Different ways to Analyse a company

Fundamental Analysis

A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).

The end goal of performing fundamental analysis is to produce a value that an investor can compare with the security's current price, with the aim of figuring out what sort of position to take with that security (underpriced = buy, overpriced = sell or short).

This method of security analysis is considered to be the opposite of technical analysis.

Fundamental analysis is about using real data to evaluate a security's value. Although most analysts use fundamental analysis to value stocks, this method of valuation can be used for just about any type of security.

For example, an investor can perform fundamental analysis on a bond's value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings. For assessing stocks, this method uses revenues, earnings, future growth, return on equity, profit margins and other data to determine a company's underlying value and potential for future growth. In terms of stocks, fundamental analysis focuses on the financial statements of the company being evaluated.

One of the most famous and successful fundamental analysts is the Oracle of Omaha, Warren Buffett, who is well known for successfully employing fundamental analysis to pick securities. His abilities have turned him into a billionaire.

No single number from the below list is a magic bullet that will give you a buy or sell recommendation by itself, however as you begin developing a picture of what you want in a stock, these numbers will become benchmarks to measure the worth of potential investments.

Even historical data’s prove that companies long term performance in the market is deeply related with companies predictability. Idea is this, to identify highly predictable companies and buy their stocks when the are trading at undervalued levels. The tools that we have discussed to identify companies like this are

(1) Consistent EPS,
(2) Consistently High Profit Margins,
(3) Consistently low debt-equity levels,
(4) Undervalued shares showing PEG ratio (using EPS or EBITDA) less than 1.

Growth Investing Approach

An investor, who follows growth-investing approach of fundamental analysis, would like to study a company like an entrepreneur. She would focus on a company’s product, target market, suppliers, customers, management, financials etc. She would want know the strength and sustainability of the business of a company. Her aim is to find a company that is going to increase its earnings in future. Her 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.

She 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. She 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. She would focus on the assets and earning potential of the companies. She tries to find out the companies whose stocks are priced at a discount to the fair value. The deeper the discount she can find, the better it is!

Dr Vijay's Approach to Stock Investing

I follow a bottom-up fundamental analysis approach in which I look for high growth companies whose stocks are available at attractive prices. I 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. I look for companies, which have low debt as it offers safety & a potential future route to raise funds. I try to find out companies whose stock is selling at low valuations so that it can offer a huge margin of safety. I 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.

Refrences : Investopedia & Dr Vijay Malik

Financial Analysis

The aim of financial analysis is to analyse the amount of income it earns 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

Income statement or Profit of Loss Statement. Refer Income statement
Balance Sheet (B/L). Refer Balance Sheet
Cash Flow statement . Refer - Cash Flow Statement

Some knowledge of accounting can be a good advantage to do financial analysis of a company. However, it is not required to be a master of accounting for stock investing. An investor who does not have a background in finance & accounting, but is willing to put in the effort needed to read the annual reports, will get the required knowledge of accounting during analysis. Therefore, I firmly believe that anyone irrespective of educational background can be a great stock picker.

Business & Industry Analysis

I am a bottom up fundamental investor. Therefore, I give more weightage to the business qualities of a company than the industry it operates in. In fact, I follow Peter Lynch when he says that:

Moderately fast growers (20 to 25 percent) in non-growth industries are ideal investments.

I try to find a company, which has shown good growth of sales & profits in past years. I consider such a company a good investment candidate irrespective of its industry. I 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, I use consistent growth in sales in past as a substitute of market research and try to analyse it further. If I 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, I 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.

We have the advantage of witnessing one of the most severe recessions ever since 2008. It is blessing in disguise as we can analyse the performance of any company during this recession and see how its business fared. If it was able to show sustained growth during 2008-2014, it is expected to have a good business advantage, which has sustained it in bad times and it might help it to grow its business further when good times (Achche Din) arrive!

More details here

Management Analysis

Management is the most important parameters and I give it more importance than any other parameter. I want to invest in companies, which are run by honest people whom I can trust with my personal money. A crook manager will always find more than one way to cheat shareholders. I avoid companies where I 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 (e.g. google). 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. Today, I am heavily invested in the stocks of that company.

For any further information, we should always call the company secretary or investor’s relations officer of the company before we commit our hard-earned money to any stock.-

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.

Learn about detailed management analysis of a stock here: Management Analysis of a Company

Equity Price and its value

Preferred Shares

Paid up capital

Paid-up capital is money that a company has received from the sale of its shares, and represents money that is not borrowed. A company that is fully paid-up has sold all available shares, and thus cannot increase its capital unless it borrows money through debt or is authorized to sell more shares.

Market capitalization

It is the value for the entire company can be bought on the stock market. It is derived by multiplying the total number of equity shares by the market price of each share. This helps to determine whether the stock is undervalued or not. For instance, if a stock with a consistent profit of Rs. 100 is available at a market cap of Rs. 200 is undervalued in comparison to another stock with a similar profit but with a market cap of Rs. 500.

Enterprise value

A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is calculated as market cap plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

By subtracting net cash (or adding net debt) to the market capitalization, we create a figure called the enterprise value, or EV. In its simplest form (which we will stick to for the purpose of this article), enterprise value is calculated like so:

Enterprise Value = Market Capitalization - Total Cash + Total Debt

This can then be divided by number of shares to compare to the stock price. Companies with a lot of net cash will have an enterprise value LOWER than their market cap, while debt-laden firms have an EV HIGHER than their market cap.

Once you have an EV figure, you can plug it in, in place of market cap, to get EV/E (instead of P/E), EV/S, and any other price-based ratio to get even more meaningful valuation metrics.

Let's do a few examples to illustrate the advantages of using EV.

More Expensive than it Looks - Prestige Brands

Let's start with a stock that is actually quite a bit more expensive than it looks - Prestige Brands (PBH). Prestige has an enormous amount of debt for its size - $1.03 billion - and a relatively small cash position of $94 million. Let's see how its market cap and enterprise value stack up:

PBH Market Cap = $27.90 per share * 51.8 million shares = $1.45 billion ($27.90/share)

PBH Enterprise Value = $1.45 billion - $94 million + $1.03 billion = $2.39 billion ($46.14/share)

Accounting for its debt makes Prestige about 65% more expensive than it looks! See how this affects its P/E and price-to-sales (P/S) ratios:

P/E 19.25, EV/E 31.82

P/S 2.34, EV/S 3.90

Using these modified EV ratios, PBH looks a lot less like a value stock than it did with the more traditional ones!

Less Expensive than it Looks - Cisco

It can work the other way, too. A stock that is actually CHEAPER than it looks is one everyone knows - Cisco (CSCO). Like many of the tech giants, Cisco carries a big cash cushion on its balance sheet, with cash and investments totaling about $47.1 billion, vs. $17.2 billion in debt. See how this affects the enterprise value vs. the market cap:

CSCO Market Cap = $22.30 per share * 5.29 billion shares = $118.1 billion ($22.30/share)

CSCO Enterprise Value = $118.1 billion - $47.1 billion + $17.2 billion = $88.2 billion ($16.67/share)

Due to its strong balance sheet, Cisco is actually 25% less expensive than it looks! Cisco is already a relatively "cheap" stock at a P/E ratio of 14.7, but looks even more attractive using EV:

P/E 14.7, EV/E 11.0

P/S 2.46, EV/S 1.84

Using these ratios, Cisco would show up even higher on value screens.

Gross block

Gross block is the sum total of all assets of the company valued at their cost of acquisition. This is inclusive of the depreciation that is to be charged on each asset.

Returns

Financial Ratios

Projected Earning Growth – PEG

Price to Earnings Ratio or P/E gave you an idea of what value the market place on a company’s earnings. The P/E is the most popular way to compare the relative value of stocks based on earnings because you calculate it by taking the current price of the stock and divide it by the Earnings Per Share (EPS). This tells you whether a stock’s price is high or low relative to its earnings.

Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near term growth is probable. However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price. Because the market is usually more concerned about the future than the present, it is always looking for some way to project out. Another ratio you can use will help you look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E for another number to remember. You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.

PEG = P/E / (projected growth in earnings)

For example, a stock with a P/E of 30 and projected earnings growth next year of 15% would have a PEG of 2 (30 / 15 = 2). What does the “2” mean? Like all ratios, it simply shows you a relationship. In this case, the lower the number the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value. Looking at the opposite situation; a low P/E stock with low or no projected earnings growth, you see that what looks like a value may not work out that way. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.

A few important things to remember about PEG:

If PEG is less than one we can treat this a undervalued. So, a company which has current market price so low that PEG levels are less than 1, makes Warren Buffett very interested in that stock.
A PEG of less than 1 makes an excellent buy if the company is fundamentally strong. If it is above 2, it is a MUST SELL. If PEG for all the stocks are not very different, one with lowest P/E value would be a great BUY.
It is about year-to-year earnings growth
It relies on projections, which may not always be accurate
Established companies have high PEG ratio reflecting their stability and low growth.
Smaller and risky companies has lower PEG . Compare their PEG with industry PEG.
PEG is not applicable to real estate and airline stocks as these are valued on the basis of their asset values.

Piotroski Score

A discrete score between 0-9 which reflects nine criteria used to determine the strength of a firm's financial position. The Piotroski score is used to determine the best value stocks, nine being the best. The score was named after Chicago Accounting Professor, Joseph Piotroski who devised the scale according to specific criteria found in the financial statements. For every criteria (below) that is met the company is given one point, if it is not met, then no points are awarded. The points are then added up to determine the best value stocks.

Profitability
- Positive return on assets in the current year (1 point).
- Positive operating cash flow in the current year (1 point).
- Higher return on assets (ROA) in the current period compared to the ROA in the previous year (1 point).
- Cash flow from operations are greater than ROA (1 point)
Leverage, Liquidity and Source of Funds
- Lower ratio of long term debt to in the current period compared value in the previous year (1 point).
- Higher current ratio this year compared to the previous year (1 point).
- No new shares were issued in the last year (1 point).
Operating Efficiency
- A higher gross margin compared to the previous year (1 point).
- A higher asset turnover ratio compared to the previous year (1 point).

A-Z Score

To detect any signs of looming bankruptcy, Altman built a model that distills five key performance ratios into a single score. The key five financial ratios are as follows. A score below 1.8 means the company is probably headed for bankruptcy, while companies with scores above 3.0 are not likely to go bankrupt.

A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets

Market Cap to GDP

Market cap to GDP – is a good indicator in telling us where the market stands against the economy.

Graham Number

Graham number is the formula Ben Graham used to calculate the maximum price one should pay for a stock.

Working capital

A measure of both a company's efficiency and its short-term financial health. The working capital ratio is calculated as:

Positive working capital means that the company is able to pay off its short-term liabilities.

Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

Working capital Ratio

The working capital ratio = (Current Assets / Current Liabilities)

indicates whether a company has enough short term assets to cover its short term debt.

Anything below 1 indicates negative W/C (working capital).
While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient.Also known as "net working capital".

Also known as "net working capital", or the "working capital ratio".

Impact of Working capital:

If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

If the ratio is less than one then they have negative working capital.
A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.

Working capital to sales (ratio)

Calculates WC as a percentage of sales.

WCR = (working capital / sales ) * 100 %

If working capital to sales ratio is more than 0.35% Means company manages profit and also pays dividends.

Working capital Cycle

Working capital is a financial metric which represents Operating liquidity available to a business and is a critical component in the functioning of any business. It is a measure of the company's efficiency in managing its operational costs. Working Capital Analysis is a crucial before taking an Investment decision in any Company.

The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, companies strive to reduce its working capital cycle by collecting receivables quicker or sometimes stretching accounts payable.

What can be interpreted from Working Capital Cycle?

Every Industry has its own dynamics in terms of its Working Capital requirements. Working Capital comparison between Peer companies will help to deduce the efficiency of the Business and also understand the Capital Allocation capability of its Management.

Most of the Fast growing companies continue to stretch their Working Capital which poses huge Balance Sheet risk. This kind of WC fueled growth is not sustainable.
- Problems of Companies like Subiksha, Jain Irrigation etc come from elongated Working Capital cycle and increasing Inventory days (or) Increased Creditor days. Both increase the leverage of the Business.
Quality of Growth can be understood from analysis of the Company's Working Capital Cycle.
- Most companies try to push growth by giving higher Credit (or) Varying Creditor days. All these happen during the boom periods and don't continue for long.

Positives Of Negative Working Capital Cycle

A Negative Working Capital cycle basically means that the company is having higher Current Liabilities when compared with its Current Assets. Negative Working Capital essentially means that the company is able to pre-sell its products and gets a decent Credit from its Suppliers which help it to grow its Business without any Capital requirements.
A Negative Working Capital cycle where the company is able to pre-sell its products (or) get advances from its customers is a huge positive for the Company's shareholders. This indicates the Huge Customer demand for its products or a very Strong Brand. Only a few companies have this favorable situation and all these Shares have been Huge Multibagger in the past. (Eg: Colgate, VST Industries, HUL etc)

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