Reblog: 8 step basic fundamental analysis for beginners

In this post I will present a simple 8 step fundamental analysis template which can be used to analyze if a a stock is investment-worthy or not.

For any stock to merit investment, the most important thing is the financial stability of the business. It is important that a company has manageable debt levels and generates enough operating profits to easily pay interest on its loans and has sufficient cash for day to day operations while delivering decent growth in revenues and profits.

I use the first four ratios described below to assess the financial stability of a company when i consider investing in its stock.

• Long term Debt/Equity Ratio –
  Debt/Equity Ratio is a debt ratio used to measure a company’s financial leverage, calculated by dividing a company’s total liabilities by its stockholders’ equity.
  Companies (excluding financial institutions) with D/E of less than 1 to be stable and can easily cope with short term downturns as they have higher reserves than what they have borrowed.
  D/E= Sum of non current debts/Shareholder Funds.

• Current Ratio –
  The current ratio is a good measure of whether the company has enough funds to finance its day-to-day operations. A bad current ratio should be considered as warning sign for sudden financial catastrophe. Ideally, current ratio should be greater than 1.
  Current Ratio= Current Assets / Current liabilities
• Interest Coverage Ratio –
  Interest coverage ratio is useful to measure whether a company makes enough money to comfortably service its debts after accounting for operating costs, depreciation and amortization. Financially stable companies have interest coverage greater than 3-4 times.
  Interest coverage ratio= EBIT/ Interest Cost.
• Cash Flows – Dubious companies may report high profits based on financial jugglery. Hence it is also important to check that reported profits are really going into the bank. Hence we need to also check cash flow statement in annual reports. A stable company should have positive operating cash flows and net cash flows in its recent years. In last two yrs I have seen a couple of cases in auto and education sector where seemingly well to do companies all of a sudden started reporting massive losses triggered by what they claimed “short term liquidity problems” to begin with leading eventual stock decline of 80-90% from peak.
  I use the next two parameters- Return on Equity & Return on Capital Employed to judge the capability and skill of the management
• Return on Equity – Return on equity measures the profits a company generates in an year over its shareholders funds. Mathematically, it is given by –
  RoE = Net Profits/Shareholders Funds,
  where shareholders funds= Equity share Capital + Reserves & Surplus.
  A RoE value of >15% consistently over a long term is decent for a stock to be considered investment worthy according to me. RoE can vary from sector to sector. So it is good to compare RoE of a stock to its peers from same sector. RoE can also appear to be high if a company is leveraged.
• Return on Capital Employed (RoCE) –
  RoCE= Earnings before Interest & Tax (EBIT)/ Capital Employed.
  For a stock to create significant long term wealth, it is necessary that the business behind it generates high RoCE. Otherwise a biz borrowing at 10% and generating 12% RoCE will only be making its bankers rich leaving very little for its shareholders. i generally prefer RoCE to be greater than 20% for a stock to merit investment. Great companies from IT, pharma, FMCG & auto sectors generally have RoCE even higher than 30-40%.

The above 6 points are sufficient for a novice investor to make reasonably informed investment decisions. Using these, one can decide which stocks to buy. However, this is only half the job done. What price to pay for a stock you like is also equally important. In the next 2 points i deal with 2 common valuation matrices that I use.

• Price to earning ratio, PE & PEG – PE is a simple ratio obtained by dividing stock price with earnings per share of the company. PEG is obtained by dividing the PE ratio with growth rate of the company. PEG of less than 1 means a stock is attractively priced and can be a good investment.
• Price to book value – I prefer to use P/B ratio for sectors like govt banks, mining & oil exploration & oil marketing instead of PE as these stocks tend to report earnings which can wildly fluctuate making very hard to compare with past performance. Stocks of cash rich companies from such sectors can be considered as value investments if they fall below book value during adverse market cycles.

The original article is penned by Mastermind, Sumit Sethi and is available here.