How to conduct Detailed Analysis of a Company.
This
current article aims to provide a framework for the detailed analysis of any stock before we have a
tendency to take deep into the threadbare analysis of any company for creating
investment call regarding 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. This analysis would focus on finding
stocks whose charts show a defined pattern where we can predict future price
and make buying/short-selling decisions about the stock accordingly. Our aim is
to find a company whose stock is set for a rise/fall in near future.
Fundamental Analysis-
Growth
Investing Approach:
An
investor, who follows growth-investing approach of
fundamental analysis, would like to study a company like an entrepreneur. He would focus on a company’s product, customers,
suppliers, target market, management, financials etc. He would want know the sustainability
and strength of the business of a company. His aim is to find a company that is
going to increase its earnings in future. His 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 dividends to be received from the company
and increase in stock price in future.
He 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. He thinks like the owner of the company and remains invested in it for
decades.
An investor, who
follows value-investing approach of fundamental analysis, would focus on finding
fair value of the company. He would focus on the assets and earning potential
of the companies. He tries to find out the companies whose stocks are priced at
a discount to the fair value.
Best Approach to Stock Investing
We
follow a fundamental analysis approach in which we look for high growth
companies whose stocks are available at attractive prices. We 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. We look for
companies, which have low debt as it offers safety & a potential future
route to raise funds. We try to find out companies whose stock is selling at
low valuations so that it can offer a huge margin of safety. We
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:
The
analysis of any company divides in four sections:
A.
Financial Analysis
B.
Business
& Industry Analysis
C.
Valuation Analysis
D.
Management Analysis
This
four sections are essential and none can be left unanalyzed.
A) Financial Analysis:
The main aim of
financial analysis is to analyse the amount of income generated 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.
Liabilities are
the sources of funds, which a company has utilized to purchase all the assets
it owns. The usual sources are shareholders 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 and loans given to
different parties that are expected to be received back within a year.
We 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. This section also includes details of cash used in making
investments or received from selling investments and cash raised from financial
institutions as borrowings or repaid to them during the last year
We
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.
B) Business & Industry Analysis:
We are bottom up
fundamental investor. Therefore, We give more weightage to the business
qualities of a company than the industry it operates in. In fact, we follow
Peter Lynch when he says that:
Moderately fast growers
(20 to 25 percent) in non-growth industries are ideal investments.
We try to find a
company, which has shown good growth of sales & profits in past years. We
consider such a company a good investment candidate irrespective of its
industry. We 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, we use consistent growth in
sales in past as a substitute of market research and try to analyse it further.
If we 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, we 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.
C) Management Analysis:
Management is the
most important parameters and we give it more importance than any other
parameter. We want to invest in companies, which are run by honest people whom
we can trust with my personal money. A crook manager will always find more than
one way to cheat shareholders. We avoid companies where we 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. 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.
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):
We
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. We 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 Every investor develops his own parameters as
his investing experience grows and we believe that every reader of this blog
would be able to find her favorite parameter as she keeps analyzing more and
more companies.
