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.
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:
B. Business & Industry Analysis
C. Valuation 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.