If you are an equity investor what would you typically rely on? You would rely on a research report or on technical calls. Let us leave out technical calls for the time being as our focus is more on long term investments. Long term investing is based on a research technique called fundamental analysis. What fundamental analysis does is to project the cash flows of a business and then discounts these cash flows backwards to arrive at a valuation. The fundamental analyst not only looks at financials of a company but also at non-financial items like the company’s reputation, its brands, its management quality and the unique business advantages that it has created. As an investor, it is not just enough for you to get a fundamental report on whether the stock is undervalued or overvalued. You need to ask some probing questions because it is your money after all! Here are 10 questions you must ask about a company’s fundamentals…
What are the prospects of the company’s line of business
When you buy a company’s stock you buy for the future. That means you are more interested in the prospects of the company rather than what it has done in the past. Does the company operate in a high growth business or is it a stable business? Does the company make products that have cyclical demand or round-the-year demand? You pay a premium for growth and your stock price appreciates if the company can show growth in the future. That is what matters, first and foremost.
Company growth is fine, but is the company profitable and how are the cash flows?
Growth is not very meaningful if it is coming at a huge cost. Take the case of many ecommerce companies. They are buying market share by giving huge discounts which are being funded by global investors. Obviously, this cannot go on forever and the eyeballs and footfalls must translate into profits for the company. That is what will determine the future value of the company. Gestation is fine, but there is only so much you can afford to wait. Also, profits are not reflective of the actual cash flows of the company. You also need to check the cash flow statements of the company to reassure that the positive cash flows from operations can finance the investments needs.
What is the market perception of the company’s management
This is slightly qualitative in nature but if the company has been around for a long time then the quality of the management is out there in the open. Business groups like Tatas, Birlas and Mahindras enjoy a premium image in the market because they have taken pains to ensure that their companies maintain the highest standards of disclosure, transparency and corporate governance. This is a key driver of valuations.
What are the risks to the business in terms of competition
Competition can arise in a variety of ways. There is product competition that can arise from better and cheaper products in the market. For example, Reliance Jio really threatened the telecom business models with their superior offering. Alternatively, it could be disruptive products. Hero Honda disrupted the two-wheeler industry with a focus on motorbikes and fuel efficiency. As an investor, keep an eye for such risks in stocks.
Does the company speak the truth about its performance
This is partially covered by the point on management quality but this also pertains to the actual executive management of the company. For example, companies like Satyam, Deccan Chronicle, Kingfisher Airlines, Amtek Auto and Bhushan Steel actually kept the shareholders in the dark about their actual performance. You surely do not want to invest in a company that can throw up negative surprises at you in the future.
What is the moat that the company has created for itself
Moat is a sustainable advantage. It can be in the form of high margins, unique patents or even in the form of market leadership. Moats are important because they ensure that the company is able to hold on to its growth and its operating margins even in tough market conditions. Generally, companies with a moat get a more attractive valuation in the market.
How will the company finance its future outlays
This is especially true for companies that have massive plans for expansion or diversification in the future. The question is how would these programs be funded? If the funding is through equity then you need to be prepared for dilution of earnings. If we are looking at funding through long term debt, then we are looking at financial risk. Remember, expansion and diversification is integral to growth. What you need to ensure is that it can generate cash flows to justify these decisions.
Are the company’s customers individuals, corporates or government
You may wonder why this important but it determines your payment cycles and the promptness of payments. Therefore it is crucial to your working capital cycle. For example, individual customers are broadly upfront customers and hence cash flows are not a problem. Credit terms become relevant when you have corporate and institutional customers. If it is a power stock that has government clients then normally government problems tend to get transmitted. Customer profile matters a lot!
How much of the promoter’s stake is pledged
In the last few years we have seen sharp correction in stocks due to this very reason. When a large percentage of shares of the promoter are pledged, they make the stock vulnerable to bank selling in the event of a margin call. Always prefer companies where the promoter pledges are low.
Does it fit into my long term goals
Finally, ensure that the stock fits into your goals and your equity/debt mix. If the investment in a stock is skewing your portfolio profile or adding more risk than warranted, you can just give the stock a miss. If the stock does not into your long term goals then the stock is not for you.
Apply this 10-factor test before buying a stock and you could be closer to buying the right stocks in your journey towards your investment goals.