Series – IV: Know THE COMPANY before investing
Buying a stock means investing in a company. Most retail investors lose money because either they buy the stock for trading and if it results into loss, they become investor or they try to catch the falling knife. There could be a variety of reasons why they do so, but it is important to remember that without proper research it is tough to make money in this market.
If you do not have time to research and understand the company you are investing in, it is advisable to take expert’s advice. Keep in mind that an expert advice means Advisor or Research Team whom you know well and have high-quality understanding of the market. Be aware of advisory trapping in the market.
In this article, we will try to articulate some of key factors one should look before investing:
1. Business model & corporate structuring (What they do & how they do ? )
Before investing in a company, look carefully at their business model and corporate leadership. Blend of well-built product mix along with strong leadership is essential for long term sustainable growth of any company.
Not to put too fine a point on it, but how long has this company been around? And how well have they worn with age?
Investor should have exhaustive knowledge of few questions with respect to:
- What do they manufacture?
- What kind of services do they offer?
- In what countries do they operate?
- What is their flagship product and how is it selling?
- Are they known as the leader in their field?
Leadership / Corporate structuring
- How much experience do they have in this industry?
- Have they run the company for a long time, or does the firm experience frequent shifts in leadership?
- Are they well regarded in their industry?
Pay attention and make sure not to miss any potential red / green flags.
2. Earning Power & stability – (Numbers do matter)
There are three financial statements available for a company
– Profit and Loss Statement / Income Statement
– Balance Sheet Statement
– Cash flow Statement
All the above has its own importance.
Check gross margin, EBIT margin and net income that a company has over time. Look for trends. Does the earnings growth increase? Even if the increase isn’t exponentially, a company that has steady and consistent earnings growth over time can be a good bet for the future.
Every thing in respect to earning should be parallelly compared with companies in same domain – generally it is called Peer Comparison.
3. Valuation Metrics:
It’s vital that one should look beyond the price of share. General tendency of retail investor is – stock with price less than Rs. 100/- are cheap. Current price or traded price is not all that investor should look into; check out the value of the company when you’re doing research.
There are multiple ways to value a company, some of the easiest metrics are
– Price to Earnings Ratio (P/E):
P/E is the ratio of the company’s current stock price to its total profit (or “earnings”) per outstanding share. So, for example, if a company’s stock is trading at Rs.100 and it had a profit of Rs.10 per share (EPS – Earning per share), its P/E ratio would be 10x.
Now, you are thinking that company with lower P/E is attractive in valuation perspective. No that’s not true, a lower ratio could indicate that investors think this company is in trouble, while a higher one could indicate that the stock has gotten overvalued.
Here a concept of statistic is applicable which is “Mean”. Always look for industry / sector P/E ratio. For instance if industry P/E is 15x and in our above example company’s P/E is at 10x than stock value will be considered as undervalued and one can thing to invest in this company considering other metrics.
To put that into perspective, too low & too high P/E ratio is not good for investment.
– Debt to Equity Ratio (D/E) :
This ratio tells us the level of how much debt the company has taken compared to its total equity. To calculate the D/E ratio, you divide the company’s total debt by its total equity (Shareholders equity).
D/E greater than 1 means company has lot of debt relative to its assets. A lower D/E ratio is generally considered a safe bet.
Exception to above statement –
Debt structure depends on the sector, for illustration, Infrastructure Company will have high debt structuring than company in information technology space.
Also, companies poised for growth may have borrowed heavily for expansionary activities which resulted in higher debt portion in their balance sheet.
These two fundamental ratios are widely used in investment world along with various valuation methodologies. One can have superficial view over pricing of stocks by considering above points.
4. Buyback / Dividend policy:
Buyback , stock bonuses and dividends distribution are some of the ways company rewards its shareholders.
Buying back shares from existing share holders generally in premium can be a simple way to pay-off investors.
Dividends are distributions made by a company to its shareholders as a reward from its profits. The amount of the dividend is recommended by its board of directors and approved by shareholders which is generally issued in cash.
Companies paying or rewarding shareholders on a regular basis are considered to be good
Valuation of a company involves lot more than this. In this article we tried to give a superficial knowledge of how to value a company, but it takes more than this to price a company’s stock value. Research is an incessant process and however investment success crucially depends on analyst’s ability to determine the value of stocks.
Investors should trade through a broking firm who is capable enough to give better advice/guidance to its investors to build long term wealth.