Which is the best stock to invest in for the long term? Which company will provide high returns in the future? How to find such high-growth companies and opportunities to invest?
All of these questions are answered when you analyse a company. If you believe that only professionals can do that, then you are wrong.
All you need to do is dedicate some time to learn how to do company analysis. In this article, we will point down a five-step framework for company analysis. This framework will help you select the best stock to invest in the Indian stock market.
This will lay down a general path and give you a perspective of how to analyse an investment option. Analysing financial statements is one way. But thoroughly researching a company goes beyond financial reports.
One of the reasons why investors often lose money in the stock market is because they rely extensively on tips. The right way to invest is to invest smartly by doing your own research.
The five-step framework to Company Analysis:
- Understand the Purpose and Context of Analysis
- Data Collection
- Process Data
- Analyse/Interpret Data
- Follow Up
By the end of this article, you will know the blueprint for company analysis.
Let’s begin with Step 1.
1. Understand the Purpose and Context of Analysis
When we decide to go on a vacation, we don’t just pack our bags and leave. We have a rough plan of where and when will we travel. Similarly, prior to doing company analysis, you must understand the purpose of the analysis.
This helps us decide what kind of data we need to collect. It gives us an idea about the approach we will follow and the tools we will use to draw a final conclusion.
Ask the following questions:
- What is the purpose of your investment?
- How long are you willing to stay invested? – Short term or long term
- Is your purpose to analyse the best company in a sector or to analyse a particular sector?
- If you had all the information you are looking for, what conclusion would you be able to draw? What question would you be able to answer?
For example, if the purpose of your analysis is to compare the historical performance of five
FMCG companies, then you can ask the following questions –
- What has been the relative growth rate of the companies?
- What has been their relative profitability?
- Will ratio analysis be enough to understand their positions in the industry?
In order to answer these questions, we need enough information to draw a conclusion. This brings us to our next step.
2. Collecting Data
Collecting data to analyse used to be difficult earlier. But today, financial data is available on our fingertips. Here are a few primary and secondary sources from where you can collect data.
a. Annual Report
Company-specific information can be easily collected from their annual reports. Annual Reports includes a summary of important activities a company has undertaken during the year. They are like report cards of the company. Every listed company has to report its performance every year to the public.
Annual Reports are useful in understanding a company’s financial position and in assessing their future. Annual Report also includes financial statements.
b. Financial Statements
This is where you will find all the numbers! A financial statement consists of a You will find these statements in the company’s annual report. There are two categories of financial statement –
- Standalone Financial Statement
- Consolidated Financial Statement
Standalone statements represent the activities of the parent company only as a single entity. It does not take into account the performance of its subsidiaries.
Consolidated financial statements include the performance of the parent company as well as its subsidiaries. All the results are combined and reported as one.
Which one should be considered by the investors for the stock analysis?
Consolidated financial statements give us a true picture of the company’s financial position. It presents the entire group as a single economic unit. Investors can easily analyse its financial health and efficiency at a glance. Especially for a company having a diversified business presence.
If the company’s subsidiaries are not directly related, investors can refer the standalone statements for their analysis. This gives us a company-specific point of view of their financial position.
The balance sheet of a company reveals what resources a company controls and what it owes to the outsider.
Learn how to read and analyse a balance sheet in detail here.
The income statement presents information on a company’s income, expenses, and profitability. It helps us understand if the management is able to grow its profit by minimizing its expenses.
Learn how to read and analyse an income statement in detail here.
Lastly, a company depends on cash for their day-to-day growth and survival. Understanding the cash flow is necessary to understand how a company generates liquidity.
Learn how to read and analyse a cash flow statement in detail here.
Financial Statements are followed by notes to accounts. They are also referred to as footnotes. They help us understand how did the company derive its reported data. These notes are essential to understanding the statements.
Collect and maintain the data in an excel sheet so that you can easily compare the numbers.
c. Conference call transcripts
These transcripts present qualitative data about the company’s present and future outlook. Various investors, bloggers, media personnel and analyst participate in these calls. They ask questions to the management which are answered on the spot by them. This makes the conversation a lot more transparent. It also ensures that there is no confusion over the direction in which a company is heading. Here are different types of conference calls held by a company –
- Earnings calls
- Quarterly meetings
- Investor updates
- Any call with investors
- Project progress updates
- Business development calls
If you read them carefully, you will be able to understand the tone behind the conversation. Understand how the management is answering these questions. These transcripts are very helpful in further decision-making. You can access them on the company’s website under the Investors Relation section.
d. Credit Reports
Ratings play a crucial role in deciding whether you should invest in a company or not. It is given by credit rating agencies after evaluating a company’s financial stability.
A good credit rating suggests that the company is financially strong and stable. While a poor credit rating means that the company is financially weak and thus can be a risky investment.
Read this article to understand credit ratings and the agencies.
By reading these reports, you will be able to evaluate the company’s ability to repay debt. It makes the comparison of two companies in the same industry easier.
e. Samco stock page
At Samco, Our research team has created a rating engine that assesses millions of data points every day to rate each and every listed company in India with an accuracy of more than 95%.
Using Samco Stock Rating, you can check the latest stock valuations, pros and cons to investing in a company, latest financial data and much more! Every stock is rated from 1 to 5 stars to simplify your company analysis further. The best part is, it’s absolutely FREE!
Samco Stock Rating – The one-stop destination for all your equity investments.
3. Process Data
After obtaining the required information, the next step is to process the data. We can use various analytical tools to do this.
a. Ratio Analysis
There are many financial ratios that help us analyse and evaluate a company. It is one of the most important tool for company analysis. We can evaluate a company’s past and current performance trends with it. We can even draw comparisons with its peers.
Financial ratios can be broadly divided into three main categories. Let’s understand their meaning and functions.
At what rate is the company’s profit growing? How much profit is the company able to earn on its capital employed? This ratio helps us understand a company’s profitability. Compare the company’s last five-year gross and net profit margin. Is it growing or declining? Your next step is to compare the same with its peer companies. Who is performing the best?
Some important profitability ratios include –
- Return on Equity (ROE)
This is one of the main financial ratios. It measures a company’s ability to generate return on its equity.
ROE Formula = Net Income / Shareholder’s Equity
While analysing companies, use the average industry ROE as a benchmark. Preferably, find the past five-year trend and analyse it. Consistent growth in ROE is preferable than uneven returns.
Read this detailed guide on what is ROE and the DuPont Model to understand it better.
- Return on Asset (ROA)
It measures how efficiently management is using its assets to generate returns. Higher the returns, the more efficient a business is in maximising its profits.
Return on Assets Formula = Net Profit / Total Assets
- Return on Capital Employed (ROCE)
It measures how much returns a company is generating for its investors. It also includes debt which gives us a comprehensive picture about the company.
ROCE Formula = Earnings Before Interest and Tax (EBIT) / Capital Employed
Read this detailed guide on how to use ROCE to select superior stocks to make more informed decisions.
Can you live for days or weeks without having cash in your pockets? No. Similarly, a company needs to have cash to ensure smooth operations. Liquidity ratios help us measure a company’s ability to meet its short-term obligations. It mainly comprises of current ratios. It helps us evaluate a company’s ability to honor its financial obligations when due.
Some common liquidity ratios include
- Current ratio
This is one of the most important liquidity ratios. It analyses a company’s ability to meet its debt obligations within 12 months. It tells us if a company is about to face default risk.
Current Ratio formula = Current Asset / Current Liabilities
Current ratio less than 1 means the company is not able to repay its creditors. This happens if the company’s current liabilities exceed current assets. The chances of default are also high.
Current ratio more than 1 means the company can conveniently clear its short-term obligations. Such companies are more preferable for investment.
- Quick Ratio
It shows a company’s ability to meet its liabilities payable in less than 3 months. It is also known as Acid Test Ratio.
Quick ratio formula = Quick asset / Current liabilities
Quick assets are current assets excluding inventory. Inventory is excluded because they often take more than 3 months to liquidate. Excluding them gives us a better picture about the company’s short-term position.
The ideal quick ratio is 1.
Quick ratio less than 1 means the company does not have enough cash to meet its short-term obligations.
Quick ratio more than 1 means the company has the ability to meet its short-term liabilities.
Read more about Liquidity ratios in detail to understand how to make the best interpretations of the result.
This compares the debt levels of a company to its assets and equity. It measures the company’s ability to meet long-term debt obligations. Before investing, always check the company’s debt position. Avoid companies with huge debts on their balance sheet.
Two important solvency ratios are –
- Debt to Equity Ratio
This one of the most important financial ratios to understand the financial strength of a company. It measures how much debt a company is holding with respect to shareholder’s equity.
Debt to Equity Ratio Formula = Total Liabilities / Shareholder’s Equity
Debt to Equity ratio of 1:1 means the company has equal equity for debt. Companies with DE ratio of less than 1 are relatively safer.
Debt to Equity of more than 2 is risky. It means for every Rs. 1 in equity, the company owes Rs. 2 of debt.
- Interest Coverage Ratio
Will you invest in a company if they are struggling to meet their interest payment obligations? Interest Coverage Ratio measures if the company can pay timely interest on its loans with its current earnings.
Interest Coverage Ratio = EBITDA / Interest Expense
A high-interest coverage ratio is a good sign. Whereas interest coverage ratio below 1.5 is considered to be bad. It suggests that the company might fail on its payment obligations.
Read how to use Interest Coverage ratio to make better investment decisions here.
These are a few important financial ratios. However, there are few ratios which needs to be specifically evaluated sector-wise. For example, we check the Capital Adequacy Ratio while analysing Indian Banking Sector.
b. SWOT analysis
To make a better decision, we need to check qualitative aspects too. SWOT stands for strengths, weaknesses, opportunities, and threats. Can the company use its strengths to open up future opportunities? What is the company’s Unique Selling Proposition (USP)? One feature or benefit of the company which makes it unique from its peers.
c. Porter’s Five Forces
Like SWOT analysis, Porter’s Five Forces Model is used to analyse a company and industry’s qualitative advantage.
Porter’s Five Forces are:
- Competition in the industry
- Threat from new entrants
- Power of suppliers
- Power of customers
- Threat of substitute products
It is broadly used to analyse the industry structure and its corporate strategy. These five forces are frequently used to measure the competition strength, attractiveness, and profitability.
These forces are self-explanatory but if gives us a fair overview about an industry. Read this detailed guide on how you can use Porter’s Five Forces Model to select a perfect stock.
d. Economic Moat
Note down the points that set a company apart from its peers. Go through their annual report where the company mentions their new developments. Understands and decode what is their greatest economic moat. For example, Colgate has almost become synonymous with toothpaste. It is dominating its industry by its brand name. Its customers are ready to pay a lot more to buy its products.
In addition, look for such companies in which the switching cost is high. For example, you will not change your bank just because another bank pays more interest compared to your banks. Such companies and sectors enjoy high moats.
Read this article to learn about the importance of economic moat in detail.
e. News and the economic environment
Is the company is in the news because they surpassed expectations? Or is it because a new scam is being unfolded?
The reason why a company is in news says a lot. The stock market is based on the sentiments of the people. Temporary negative news will result in a drop in the share price. But if you believe that the fundamentals of the company are strong, you have no reason to worry. In such a case, ignore the news and look at the long-term picture.
However, if the management’s activities are being questioned, then you may have a reason to worry. Avoid companies where the management themselves aren’t able to execute their plans ethically and efficiently.
You can adopt a top-down approach. Here you first analyse the economic environment, sector-specific news and then shortlist the best companies.
For example, FMCG sector has been in news for how it continues to grow its revenue and profit margin amidst the pandemic. The products offered are tagged as necessities and hence they have the benefit of always being in demand. Your next step is to shortlist the best FMCG companies to carry on your analysis.
Information on the economy, industry and peer companies is useful in putting the company’s financial performance and position in perspective. It makes the assessment more rigorous.
Now that you have enough data, is time to move on to our next step.
4. Analyse/Interpret the Processed Data
This is where you will have a fair idea about which company is better. But that is not enough. You are only halfway done. Your next step is to interpret the data carefully. Find the answers to the questions you asked in the first step
Ask these two very important questions –
Will people still be using the same product or service 10 to 15 years from today?
The company needs to be operative 15 years from now if you are investing for the long term. Why invest in a company whose product can be easily replaced in the coming years? Hence, always look for a company with a long life. Such companies have great potential to grow.
For example, do you think people will be using toothpaste or/ and brush 15 to 20 years from now? Of Couse, yes. There might be innovations or/ and addition, but the core product will always remain as it is.
Is the management efficient and qualified?
The management is the soul of the company. Good management shows that the company has the potential to expand its business. Whereas bad management can lead a company to a dead-end. It hinders growth and demotivates the employees.
Hence, always remember to carefully research the top-level executives. What are their qualifications? How long have they been serving as a board member? How is the company performing under their leadership? Which bold steps have they taken to improve and expand their business?
You will find all the management-related information in the company’s annual report.
5. Conclusions and Follow-Ups
You are almost done with your company analysis. At this stage, you are certain about which companies you want to invest in. However, there is one more point that needs to be addressed.
Once you finish working on the previous four steps, your last step is to follow up. Did any major change take place in the company? Did the company publish their quarterly results?
If such changes have a material effect on your assessment, make necessary alterations. Repeat this process on a yearly basis. Periodic review helps you monitor your investment. It can save you from a loss or it can present you with another investment opportunity.
Don’t get involved in investments that are overly complex. Warren Buffett invests in a company only if he is able to understand their operations. For example, do not invest stock of a pharmaceutical company without knowing what medicines it produces.
Remember this five-step framework while conducting company analysis. It will help you make an informed investment decision. By understanding the company’s past and present, you will be able to curate your opinion on how the future might be.
Always look at the quantitative as well as qualitative aspects of the company. These are the key points to consider which conducting company analysis. It needs extensive research but is always worth it. Remember, this was a general framework to company analysis.
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