Story of a thousand numbers

 

Stock analysis – Story of a thousand words numbers, a beginners guide

 

Investing is an art, not a science. To implement company analysis with the right approach, one needs to look beyond the numbers. 1 crore can either be profits or debt, where and how it is portrayed is the cornerstone for a successful analysis.

 

Analyzing a company is never an easy task. It requires a huge amount of data from various sources. Does it mean sitting for hours in front of the numbers trying to fathom just one thing, is this company worth buying?

People look at different things when investing their money. Someone might analyze the sector, and some might just ask a friend’s advice. Although using these methods might get you the right investment, but no company can survive if it is not doing financially well. Thus, one needs to analyze a company’s finances: its balance sheets, income statement. All this needs to be done in a process which is popularly known as fundamental analysis. 

 

 

FUNDAMENTAL ANALYSIS:

 

Beginning the analysis:

The first step to fundamental analysis is to pick a sector. This may be technology, automobiles, pharma, whichever seems most appropriate, or sometimes whichever is one’s favorite. The sector that is picked should have high growth potential in the coming years. Now the question arises, how do we know which sector has future growth potential? The answer is simple, research and analyze. A lot can be interpreted just by seeing how the government is planning to spend its budget. The current budget allocation (PowerPoint Presentation (indiabudget.gov.in)) of India gives importance to pharma and construction implying growth in these 2 sectors. Start with this year’s budget allocation and narrow down to GDP contribution, growth rate YOY and estimates by economists/investors. Similarly, read the news and follow trends. 2019 and 2020 saw a massive shift of trend to electric vehicles. Finding sectors that provide such opportunities is pivotal. A bad company in a good sector may perform better than a good company in a bad sector. 

 

Percentages and Ratios:

Now that the sector is decided, comes the step of shortlisting the companies. This is done by taking growth percentages, profit margins, and ratios. Growth percentages and Ratios are different for each sector. To figure out whether 10% growth is good or whether a P.E. Ratio of 25 is good, you need to look at the sector average. If not average, some minimum requirements are pertinent for all companies.

Essentially, looking at growth percentages. Each company has different growth rates related to its sector performance. Due to this difference, growth rates are measured juxtaposed to a single entity, the country's GDP. Taking one such example of Revenue and GDP.

 

Revenue Growth-

Revenue growth rate over the last 10 years should match with the GDP growth rate of the country. GDP growth rate denotes the YOY growth of a country's output and is hence adjudged an appropriate relating standard. Taking India’s example, its average GDP growth over the past decade has been 6.6%. Any company that is foreseen to bear a good return on investment should match its revenue growth to the country’s GDP. If the company cannot sustain along with the country’s GDP, it is a sign of weak fundamentals. Any company that is expected to requite on its investment should grow at the same rate, or a higher rate, as compared to its country. 

Coming to a vastly intricate yet profoundly simple header. Although countless ratios can be used to analyze a company, some basic ones are ample to isolate the best investments. One very simple, and the most widely used ratio is:

P.E. Ratio-

 To see whether a stock is over or undervalued, simply look at the P.E. Ratio. Its formula is- Current share price/EPS.

Although any company having a P.E. Ratio above 25 is considered overvalued, in some cases companies of a particular sector might have a higher P.E. Ratio due to the norm set by their peers. In such cases, companies having a ratio that is not too far below the average or too far ahead are perceived as the best. It is considered ideal to compare ratios between peers to understand the sector's performance and hence infer the company. If the P.E. Ratio is too low or negative, it may imply that the stock is undervalued. The reasons could be due to no growth prospects, no returns expected in the future, and weak financial statements. When the P.E. ratio is too high, the stock is considered overvalued indicating that the current stock price is overpriced and should not be bought at this price. In the end, it all depends on the situation, the company, the sector, and the broad outlook among other investors in the stock market. 

There are numerous screeners where investors can put in their ideal growth rates, ratios, etc, and receive a list of companies that satisfy the requirements. It may so happen that there is only 1 company left but that is a rarity. Generally, there will be 2-3 companies that will be left out of which one needs to be picked at the end. 

 

Financial Statements:

The final step requires some hard work but it’s the final piece of the puzzle. Now that there are a small number of companies left to analyze after a brutal process of filtering, it’s time to analyze the books. Analyzing financial statements is the last nail in the coffin. From analyzing the books, you get the best idea about the business and its activities.

There are mainly 3 financial statements that a company releases at the end of the fiscal year. But before going into them, it is important to read the annual reports of the company. Annual reports contain all the statements and even have letters from the CEO. Annual reports help you understand why there was a change in the company’s financials. A slump in sales could be due to an international branch not reaching its estimand ate, a decrease in retained earnings could be due to new machinery purchased from the retained earnings. All this is understood by reading the annual report.

Coming to the financial statements or books as they are known. These are analyzed by focusing on certain categories such as “current assets/liabilities”, “cash flow from investing/operating/financial activities”, “retained earnings”, “stockholders’ equity” etc. All these figures have different criteria through which they are calculated. It may so often happen that a negative figure may be considered good for the company and a positive figure as bad. 

E.g., Taking cash flow from investing activities for this example. Investing activities show the effects of investments done by the company. Negative cash flow from investing aper casees percase due to various reasons but ordinarily implies that the company is investing in non-current assets (plant, machinery). Hence the cash flow appears negative. However, in the long run, investing activities will provide returns to the company, as an increase in machinery and plant generally signify an increase in production and sales for the company. Therefore, negative numbers are not always execrable, whereas positive numbers are not always admirable. Investing activities can be positive when the company has sold its assets, leading to a reduction in machinery/plant implying a slump in sales and production numbers in the future.

*This was just an example of long-term assets. Several other reasons owe to a company’s negative or positive cash flow.

 

(Amazon, the 3^rd largest company as of Sept 2020 has had negative cash flow from investing activities since the past 4 years!)

Forecasting: 

Sometimes all these steps are not sufficient to decide, and you are still left with more than one company. This is where the last step comes into the picture. Taking various categories such as Sales, Revenue, Profit After Tax, EBIDTA, Retained Earnings, and a few more. Take out their data of the past 5 years and how they averaged on a YOY growth rate basis. A company may have 5% sales growth over the past 5 years. Growing its current sales YOY by 5% and increasing the growth rate by a small amount (say 0.5%) after every year. Doing this for the next 5-10 years would give a fair idea of how much the company will earn over the next few years.

Data of the selected categories should be taken out. Once done, the average growth changes YOY should be calculated. For e.g. A company may have 5% sales growth over the past 5 years. Growing its current sales YOY by 5% and increasing the growth rate by a small amount (say 0.5%) after every year.

You will eventually be able to see how much the company will earn in the future and hence devise its valuation. As you value the company in the future, you understand how much it has grown in the past and how much will it grow in the future. Through this step, you get a rough idea of the company's performance in the future. 

 

Conclusion:

Each step you take in fundamental analysis is focused on one thing, valuing the business. All these steps are taken to see if the company/stock is undervalued right now. The future is not something that can be accurately predicted, but carrying out fundamental analysis gives a fair idea of the companies performance in the future. 

Each investor has a different approach, and each one has a different mindset. Some might give more importance to the sector and some might give more importance to ratios. Some might not give any importance to fundamentals or valuation. It depends entirely on the investor and how they perceive information.

In the words of Warren Buffet, “invest in only what you know”.

*the above-mentioned steps and companies are not investment advice*