What do you look out for in a stock when you are about to invest?
Is it the price, earnings, Free Cash Flows of the company or something else?
What kind of valuation technique you would look for?
I am sure you would be wondering where to start from as it is an investment which you are putting your money in.
There are numerous ways to value a company/stock but the best way is to value a stock is by:
1) IDENTIFY THE SECTOR
The best thing to start from is understanding the industry. Using a Top-To-Down Approach is one of the best technique to get a macro view of a sector.
If the sector performs, the company will also perform.
2) SELECT THE BEST COMPANY
In a Top-to-down Approach, after the industry is selected after screening all the growth drivers that could boost the industry, the best stock is selected. But before selecting the stock we need to understand few things like the business model of the company, how the company works, its revenue and cost drivers, management, competitors etc.
3) UNDERSTAND THE FINANCIALS
While selecting the stock, investors need to examine the financials of the company which is an integral part of the valuation. The investors need to understand that stock prices would improve only when the fundamentals are strong. Reading a Balance sheet is a task for novice investor but ultimately mastering it would give him that confidence to take right decisions when investing.
While examining the Financials the investor should consider three things- balance Sheet, Profit and Loss statement and Cash Flow Statements.
At the start of the process one should check the shareholders’ Funds as to get an idea how much percentage stake does promotors have?
It states the controlling power of the promoters in the company apart from regular shareholders.
While considering the balance sheet we need to consider the Loans/Liabilities of the company and focus on its payment cycles. Considering the secured and the unsecured loans gives us a better understanding of company having its total debt, whether it can pay off at regular intervals as well as if the loans are taken for business purpose, is the money utilised there itself which can be seen in the form of its fixed assets or FD Balances in that case. Basically where the funds are parked is utmost important.
Another use of loans is to check whether that loan is used for purchasing assets as Capital Expenditure. If that is the case an investor should check for the capacity utilization percentage whether it is at par with industry or no and is FCF generated regularly. An investor should also check ROCE/ROI which is one of the most important valuation parameters.
The Profit/Loss account clearly indicates the operations of the company whether it is managed well or no. Since we are aware generally of company having cash/non-cash items both in P&L it is important to determine whether if ait'smpany incurs loss is it because its non-cash items or because its regular operations.
4. ANAYLSING THE RATIOS
Some of the important ones are:
I. Returning on Equity(ROE)
It’s simple to calculate, return on equity is one of the crucial valuation ratio accounted for. ROE is surrounded by the three mains “levers”- profitability, asset management and financial leverage by which company’s management runs the business.
II. Return on Invested Capital(ROIC)
It is not always profit margins that determine company’s integrity and desirability. It’s how much cash which can be produced by each rupee of cash invested in a company by either its shareholders or lenders. Comparing a company’s Return on Capital with Weighted Average Cost of Capital(WACC) reveals whether the invested capital is being used effectively.
III. Return on Capital Employed(ROCE):
It is another most important financial ratio which measures a companies profitability and the efficiency with which its capital is employed. A higher ROCE would mean that the company is using its capital more efficient manner. ROCE should be higher than the company’s capital cost otherwise it would indicate that the company is not employing its funds in an efficient manner.
ROCE= Earnings before Interest (EBIT)/Capital Employed*
*Capital Employed is Total Assets- Current Liabilities.
5. CHOOSING THE RIGHT VALUATION METHOD
When you are ready with your analysis for any stock you have selected, the last step and the most important and crucial part is which valuation method to choose.
Different valuation methods is used for differeofdustries. Different Ratios are used for different industries. But the main point is which valuation method. This series of valuation methods, one can understand the fundamentals about the company’s business to value its share.
There are few valuation approaches where an investor can choose from:
Discounted Cash Flow
Book Value Multiple