How do I select a stock for investment?
The answer 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 There This is answer is more appropriate for beginners.
There is no defined way of analysis to find a good company. Investors can analyze a company in many different ways depending upon their approach.
Technical Analysis:
An investor, who follows technical analysis, would study past stock price & volume data and various indicators derived from this data. His analysis would focus on finding stocks whose charts show a defined pattern where he can predict future price and make buying/short-selling decisions about the stock accordingly. His aim is to find a company whose stock is set for a rise/fall in near future. I don’t know much about technical analysis except for few basics i use.
This is mainly used to find entry point or to decide the time of investment.
There could be two major approaches for a long term investors.
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, target market, suppliers, customers, management, financials etc. He would like to know the strength and sustainability 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 increase in stock price as well as dividends to be received from the company in future.
He focuses on finding companies, which have a sustainable business advantage, which can last for decades so that he 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.
Value Investing Approach:
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. The deeper the discount he can find, the better it is.
Fundamental Analysis:
Detailed Analysis of a Company:
Financial Analysis
Business & Industry Analysis
Valuation Analysis
Management Analysis
A)Financial Analysis:
It mainly has three parts.
Profit & Loss Statement (P/L): Provides details of total income that a company has earned in a year . 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. It is better to 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 shareholder’s own money (equity), retained earnings (profits earned but not distributed to shareholders) and debt.
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.
It is better to 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
It is better to focus on companies, which generate good amount of cash flow.
B) Business & Industry Analysis:
Try to find a company, which has shown good growth of sales & profits in past years. 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.
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 very important parameters . It is better to invest in companies, which are run by honest people whom we can trust with personal money. A crook manager will always find more than one way to cheat shareholders.
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.
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 very 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 of a stock by profit/earnings per share . It represents the price an investor pays to buy Rs. 1 of earnings. Generally speaking low PE is a good sign of investment.
Price to Book Value ratio (P/B):
It is calculated by dividing the current market price 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.
Market Capitalization:
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, 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.
So keep learning, keep your eyes and ears always open, you never know you can find a multibagger idea anywhere anytime.