Creating a portfolio of equity stocks is, normally, the easiest task. It is just about identifying a stock and adding it to the portfolio. The tougher part is monitoring the stock. Having bought a stock, it is not just about stock performance. You need to understand how the company is performing — both in terms of financial and non-financial parameters. How do you as an investor determine the financial health of the stocks that you hold? Broadly, there are six critical factors that you must consider which will give you a quick view about the financial health of the stocks.
1. Check for profitability and growth
As we say in the e-commerce business, eyeballs are OK, but how about sales? When it comes to evaluating the financial health of your stocks, you need to go a step further. The question should be, “Sales are ok, but what about profitability”. The long-term performance of the company is largely predicated on two factors. How fast the company is able to grow and how profitably the company is able to grow. Growth is central to any stock and that is what investors do prefer. But growth in sales can be purchased through discounts or through price wars. The bigger question is: how does the company sustain margins and how does the company grow profits. If you find that the company is able to grow profits and sustain healthy margins, then you can move on the next step.
2. Check for operating efficiency and liquidity
Operating efficiency and liquidity basically measure how efficiently the company is using its fixed assets and its working capital to grow profitably. Normally, if the company is not able to grow profitably (we discussed in the previous point), then the reason is either because the company is not using its fixed assets efficiently or its working capital is not properly utilized. Asset turnover which is the ratio of (Sales/Assets) is a good measure of operating efficiency. To fine tune this definition, one can use fixed assets instead of total assets. Similarly, whether too much working capital is locked up in inventories, is judged by the quick ratio and the average collection day period. Both put together determine your business liquidity. Especially for manufacturing companies, only a combination of fixed assets efficiency and working capital efficiency can sustain profits.
3. What is the financial risk in a company?
Has the company taken on more debt than it can handle? In corporate finance, it is possible to visually improve shareholder wealth by adding debt. That is because the cost of equity is higher than the cost of debt. But, debt has a problem! It is a financial commitment and, therefore, it adds to the financial risk. Financial risk is measured in two ways. Firstly, it is measured as leverage which is the ratio of its long term debt to its long term equity. But that only tells you about the quantum of debt. You also need to understand about the cost of debt and that is only obvious from the coverage ratios. An important coverage ratio is the interest coverage ratio which measures how many times the EBIT covers the interest cost (EBIT/Interest Cost). To make your ratio more realistic, you can also consider the sum of interest and principal payable to calculate the real coverage ratio. The higher the ratio, the safer it is for the investor.
4. Check for emerging competition
Remember, competition does not come from existing competitors alone, but also from new competitors and new products. For example, the biggest competition for Nokia and Motorola came from Apple smart phones and Samsung smart phones. They were never really considered as competitors. Similarly, the big competition for the auto industry the world over is coming from alternate energy cars like Tesla and the rise of driverless cars from Google. How the company has positioned itself against competition is extremely important. There are some key questions you need to ask. Has the company created a moat, which is a unique advantage that will help the company sustain its competitive edge? Has the company created entry barriers like a strong brand, a high quality product, strong distribution network etc? While this is largely a qualitative aspect, it can also be quantitatively measured through overall market share, core market share, incremental market shares etc.
5. Keep a tab on the cash flows of the company
When it comes to evaluating a company; the cash flows matter a lot more than the income statement. The cash flow shows how much cash is being realized. The cash flow statement is broken up into operations, investments and financing. The first thing you need to ensure is that the operating cash flows are sufficient to cover the capital investments to a large extent. The lesser the company has to rely on external financing, the better it is. Cash flows are less vulnerable to creative accounting as they account for actual cash that is coming in and going out of the company.
6. Focus on the quality of management and governance
Finally, a good management trumps all other aspects. A good management can run a lousy business but a lousy management cannot even run a good business model. That is why management quality matters a lot! From a shareholder wealth point of view always focus on companies that follow the highest standards of transparency and disclosure. Why do companies like Infosys and TCS get premium valuations in the market? That is more due to the standards of transparency that they follow. More importantly, if you have to make money as a shareholder, then you need the company to follow high standards of corporate governance. Here corporate governance refers to putting the interests of minority shareholders above all else.
The last point on corporate governance may be essentially non-financial, but it does have an oversized impact on the valuation of the firm. It is when you get these 6 factors in place that you have a genuine value creator in the stock market.
(By Jaikishan Parmar, Senior Research Analyst, Angel Broking)