How to Select Fundamentally Strong Stocks? Here's a Guide

Creating an investment portfolio isn't a gamble.

You can't build your investment portfolio by asking for tips or tossing a coin to pick a stock. You need to do proper analysis and research.

Everyone wishes for high returns with minimum risk. Unfortunately, that combination doesn't exist. The key to winning in the stock market is to generate consistent returns over time.

What does that mean?

Earning consistent returns means the having the ability to generate returns across market cycles.

Not all companies generate consistent returns. However, fundamentally strong stocks offer consistent growth with less volatility.

That brings us to the most important question... How can you select fundamentally strong stocks?

You can do this by thoroughly analysing a company's business and financial health. You will also have to analyse various quantitative and qualitative factors.

Here's how you can go about it...

Financial statements

Analysing a company's past and current financial statements is the first and foremost step.

Balance sheets, income statements, and cash flow statements will help you understand the past and current operations of a business.

Look at the company's revenue, expenditure, cash flow, and dividends over the years. Consistent growth is certainly an indication the company is doing well and has good prospects.

Financial ratios

There are numerous financial ratios that you can analyse from the financial statements. Each ratio will help you understand a company's financial health and performance trend.

Here are a few...

1. Profitability ratios

   Profitability ratios help evaluate the ability of a company to generate income compared to its expenses. Ideally, companies with higher profitability ratios are preferred.

   The following ratios will help you understand the profitability of a business:

   • EBITDA Margin - Earnings before interest, taxes, depreciation, and amortisation (EBITDA) represents the operating income generated by the company.

     EBITDA margin is an estimation of this operating income with respect to the total revenue. It's a popular relative valuation technique, where you can compare the performance of companies belonging to the same sector.

     EBITDA Margin = Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) / Revenue
     
   • Net Profit Margin - Net profit margin helps in understanding the company's ability to generate profits from its sales. A high net profit margin indicates that a company is performing well.
     
     Net Profit Margin = Net Profit/Revenue
     

2. Operating ratios

   Operating ratios help measure the efficiency of the management in managing costs.

   These ratios help to assess the effectiveness of an organisation in maintaining a lower cost of operations.

   Here are some operating ratios you can evaluate -

   • Working Capital Turnover - Working capital turnover ratio helps in estimating the effectiveness of a business in using its working capital to generate revenue. A higher ratio indicates higher efficiency of the company in leveraging its working capital.
     
     Working Capital Turnover = Net Sales / Average Working Capital
     
   • Inventory Turnover Ratio - Inventory turnover ratio is a useful indicator of a company's ability to convert inventory into sales. The ratio also indicates whether management is effectively controlling inventory expenditures i.e. how many times it has sold and replaced inventory in a given period.
     
     Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
     
   • Total Asset Turnover - Asset turnover ratio measures the efficiency of a company in using its assets to generate revenue. A higher asset turnover ratio indicates the company is more efficient at putting its assets to use. Total Asset Turnover = Net Sales / Total Assets
     

3. Leverage ratios

   Leverage ratios help measure the company's ability to meet its financial obligations. They will also help you understand how a company is financed (equity or debt).

   If a company is highly leveraged and unable to generate profits, it can be a cause of concern for the investor.

   Here are two leverage ratios you should consider -

   • Debt to Equity Ratio - Debt to equity ratio denotes a company's debt position. A high debt to equity ratio is risky. Ideally, a ratio less than 1 is considered good, while anything above 2 is highly risky.
     
     Debt to Equity Ratio = Total Debt / Total Equity
     
   • Interest Coverage Ratio - Interest coverage ratio helps in understanding the debt repayment capacity of a company. Higher the ratio, the better the company's ability to pay its debt.
     
     Interest Coverage Ratio = EBIT / Interest Expense

4. Valuation ratios

   Valuation ratios are useful to determine the investment potential of a company. They help understand the stock price with respect to the company's financials. Analysts and investors widely use these ratios.

   Here are two commonly used valuation ratios -

   • Price to Earnings (P/E) - A higher P/E ratio can indicate that the company's share is overvalued while a lower P/E indicates that a company is undervalued.
     
     Price to Earnings (P/E) = Current Market Price / Earnings per Share
     
   • Price to Book Value (P/B) - P/B ratio of a company compares the market value of the shares to its book value. A higher P/B ratio indicates the stock is overvalued.
     
     Price to Book Value (P/B) = Current Market Price / Book Value per Share

You can use these ratios to compare a company with its peers and see where it stands. Peer comparison helps in finding financially strong companies.

Corporate governance

Corporate governance helps in understanding the practices and processes employed by a company. Good corporate governance will automatically lead to a strong business. Unethical practices cannot sustain the business for long.

Yes Bank is a good example of failed corporate governance. The bank had given loans at high-interest rates to companies whose repayment capacity was low.

Consequently, the bank's non-performing assets (NPAs) increased. Under the RBI's scrutiny, it was found that the company had more NPAs than it was declaring. Due to its poor corporate governance and practices, the management failed to keep the business running.

As a result, the stock started witnessing a fall in its share price from Rs 394 in August 2018. It's currently trading at Rs 13.9 (as on 7 January 2022).

On the other hand, one of the best example of good corporate governance practice is the Tata Group.

The group has proven its ethical practices and has stood strong since its inception in 1868. Tata group is one of India's oldest and largest conglomerates. The group always strives to maintain the right balance between individual, social, economic, and community goals.

Future prospects of the business and industry

Financial statements, financial ratios, and corporate governance practices all determine the company's past and present situation.

However, what also matters is its future prospects. Only if the company has good opportunities in the future it will be able to generate returns for its investors.

Therefore, you should understand the business, its future prospects, expansion plans, and industry outlook. Evaluating a company in this way will help you decide if the stock is worth investing in.

• Looking beyond numbers and valuation metrics...

  Finding fundamentally strong stocks means going beyond valuation metrics. Numbers certainly help you shortlist companies that have been doing well, but what matters is the road ahead.

  As a thumb rule, always invest in a good company with strong fundamentals rather than an undervalued stock with poor fundamentals.

  Here's a list of parameters that you should consider...

  • Macroeconomic factors

    Macroeconomic factors such as GDP and inflation can have an impact on your portfolio.

    GDP is the value of all the finished goods and services in a country during a specific period while inflation is an increase in the price levels of goods and/or services.

    Both offer a quick view of the economic health of the country.

    When the GDP falls, investors tend to stay away from the market causing a corresponding drop in stock prices. On the other hand, when the GDP increases, investors are optimistic about the future and buy more shares which positively impacts the stock market.

    While the relationship between the market and GDP is direct, the relationship with inflation is inverse.

    When inflation rates rise, stock markets tend to fall and vice-versa.

  • Industry trends

    Industries evolve. Technologies become obsolete. We have seen technological advancements destroy certain products and companies.

    You need to evaluate how quickly a company is able to modify its processes to the evolving trends and how fast it is able to generate business.

    This can help you understand how receptive a company and its business model is to the ever evolving changes around it.

    For example, artificial intelligence and machine learning are paving the way forward in the technology sector.

    Take the example of Tata Elxsi, a technology and design services leader for over three decades.

    The company recently established the Tata Elxsi Artificial Intelligence Centre of Excellence to address the growing need for intelligent systems.

    Swiftly adapting to the technological changes around, the company was successful in developing self-driving cars and video analytics solutions. The company's stock has given a whopping 180% return in the last one year.

  • Competitive advantage

    A company's ability to sustain its market share over time is what matters. A competitive advantage can be anything ranging from brand name and goodwill to patents etc.

    For example, IRCTC currently enjoys a 100% monopoly in its industry. It is an e-ticketing and catering company that has no competitors yet. IEX, CAMS, and CDSL are more such examples which have strong moats.

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To sum up...

Investing in fundamentally strong companies will require you to consider all the above parameters in conjunction. You cannot consider any of them in isolation. Every ratio and parameter has its significance in evaluating the company's business and financial health.

Also, it's a popular misconception that only largecap/bluechip stocks are fundamentally strong companies and only such companies can generate consistent returns. However, smallcaps, midcaps or even penny stocks can be fundamentally strong.

Investing in a fundamentally strong stock is a long-term investing strategy. Hence, don't expect overnight gains.

Finally, evaluating and investing in fundamentally strong stocks isn't the end. You will have to review the company and stock performance from time to time. Any irregularities will require you to reconsider your holdings. Hence, always keep a track of your investments.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...