With a wide range of companies available to invest in, it gets a bit confusing to decide as to which company should one choose. Lets look at some of the parameters once should assess before zeroing on an investment target.
The business: This is the most important parameter before deciding to invest. One should know what the company is doing to earn. Whether the company is in a growth or a matured phase. One should identify the economic drivers that affect the business so that one can minimize risks and maximize return. We tend to do number crunching forgetting the larger picture. One should understand the sector in which the company operates, the drivers of the business and the competitive standing of the company. After that, the investor must rationally assess if an investment in the company is worth. It's better to do nothing with your money than something you don't understand.
For example, in case of software companies, while Infosys and TCS have been around for more than 20 years and service different arenas of software development, they command a premium in terms of its valuations. i-Flex and 3i Infotech get 50% of its revenues from products and remaining from services. Though products business offers more scalability, which today is the need of the hour for the Indian IT industry, it has more risk when compared with services. Geometric Software is into a niche area, which requires scalability. The risk therefore increases. Hence, one must carefully understand the business before investing.
Operating Margins: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. It gives idea of how much a company makes (before interest and taxes) on each rupee of sales. If a company's margin is increasing, it is earning more per rupee of sales. Also the importance of operating margin cannot be understated, as it will help one to understand the competitive position of a company. Rising gross margins tell you that either the firm is either reducing cost or raising prices. Conversely margins also indicate that either the production costs are increasing or the firm cannot raise the prices proportionally in order to maintain the market share. This could be a red flag. In FY07, Britannia witnessed sharp decline in its operating margins. This was due to higher wheat prices. The company however could not increase the prices of the final product due to the high competition in the segment. This led to a sharp fall in margins from 11.6% to 5.7%.
Return ratios: One way to analyze your financial health by looking closely at the financial ratios. Ratios are used to make comparisons between different aspects of a company's performance or within a particular industry or region. Return on assets (ROA) ratio tells how well management is utilizing all the company's resources (assets). The number will vary across different industries. Capital-intensive industries will have a lower ratio while a service industry will have a higher one, as the assets required are less. Return on equity (ROE) measures how well the business is doing in relation to the investment made by its shareholders. It tells the shareholders how much the company is earning for each of their invested rupee. ROE offers a useful signal of financial success since it might indicate whether the company is growing profits without pouring new equity capital into the business. An increasing ROE indicates that the management is performing well with the shareholders money. It indicates firm's growth rate.
However one should not look at the ratios of the company individually. It should be compared with its peers and the industry as a whole. For instance, your business may have experienced a growth in its net profits by 20% over the last 3 years, which may look good. However, if its competitors have experienced an average increase of 40%, then the company's business is actually under-performing the industry as a whole.
Cash flows: Cash flow measures the cash that moved in or out of a company during a reporting period. Operating cash flow measures the change in cash balances resulting from a firm's main business. Non-cash accounting entries are deducted while calculating net income. Operating cash flow is mainly net income with the non-cash accounting entries added back. So, generally, operating cash flow should exceed net income. It is important to note the distinction between being profitable and having positive cash flow transactions, just because a company is bringing in cash does not mean it is making a profit (and vice versa).
Debt: Leverage is not always a bad thing. But if the interest rate increases it will result in higher debt-service costs, cutting into the earnings of debt-heavy companies. The higher a company's degree of leverage, the more the company is considered risky. A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides cushion and is seen as a measure of financial strength.
Macro factors: This is with reference to the economy or the sector as a whole. One must also look at macro factors like the GDP growth, the technology changes, and the government regulations affecting the sector, which may affect the company.
Valuations: Finally, this parameter is the deciding factor to buy the stock. The stock price carries all the information in the market about the future prospects of the company. As the earnings of a company grow, so should its share price. Price-earning ratio (PE) is an important factor that investors look at while selecting an investment target. PE is a simple ratio of a company share price to its earning per share.
Hence, it is important to look at various parameters and not rely on tips. The better informed you are, the better the choices you will make. To quote the legendry investor, Mr. Warren Buffet, "Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years".