9 Important Points to be considered before you choose to invest in Stocks:
Benjamin Graham once quoted: “The individual investor should act consistently as an investor and not as a speculator.”
Investors choose stocks based on the fundamental analysis and stay invested for long-term. They do a careful analysis of the company and then decide to invest in it. Short-term price changes do not motivate/de-motivate investors. They do not enter/exit stocks frequently. In fact, they keep their portfolio diversified to manage risk.
On the other hand, a speculator looks to generate short-term returns, and their choice is based more on chance than analysis. They may go by historical data, rumors, tips or gut feelings & anticipate the movement in stocks prices.
Once you make sure that you want to invest and not speculate, it’s important from an investor’s perspective to do fundamental analysis of the stocks you want to invest in. Let me take you through some of the important points that you must consider before investing in stocks:
1. Understanding the Business Model of the Company
A business model is a representation of how a company operates. It is a plan implemented by a company to generate revenue and make a profit from its operations.
According to a study conducted by Harvard Business School, the three characteristics of a good business model are:
• It has to be aligned with the company goals.
• It must be self-reinforcing.
• It should be robust.
By understanding the business model, one gets to know about the sources as well as the quantum & frequency of the company’s revenue.
“I think you have to learn that there’s a company behind every stock, and that there’s only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.”- Well, that’s what Peter Lynch says about understanding a company.
2. Industry Analysis
One should acquire the knowledge of the industry in which the company is operating into and the growth potential of the industry. An industry will have its sub-parts, called as Sectors (a group of related industries). For example, Healthcare industry will have related industries such as pharmaceutical, medical device, biotechnology, etc.
Some of the steps one can follow for Industry Analysis are listed below:
• Check for the industry’s past & present trends.
• Identify the sectors within the industry which are doing good.
• Go through the most recent industry report and look for the factors influencing the industry.
By doing industry analysis, one gets to know about the forces driving the industry, attractiveness of the industry and the success factors of the industry.
3. Competitive Advantage
The true competitive advantage for a company is something which can neither be copied nor bought. One of the ways of identifying the competitive advantage is by identifying, how the business of the company operates. An investor must know about the competitors of the company and how a particular company has an advantage over its competitors. A company with strong competitive advantage will make a profit in the adverse market conditions as well.
A pharmaceutical company may have the competitive edge over its competitors by producing a certain drug through its research and having a patent on that drug so that no other company is allowed to launch the similar drug in the market.
Examples listed below will give you an idea of how companies have gained competitive advantage over its peers:
• Gillette has been successful in creating a niche of disposable razors for the customers.
• Intel through its faster processor technology has thrived the companies to use its platform.
• Microsoft still dominates the operating systems market by tying up with the computer hardware manufacturing companies; as a result, most of the personal computers come with the pre-installed Microsoft software.
Top management is the backbone of any company as they are responsible for making strategic decisions of the company and plays a crucial role in deciding the fate of the company.
One should check the details about the top officials such as; how long they have been working with the company, their roles and responsibilities, educational and previous experience details, management style, etc. Some of the eminent leaders like Steve Jobs, Ratan Tata, Michael Porter, Richard Branson, Bill Gates have turned around the company’s fortunes through their leadership and management style.
If the company’s management keeps on changing, then it’s not a positive reflection, and one must think over, before picking the stocks of such company.
5. Corporate Governance
These are the policies framed in line with the interest of the shareholders, the formation of the board of directors, periodic reviews of the accounts of the company, etc. It shall be designed for regulating risks related to corporate activities such as corporate disasters, threat to investor interests, staff members, society, etc.
“Good corporate governance is about maximising shareholder value on a sustainable basis while ensuring fairness to all stakeholders: customers, vendor partners, investors, employees, government and society.”– said Mr. N R Narayan Murthy, Co-Founder- Infosys.
Some of the widely followed principles for Corporate Governance are listed below:
• Leadership: Capable and competent board should head the company and work towards achieving short and long term objectives of its business purpose .
• Accountability: The board should clearly communicate to its shareholders on how the company is moving in line with its business objective and other responsibilities.
• Fairness: The Company should work to protect the right of all its shareholders and treat them equally.
• Compliance: The Company must comply with the laws of the countries in which it is operational.
There have been past instances when companies have not adhered to good Corporate Governance norms resulting in damage to the company as well as the society. As a result of which, companies have to pay an enormous amount of fine. One such incident was Bhopal Gas Tragedy.
Bhopal Gas Tragedy: An incident which took place on the night of December 2-3, 1984 in Bhopal, M.P. at the Union Carbide India Limited (UCIL) plant, is one of the major disasters of all time resulting in thousands of casualties. The incident was a result of the negligent management and deferred maintenance. As a result of which the routine pipe maintenance caused a backflow of water into the MIC tank tripping the disaster. The owner of the company had to pay millions of dollars to settle litigation against the disaster.
6. Analyse Company’s annual and quarterly reports
Every company has to publish its annual as well as the quarterly report. It contains various details about the company like its Shareholders, Financial statements, Management discussions and analysis, Corporate Governance report, Risk Management report, Accounting Policies, Auditors report on financial statements, etc.
You can compare the recent performance of the company to its previous year/quarters performance. In addition to this, you can also compare its performance with its peers.
7. Evaluate Balance Sheet
Balance Sheet is a financial statement which contains the information about the company’s assets that it owns, liabilities that it owes and its shareholders equity. It represents the financial position of a company at the end of a specified date. The equation that goes along in the balance sheet is:
Assets = Liabilities + Shareholders Equity
The two sides of the balance sheet as mentioned in the equation above must match out. The effectiveness of a company’s balance sheet can be evaluated by checking its working capital adequacy and asset performance.
Working Capital is an indicator of company’s financial health. It indicates whether the company’s short-term assets are adequate to cover its short-term obligations /liabilities.
Working Capital = Current Assets – Current Liabilities
If a company’s current liabilities exceeds its current assets, it is an indicator that company may not be able to meet its short-term/current obligations, and if the working capital continues to decline over a period, then it’s not a good sign and requires further analysis.
The most valuable assets of a company are its receivables and inventory. It’s important to understand how fast these assets are getting converted into cash over a period. The lesser time it takes, the better is the operating cycle. One should check about the assets; the company is holding, maintenance cost associated with the old assets, investments in the new assets (whether they belong to the same industry?), how much debt company have and where is it using its debt?
8. Review the Financial Performance through Ratio Analysis
Benjamin Graham said “Buy not on optimism, but on arithmetic.”
An investor must look at the financial performance of the company and compare it with similar companies or with the historical data of its own. It can be done using the financial ratios. Data for financial analysis can be taken from the financial statements of the company; balance sheet, income statement, cash flow statements.
Balance sheet contains the details about the company’s assets and liabilities. Income statement contains the details about the revenues generated, expenses incurred and profit or loss for a period.
Cash flow statement includes the information about the movement of cash in and cash out in business. Cash flow is based on mainly three activities which are Operating, Investing and Financing activities.
There are some key ratios which should be looked upon, for the evaluation of financial performance of the company which are broadly classified into 5 categories:
• Liquidity Ratios – Current Ratio, Quick Ratio
• Efficiency Ratios – Assets Turnover Ratio, Inventory Turnover Ratio
• Profitability Ratios – Earning Per Share, Operating Profit Margin, Return on Equity, Dividend Yield
• Valuation Ratios – Price Earnings to Growth Ratio, Price to Book Ratio, Price to Earning Ratio
• Leverage Ratios – Debt to Equity Ratio, Interest Coverage Ratio
Also read: Financial Ratio Analysis for Investors
9. Quality of Earnings
An investor should also enquire about the source of earnings for a company. The earnings could be from the core operations or from other sources which may not exist in future. They may also try to find the portion of cash and non-cash income of the company, company’s principal expenses and its frequency, non-cash expenses such as depreciation.
For Ex. principle expenses for a software company could be towards software development expenses, salaries and bonus paid to the employees, cost of software packages, etc. In a similar way principle expenses for a manufacturing company like Tata Steel will have expenses associated with the purchase of power, employee benefit expenses such as salaries and bonuses, Freight and Handling charges, etc. Cash income/expenses of a company can be determined from its Cash Flow statements.
To be a successful investor, one should look into the qualitative as well as the quantitative aspects of the stocks they want to pick. The points mentioned above will certainly guide you to choose the right stocks.
This article should not be construed as investment advice, please consult your Investment Adviser before making any investment decision.
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