Are you in good company Look before you leap

Written by P Saravanan | Updated: May 6 2014, 14:24pm hrs
Retail investorsOne of the biggest challenges faced by investors and financial institutions alike is to decide how to invest for future needs. (AP)
One of the biggest challenges faced by investors and financial institutions alike is to decide how to invest for future needs. While their goals may be different, all face the same set of challenges that extend beyond just the choice of what asset classes to invest in.

An industrys prospects within the global business environment will determine how well or poorly an individual firm will fare, so industry analysis normally precedes company analysis. Few companies perform well in a poor industry, so even the best company in a poor industry is a bad prospect for investment. After determining that an industrys outlook is good, an investor can analyse and compare individual firms performance within the entire industry using financial ratios and cash-flow values.

You undertake company analysis to identify the best company in a promising industry. This involves examining a firms past performance, and more important, its future prospects. After you understand the company and its outlook, you can determine its value. As the final step, you compare this estimated intrinsic value to the price of the firms stock and decide whether its a good investment.

Good companies

Company analysis cover factors that determine the relative competitive position of a firm within its industry. Equity shares of good companies are not necessarily good investments. After analysing a company and deriving an understanding of its strengths and risks, investors must compute the fundamental intrinsic value its share and compare it to its market value to determine if the companys stock should be purchased or not.

The share of a good company with superior management and strong performance could be priced so high that the intrinsic value of the share is below its current market price. In contrast, the share of a company with less success based on its sales and earnings growth may have a stock market price that is below its intrinsic value. In this case, although the company is not as good, its stock could be the better investment.

Growth companies vs growth stocks

The share of a growth company is not necessarily a growth stock. Recognition of this difference is essential for successful investing. Growth companies are those that consistently experience above-average increases in sales and earnings. This definition has some limitations because many firms could qualify due to certain accounting procedures, mergers, or other external events. Growth companies are those companies with the management ability and the opportunities to make investments that yield rates of return greater than the firms required rate of return. Growth stocks are not necessarily shares in growth companies. A growth stock is a stock with a higher rate of return than other stocks in the market with similar risk characteristics.

Company analysis indicates the firms relationship with its industry, which should indicate whether the companys past performance is attributable to its industry or if it is unique to the company. These examinations help the investors to understand the companys past performance, but also provide the background to make a meaningful estimate for the future.

The writer is an associate professor in finance and accounting at IIM Shillong