1) Check the fundamentals
Does not matter if you are driving a hatchback or a luxury sedan, if the wheels of the car do not have enough air, you are not going to go far enough. Similarly, in stock investments, irrespective of valuation, market rumours, star ratings, etc. if the company under consideration is not fundamentally strong, your stock investment is not going to bear fruits. But how do you check the fundamental strength of a company? You go with numbers. Financial ratios help you analyze a company from a 360-degree perspective. They cover a wide range of aspects ranging from stability, operational efficiency, profitability, liquidity, etc. They let you add meaning to raw financial numbers.
Here are the top seven financial ratios that would help you decide whether the company in question deserves your time and hard-earned money.
- Earnings Per Share or EPS
- Debt to Equity Ratio
- Return on Equity or ROE
- Price to Earnings Ratio (P/E)
- Price to Book Ratio (P/B)
- Price to Sales Ratio (P/S)
- Current Ratio
These financial ratios are like the written entrance examination you have to clear before you qualify for your interview round! Once you find that the company has performed well on the above parameters, it is time to move to the other parameters.
You might be wondering, if a company is fundamentally strong, is that not a good enough reason to invest in it. Why bother with additional steps or efforts. While the question is valid, the limitation of many financial ratios is that they are a lag indicator. They tell you how the company has done in the past and not much about its future prospects. Hence, it is important to look at other factors to make sure you choose the right stocks.
2)Your understanding of the company
Do you understand the company? Its products or services, business model, competitors, market standing, etc? In order to ascertain the future prospects or growth plans of any company, you need to understand it in great depth. For instance, does the company have an offering which will be required even after two decades? For example, if someone had invested in a typewriter company’s stocks decades back, where would he or she stand now. The product has a limited shelf life and is no longer in use. However, if you take the example of a product like soap, it is going to be in use forever. There may be new versions, but the basic product will continue to exist.
Hence, it is important to choose a company that you understand and whose offerings have a long lifespan. Stocks of such companies have the potential for superior growth (thanks to the strength of compounding)
3) Look for the “moat”
If you have visited any fort or castle, you would have noticed a deep and wide ditch around it (earlier filled with water or ferocious reptiles). The purpose of the moat was to act a defence in times of attaching and protect the kingdom. When you look for companies to invest in, you need to look for a similar moat. This economic moat arises from a company’s distinct advantage over its competitors. It helps the business to be sustainable as well as earn higher profits. So, go for a company with a wider economic moat around it.
4) Depth of debt
Remember when Bee Gees crooned How deep is your love! You need to ask how deep is the debt of the company. Debt financing is a great way to generate funds but if not kept within limits, it is as dangerous as a ticking time bomb. It is extremely important to look at the company’s financial statements such as balance sheet. Companies with huge debt as they can be a risky proposition. Remember, in the event of the company winding up or becoming bankrupt, creditors will get priority to recoup their money.
Pro Tip: Debt can be worded differently in different sectors. For instance, check for NPAs (Non-Performing Assets) in the financial statement of Banks or NBFCs.
5) Captain(s) of the ship
You could have the best product/service, strong fundamentals and a great Unique Selling Proposition. But if you do not have the right people at the help of the company, all the good things will come crashing down. It is crucial to analyze the company’s management and the core team.
Get answers to these questions:
i) What is the strategy of the company?
You should know where is the company headed and what are its goals. The vision, mission, value statements and Employee Value Proposition would give you a fair idea about this aspect.
ii) How stable is the management team
A long and steady tenure is often considered as an indicator of a healthy and robust company.
iii) Promoters and share buybacks
Promoters possess the deepest knowledge of the company. If you find them giving up their shares, it is a red flag. You should dig deep as it may be a signal that the promoters do not have trust in the stock’s potential to grow. Though that may not be the reason always. They may need funds to start another venture! The idea is to ask tough questions, get the answers and make well-informed decisions.
Again financial ratios come to your rescue. Look at Return on capital employed (ROCE) in addition to ROE (Return on equity) to determine how efficiently are the investments being translated into revenues and profits.
v) Qualitative aspects
Transparency, honesty and integrity may not be quantified but play a significant role in strengthening the management of the company. You can assess these factors by looking at how the core team has handled tough market conditions, bad results or economic sluggishness.
When you consider all these factors (in unison), you will end up with a great stock. Add the concept of valuation that we discussed earlier and you cannot go wrong with your stock investments. Remember though, all that shines is not always gold. Just because a stock is cheap does not make it a good investment opportunity. Its intrinsic worth should be the determining factor.
Finding the right stocks can be a cumbersome or tiring process. But the result of that hard-word is extremely sweet.
We have listed down 7 golden rules of stock market investments that can help you build a strong portfolio in stock market.