1) Know the promoters background
To find out if the story is true know the storyteller. In most of the literature about stock evaluation all the analysis is about macroeconomic indicators, industry , ratios, EPS ( Earning per Share ) and all. While these factors cannot be overemphasizes, the one factor that seems to have been played down if not ignored is Corporate Governance. While we look at small / mid-sized companies that seems to be growing at a phenomenal rate, is in the right industry and promises to be the next Facebook, how will be ensure that this is not the new Enron?
It is all the more important in the emerging markets where we have 10 Satyams for every TCS. When we look at the Indian equity sector, it will be easier to find a fraudulent company with no business ,whose share price has gone up by 1000 % plus in a short span of time than an undervalued good quality stock.
The other ten factors are as follows: We will develop on this thought going forward.
2) Promoter holdings
3) Mutual fund increase / decrease in holdings
4) Volume data
5) Comparison with industry and competitors
6) P/E ratio and forward PE
7) Debt equity ratio
8) Interest coverage
9) Operating Profit Margin
11) Dividend history
Promoter holding: Are the promoters confident in their own company. How has the percentage of promoter holdings changed over the years? This is a very strong indicator of the promoter confidence in the performance and future prospects of the company.
Higher promoter holding also signifies long term stability for the company. In the context of India we also need to keep an eye on any promoter holding that has been pledged to the lenders. Any liquidation of pledged shares due to non-payment of debt will lead to increased volatility of the share prices. Pledging of shares by the promoters also reflects weak financial position of the promoters.
Mutual fund increase / decrease in holdings: What’s the view of the institutional investors about the outlook of the company? Are they happy with the corporate governance? The increase or decrease in holdings is a surrogate variable to measure the view of the institutional investors.
Volume data: We will discuss this strong indicator in greater details when we discuss technical indicators for buy / sell signals. In a nutshell any up movement in price supported by strong volume denotes a strong up move and vice versa.
One more point to note is a strong price movement with very low volumes may be a trap for small retail investors. Many shares in emerging markets are manipulated by the operators. It’s advisable to stay clear of such companies.
Comparison with competitors: Invest in wide-mote companies. Wide – mote companies are in profitable industries and they have competitive advantages against its competitors. This comes from strong brands, access to low cost resources etc. Identifying such companies early in their growth cycle and investing in them is the key to long term wealth accumulation.
PE ratio: Once a good investment stock has been identified one as to look at the price of the stock to decide whether the company is undervalued, overvalued or right valued. Does the price factor the future growth prospects of the company? The price earnings ratio is one of the key indicators to determine the same. Some questions to ask are:
1) How does the company’s PE compare with its competitors?
2) What has been the company PE over the past few years? How does todays PE compare with the same.
3) What is the expected growth rate of the company? To what extent does the forward PE factor in the expected growth rate?
Debt Equity Ratio: This ratio shows the shareholders equity to debt. A highly leveraged company will find it difficult in a down cycle to service its debt. Also as most of the long term debts are on floating interest , as global interest rates goes up companies with high leverage will have to pay more interest. In today’s scenario it’s better to stay clear of such companies. This ratio has be considered jointly with Interest coverage ratio.
Interest Coverage: EBIT ( Earnings before interest and Taxes ) /Interest Expense, Lower ratio denotes the company is having problems in servicing its debt. Any ratio lower than 1.5 denotes bad health for the company .In case the ratio falls to one or lower the company has overstretched its balance sheet .
Operating profit margin: (Operating Income / Sales revenue) this ratio helps us to understand if our wide –Mote Company is losing its ground. When compared our previous years if the operating profit declines the company is possible losing its pricing power. However this has to be seen in context of the industry. As the industry moves along its life cycle the operating profit margin of the industry declines.
Scalability: The Company may be in a great niche with excellent profitability; however the business model made not be scalable. Thus the company will not be able to absorb fresh capital and will have a flat growth rate. There is not be much scope of growth and thus PE expansion.
Dividend history: This is one indicator which may give false signal if not understood in the context of the industry and the situation of the company. A company in a mature industry is expected to return most of the profits earned to the shareholders in form of dividend. Whereas a company in a growth industry may not pay dividend as they will be able to utilize the capital in more profitable growth industries. However in case the company is holding a lot of cash but not returning the same to the shareholders it is possibly a red flag to keep an eye on.
In our stock ideas we will see how different companies compare based on these matrix .
Happy Investment !!