Apply the following tests to any stock you deem worthwhile investing in. within 10 minutes of this test, you will be able to eliminate the stocks that do require more of your precious time and energy. Eliminating the not-so-promising stocks will allow you to focus on the ones that have great growth potential.
1. Is the management competent? Do they have a vision? Is the bod independent?
Evaluate the top management - CEO, CFO and COO. Do they have a compelling vision, a business philosophy? Do a quick background check. Read up on their qualifications and work experience.
Moreover, try to access if the company is entirely dependent on the CEO or have they formed a management team. Look at Infosys Ltd. They had a team of top-level managers and each one of them was a well-known face of the company over time - Narayan Murthy, Nandan Nilekani, N. S. Raghavan, S. Gopalakrishnan, S. D. Shibulal.
Additionally, it is very important to analyse the Board of Directors. A large percent, preferably more than 50% of them should be entirely independent (not related to the owner of the company). And it's even better if they have work experience in other publicly listed reputable firms.
2. Has the company ever made operating profit?
companies that are yet to start-up, are unproven or are developing a fancy product might look the most attractive investments but can get you in trouble. It's best to avoid such businesses. Mostly because their entire business and the valuation depends on that one product, like treating a rare disease or some new and exciting product.
Look at DishTV. the business looked very attractive with the entire cable digitisation process on its way. But it wasn't profitable for the longest time and has lost more than 70% of its stock value.
3. Cashflow from operations consistency?
companies can report profits on their books for without generating any actual cashflow from operations. Look at the cash flow statement in the annual report and see whether the cashflow from operations number has been positive and for how long.
eventually the companies with negative cashflow will have to seek financing from outside which makes it a risky proposition.
4. How consistent is the earnings growth?
Consistent earnings growth is an important feature of a good company. it indicates that the company is fairly well-established and the management knows what they are doing. Erratic or inconsistent earrings growth rate can mean a lot of things:
a. the company is in a cyclical business
b. they aren't able to respond well to competition
Cyclical companies with proven business models need not be avoided. provided they are available at a good discount to their fair value.
5. How much of other income or expense is there?
We often glance at the total income of a company in the summary available and make calls on the trends etc. This can be extremely detrimental. Companies can very easily hide bad times or decisions with the use of one-time charges or other income.
Always check: other income as a % of total revenue and its consistency.
When it comes to other expenses always look for details and see how often does it happen. It's usually a sign of the management using loopholes to hide bad decisions.
6. Clean Balance Sheet?
Debt isn't always a terrible thing. but companies with a lot of debt require extra care. If the debt-equity is more than 1 dig deeper.
a company with a fairly stable business, like a HUL is more likely to service the debt in a timely manner than companies with volatile businesses.
try to assess when the debt is due and if it comes with simpler terms and conditions for re-payment. if it is complicated it maybe not be worth your while.
7. Are the returns on equity consistently over 13-15%, with a reasonable leverage?
Experts believe that the Indian stock market is known to generate anywhere between 13-15% of total annual return over the long term. it has been a well-established benchmark for fund managers investing in India across the world.
Ensure, a non-financial firm generates a ROE of 15% or more whereas a financial firm should be generating a higher ROE consistently. This has to be looked at in conjunction with the leverage (debt to equity ratio). A 15% Roe and a highly leveraged company is no good.
the only exception is in this will be cyclical companies like the ones in the Shipping sector. their ROEs will vary wildly according to economic activities.
8. Has the number of shares increased or fallen over the years?
Increasing number of shares can be a worrisome factor for the investor. it usually means the company is issuing shares for two reasons:
a. acquisitions by issuing fresh equity, which have always been tricky and the success rate for most have been low.
b. company is granting to many options to employees which when exercised will lead to dilution of your ownership stake.
Shrinking number of shares is usually a big plus. it means the company is buying back shares to return money to shareholders. Or that the owners believe in the growth potential of their own business and the stock price is currently under-valued.