Picking the Right Company

After you have decided that the economy is good investing in and after you have identified the right industry to park your money, you should lay your hands on the right company. As Peter Lynch says, “Identifying the right industry but the wrong company, is like marrying into the right family but the wrong girl.”

Here are eight financial and three non-financial parameters that you should look into when you invest in a company.

Return on Capital employed: This refers to the amount earned by the company on the total funds employed in business. The capital means both equity capital and loan capital. Equity capital would of-course included reserves as well. Return would mean profit after tax plus interest on long term funds, adjusted for tax. This measures the productivity of money and is the closest measure of finding out the underlying economics of the business. The higher the ROCE, the better for the investor. At minimum, ROCE should be equal to the Weighted Average Cost of Capital (WACC) of the company. The WACC is the rate of return that equity shareholders and debt holders put together want to earn.

Return on equity: Return on equity measures the total return earned on the shareholders fund invested. It is the ratio of profit after tax to shareholders funds. Over the long term, the value of a company would move in lock step with the return on equity. The higher the ROE, the better for the investors. Generally, ROE is higher than ROCE since the cost of debt is generally lower than ROCE thus resulting in equity holders enjoying a higher share in the total returns pie.

Historical sales growth: This is an indicator of how the company has been able to grow its business over the long term. This, compared with the industry growth rate would give an indication of whether the company is increasing its market share or not. Also, this would help in finding out whether the business is in growth or maturity phase. This will also you to understand the seasonality of the business and accordingly interpret the growth of recent past.

Free cash flows to shareholder: Business is not about booking accounting profit; hence cash surplus is more important than accounting surplus. Free cashflow is found out by deducting the upcoming maintenance capital expenditure from the cash from operations. A business might be earning lots of profits, but if a large portion of it are to be spent in maintaining the fixed assets, then the “real returns” to shareholders will be less. Thus, the higher the free cash flows, the better for the investor.

Debt/equity ratio: This compares the debt employed in the business relative to the equity component. Also called leverage, this can help magnify the return to the shareholder and is invariably used for that purpose. However high leverage would create problems for the company, especially when there is a business slowdown. Though there is no hard and fast rule of what is the ideal debt/equity mix, a debt /equity ratio of higher than 2 is considered risky.

Working capital: In simple terms, working capital refers to the amount of cash required by the company to run its day to day business. The need for working capital arises since there is a time lag between business expenses and realization from customers. Higher working capital means that cash is locked in unproductively. The ratio of sales to working capital is important. Higher this ratio the better because it implies that there is a bigger bang being got for every rupee of working capital

Profitability margins: Margins refer to the difference between sales and cost. Margin is an indicator of the value add provided by the business to the customer.. Consistently higher margins imply that the business has the ability to pass on the hike in cost to the customers. Some of the crucial margin numbers that you should chase are Gross Margin, EBIT margin and Net margin. Gross margin is the ratio of gross profit to sales where gross profit is the difference between sales and manufacturing cost. EBIT margin is the ratio of operating profit to sales where operating profit is profit before interest and taxes. Of-course in the end the ratio of net profit to sales is crucial

Degree of exposure to macro factors: An investor should be aware of the exposure of the company to macro factors like exchange rates, interest rates, inflation etc. For instance, depreciation of the rupee is good for exporters, whereas it increases the cost of imported goods for importers. Similarly, a company with high amount of borrowing at floating rates would see an increase in interest cost if the PLR is increased.

Non financial factors

Quality of management: Management is the trustee of the shareholders funds and is responsible to run the business in the best interests of the shareholders. A good management consistently displays two traits. One, employing the shareholders funds in “high return” projects after careful analysis. And two, linking the rewards of the management closely with that of the shareholders. Investors should carefully study management guidance, managerial remuneration policy etc to see whether management actually acts in the interest of the shareholders.

Competitive advantage and its durability: You should carefully understand the unique selling proposition of the company that will help the company to sustain in today’s highly competitive environment. This can be in the form of established brands (for FMCG, fashion businesses), patents & Intellectual property rights (for pharma, technology companies), location (for hotels, retailers), cost of funds ( for banks, NBFCs), quality of manpower (for software companies). If the company does not enjoy any unique advantage, then it becomes highly vulnerable to competition and is likely to make lots of compromises like price cut etc in order to ensure its sustenance.

Accounting policies: You should understand key accounting policies to find out whether they are reasonably conservative. A very aggressive accounting policy is not good as it might temporarily inflate the profits and cause fluctuations in earnings. A few common accounting manipulations include capitalizing expense; making inadequate provisions; non disclosure of off- balance sheet commitments (like contingent liabilities, hedging contracts etc); big bath accounting (namely booking fictitious expenses when PE of the company is low and reversing them when PE multiple improves; not routing expenses through income statement (directly adjusting losses against reserves).

Now that you have a clue to how company analysis is done at a broad level, you should be able to pick stocks.