushion in case of any error made in stock selection since market is prone to extreme fluctuations at times, making it very difficult for the investors to hold onto it. Patience is a key to long term success as it has been seen in history that few excellent stocks have not given any return over the years so market is sure to test your patience.
The concept of margin of safety is equally important in real life. For example, when a bridge is constructed, the load it will carry is estimated at say 15000 pounds at a point in time. But actual construction is made keeping in mind higher load say 25000 pounds involving some margin of safety.
Benjamin Graham said, “There is no such thing as a good or bad stock; there are only cheap stocks and expensive stocks. Even the best company becomes a ‘sell’ when its stock price goes too high, while the worst company is worth buying if its stock goes low enough”
Moat is a method of creating a competitive edge so as to drive out competition and also to retain its market share. It may be in the form of high switching cost, cost advantage, technological innovation etc. Few Indian companies with moat are Bata India, Pidilite, Asian paints etc. Investor would be greatly rewarded if the company is able to sustain its moat because the company is able to generate high ROE going forward.
Warren Buffett said, “Look for the durability of the franchise. The most important thing to me is figuring out how big a moat there is around the business. What i love is of course is a big castle and a big moat with piranhas and crocodiles”
There are some of the key factors to be kept in mind before investing and the above points will give you a basic start to begin with your investment. Diversification is also one of the important aspects to focus as it will lower your risk. However everyone has its own style of stock picking so these points should be used in a way satisfying your investing need.
This article has been contributed by Ankit Jaiswal, a research associate in Elearnmarkets.com, with a strong passion for fundamental analysis in the financial market. He believes fundamental analysis is a key to successful investing and hence, he recommends everyone to dig deeper into company’s fundamentals.