This article is a part of the series of articles “Selecting Top Stocks to Buy“.
In this series, we have learned about getting the right perspective towards stocks investing & the qualities required to become a successful investor (Part 1), different stock picking approaches & the guidelines for selecting the suitable stock picking approach (Part 2) and the process of shortlisting stocks for detailed analysis & various tool available to an investor for shortlisting of stocks (Part 3).
The current article aims to provide a framework for the detailed analysis of any stock before we delve deep into the threadbare analysis of any company for making investment decision about its stock.
It is said that there is no single path to success. Similarly, there is no single defined way of analysis to find a good company. Investors can analyze a company in many different ways depending upon their stock picking approach.
An investor, who follows technical analysis, would study past stock price & volume data and various indicators derived from this data on charting software. Her analysis would focus on finding stocks whose charts show a defined pattern where she can predict future price and make buying/short-selling decisions about the stock accordingly. Her aim is to find a company whose stock is set for a rise/fall in near future.
Growth Investing Approach:
An investor, who follows growth-investing approach of fundamental analysis, would like to study a company like an entrepreneur. She would focus on a company’s product, target market, suppliers, customers, management, financials etc. She would want know the strength and sustainability of the business of a company. Her aim is to find a company that is going to increase its earnings in future. Her belief is that when a company increases its earnings, the demand for its stock will increase. Increasing demand of the stock would lead to increase in the price of the stock of the company. The investor would gain from increase in stock price as well as dividends to be received from the company in future.
She focuses on finding companies, which have a sustainable business advantage, which can last for decades so that she need not shift out of the stock of a company every few days. She thinks like the owner of the company and remains invested in it for decades.
Value Investing Approach:
An investor, who follows value-investing approach of fundamental analysis, would focus on finding fair value of the company. She would focus on the assets and earning potential of the companies. She tries to find out the companies whose stocks are priced at a discount to the fair value. The deeper the discount she can find, the better it is!
My Approach to Stock Investing
I follow a bottom-up fundamental analysis approach in which I look for high growth companies whose stocks are available at attractive prices. I focus on finding companies, which have grown their sales & profits at a good pace in past and have the business strength to keep growing in future. I look for companies, which have low debt as it offers safety & a potential future route to raise funds. I try to find out companies whose stock is selling at low valuations so that it can offer a huge margin of safety. I believe that if earnings of a company increase then stock price would also rise. However, no one knows the timing of stock price rise and this is the uncertainty/risk, which requires patience of staying put with good stocks. The patience of staying invested in good companies is rewarded handsomely.
Detailed Analysis of a Company:
There is no particular order in which an investor should approach these sections. One may start from financial analysis or management analysis. However, all the four sections are essential and none can be left unanalyzed.
A) Financial Analysis:
The aim of financial analysis is to analyse the amount of income it earns in sales, amount of profits it is able to retain for shareholders after factoring in all expenses & taxes and the growth in sales & profits over past. Financial analysis also focuses on the sources of funds, which a company has used for creating its assets. It also involves the analysis of the amount of cash it generates from its operations and utilization of this cash, whether for investments or debt repayment etc. The aim is to find companies, which have a healthy financial position that can offer potential for future growth.
Financial analysis involves reading of annual reports of a company. It comprises of detailed analysis of three main financial statements:
Profit & Loss Statement (P/L):
This section of financials provides details of total income that a company has earned in a year (also called Topline). It provides details of all the expenses the company has incurred to earn the topline. It also provides details of the taxes the company paid to the govt. authorities. The part of topline, which remains after meeting all the expenses and taxes, is called net profit or Bottomline.
I focus on companies which earn a lot of money (topline), use minimum amount to earn that money, pay due amount of taxes on its profits and increase the sales (topline) & earnings (bottomline) year on year.
Balance Sheet (B/S):
This section of financials provides details of all the assets and liabilities of a company at the last date of the financial year. In Indian context, it provides details at March 31 of any given year.
Liabilities are the sources of funds, which a company has utilized to purchase all the assets it owns. The usual sources are shareholder’s own money (equity), retained earnings (profits earned but not distributed to shareholders) and debt (borrowings from banks and other sources)
Assets provide details of utilization of the money raised under liabilities. Assets comprise of fixed assets, investments and current assets. Fixed assets are permanent fixtures that generate revenue year after year for the company e.g. plant & machinery. Investments reflect the money that the company has invested in different other companies, joint venture, subsidiaries etc. which are expected to earn money for company’s shareholders. Current assets are usually consumed within next one year. Current assets include inventory that gets consumed and gets sold as finished product within a year, cash & similar investments kept by the company to meet day to day requirements and money due from customers (account receivables or debtors) and loans given to different parties that are expected to be received back within a year).
I focus on companies, which use minimum amount of debt and create assets that keep on generating revenue for the company year after year without the need of frequent expenses to maintain these assets.
Cash Flow Statement:
This section provides details of the cash that a company has generated in last financial year from operation (cash-flow from operations or CFO). This section also includes details of cash used in making investments or received from selling investments (cash-flow from investing activities or CFI) and cash raised from financial institutions as borrowings or repaid to them during the last year (cash-flow from financing activities or CFF)
I focus on companies, which generate good amount of cash flow from operations that can take care of their requirements of investment (CFI) and repayment of debt (CFF). If a company generates so much cash that after taking care of CFI and CFF, it still has surplus left, it is a dream company and I buy as many stocks as I can (Shop till you drop!!).
Some knowledge of accounting can be a good advantage to do financial analysis of a company. However, it is not required to be a master of accounting for stock investing. An investor who does not have a background in finance & accounting, but is willing to put in the effort needed to read the annual reports, will get the required knowledge of accounting during analysis. Therefore, I firmly believe that anyone irrespective of educational background can be a great stock picker.
Learn about detailed financial analysis of a stock here: How to do Financial Analysis of a Company
B) Business & Industry Analysis:
I am a bottom up fundamental investor. Therefore, I give more weightage to the business qualities of a company than the industry it operates in. In fact, I follow Peter Lynch when he says that:
Moderately fast growers (20 to 25 percent) in non-growth industries are ideal investments.
I try to find a company, which has shown good growth of sales & profits in past years. I consider such a company a good investment candidate irrespective of its industry. I try to focus on the performance of the company in comparison to its industry peers and try to find out if it has any business advantage over its peers.
Warren Buffett calls this business advantage “Moat”. Many investors visit company stores, manufacturing plants, meet its customers, suppliers, vendors etc. to find out the moat of a company. If time permits, an investor should do these activities, as these will give her information that the stock markets are yet to come across. However, many individual investors including me, have limited time left after the daytime job and therefore, cannot go to the market and meet different stakeholders of the company. Therefore, I use consistent growth in sales in past as a substitute of market research and try to analyse it further. If I find a company has been growing at a rate of 20% year on year for past 10 years whereas its peers are growing only at 10% or less, I analyse it further. If 10 year back it had a single manufacturing plant and it has increased its capacity to 5-6 plants now where it is able to sell the entire production of these 5-6 plants, then the company is bound to have a sustainable advantage “Moat”.
Moat can be discovered after doing market research if time permits but detailed analysis of past growth, other financial parameters like higher profit margins as compared to industry peers, can easily provide an investor the indication of a sustainable business advantage.
We have the advantage of witnessing one of the most severe recessions ever since 2008. It is blessing in disguise as we can analyse the performance of any company during this recession and see how its business fared. If it was able to show sustained growth during 2008-2014, it is expected to have a good business advantage, which has sustained it in bad times and it might help it to grow its business further when good times (Achche Din) arrive!
Learn about detailed business & industry analysis of a stock here: Business & Industry analysis of a Company
C) Management Analysis:
Management is the most important parameters and I give it more importance than any other parameter. I want to invest in companies, which are run by honest people whom I can trust with my personal money. A crook manager will always find more than one way to cheat shareholders. I avoid companies where I see even the slightest sign of compromise of integrity.
Management analysis is mainly a subjective exercise however; it contains some objective parameters as well. We should read profile of promoters, search about their credentials, any issues, penalties, regulatory actions etc. about them from public sources (e.g. google). We should do similar checks about independent directors as well. Once we are convinced that there is nothing to question their character & integrity then we should move ahead with further analysis.
As an investor should stay invested in stocks of a company for decades, management succession plans become a vital factor. As in India, most businesses run in families, we should see whether the key promoter has introduced her next generation into business. We should read about the next generation. We should find out their education credentials and the amount of experience they have already had working under guidance of their parents.Certain parameters like salary being paid to children of key promoter are good indicator of values being instilled by promoters in her children. I was amazed to find a company, which made about Rs. 50 cr. (INR 500 million) in profits but the promoter paid only Rs. 10,000/- (INR 0.01 million) per month to his daughter who had joined the board of directors. Today, I am heavily invested in the stocks of that company.For any further information, we should always call the company secretary or investor’s relations officer of the company before we commit our hard-earned money to any stock.
Many objective parameters can provide indications about investor friendliness of the promoters & management:
- A comparative analysis of salary drawn by promoters and the profits of a company is a good parameter. The promoter should not have a history of seeking increase in remuneration when the profits of the company declined in past.
- Successful execution of increase of production capacity especially by green field plants is a good indicator of competent management. It is very good if the capacity addition has been done without facing any delays.
- A company that has consistently increased its dividend payout with increase in profits in past, usually has a good management.
- Purchase of shares of a company by its promoters is a sign of a good promoter. However, selling of shares by promoters is not necessarily negative. Company’s shares are usually promoter’s biggest asset and they usually sell it whenever any cash requirement arises in personal life.
Learn about detailed management analysis of a stock here: Management Analysis of a Company
D) Valuation Analysis:
There are many parameters, which need to be studied to analyse the valuation levels of a company. Some of the important parameters are:
Price to Earnings ratio (P/E):
I believe that P/E is the single most important parameter to analyse whether stock of any company is overvalued or undervalued at any point of time. It is calculated by dividing the current market price (CMP) of a stock by profit/earnings per share (EPS). It represents the price an investor pays to buy Rs. 1 of earnings. I prefer the companies, which are available at low P/E ratio, preferably less than 10.
Price to Book Value ratio (P/B):
It is calculated by dividing the CMP of a stock with the book value (shareholder’s equity + retained earnings) per share. It represents the price an investor pays for Rs. 1 of net assets after settling all outsider liabilities of a company. I find P/B ratio irrelevant due to usage of historical cost of company’s assets while calculating book value. The historical cost might not represent the current market value of company’s assets. However, P/B ratio is very important for companies in financial sector where most of the assets are cash assets and book value is good indicator of net worth of the company.
Benjamin Graham said that an investor should look for companies where P/E * P/B is < 22.5. However, I focus mainly on companies with P/E <10 while ignoring P/B ratio.Every investor develops her own parameters as her investing experience grows and I believe that every reader of this blog would be able to find her favorite parameter as she keeps analyzing more and more companies.
It represents the value of all the shares of a company and indicates the value for which the entire company can be bought at any point of time. Companies are divided into micro-cap, small-cap, mid-cap and large-cap based on their market capitalization. I prefer investing in companies, which are currently micro-cap or small-caps as these companies represent the section of economy, which can grow fast and become future large-caps.
There are many other parameters like return on equity (ROE), return on capital employed (ROCE), dividend yield etc. which are analysed by different investors to find out stocks which hold the potential for provide good returns in future. We would analyse many such factor in the subsequent article in this series that would be dedicated to valuation analysis.
Learn about detailed valuation analysis of a stock here: Valuation Analysis of a Company
In the current article of this series “Selecting Top Stocks to Buy”, we discussed various aspects of analysis of any company. An investor should analyse the companies from each of these angles: financial, business & industry, management and valuation before she invests her hard-earned money in any stock.
The investor should realize that her rejection rate of stocks would always be high as good companies selling at attractive prices are always difficult to find. However, finding one good stock each year is more than sufficient. 10 good stocks in one’s lifetime can make one a billionaire. The investor should never be in a hurry. She should learn to be patient and should hold the impulse to buy a stock if she does not find a good stock. The investor should have very strict stock selection criteria for adding stocks in her portfolio so that she can be confident that only right stocks are selected. Easy selection criteria will lead to many undesirable stocks in the portfolio, which will require selling soon after buying. This would lead to wastage of time and effort put in stock selection. The key is to find if company would survive for next 25-30 years and whether the investor can visualize it being there after many decades. Economic cycles of upturn and downturn will be there. A good company can weather all of them and come out a winner.
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Future articles in this series would be dedicated to detailed discussion of financial, business & industry, management and valuation analysis of companies. We would learn about the concepts and parameters of such analysis by applying it to analysis of a sample company. We would learn about interpreting different ratio and finally making investment decision by taking a comprehensive view of company’s performance.
I would be happy to learn about your feedback on this series of articles and your experiences of stock investing. You may share your inputs in comments section below.