If you are not willing to put in the time and effort to study the share market and invest in the same, it would be better to invest through mutual fund. Spend at least that much time on your share investment study as you would do to buy a new fridge. Most people make their share purchase decisions based on the following:
1. Reference from your stock broker, who earns brokerage only when you buy and sell your shares.
2. Hot tips from your friends.
3. Noise on CNBC or other news channels
Just investing into blue chips would not protect you. Some of the blue chips are so overvalued that it could take years to get any returns on your investment. Sometime a mediocre company attractively priced could be a better investment than a blue chip company which is growing at 20% every year.
While going through the Annual Report, always read Directors / Chairman’s Report and check the auditors notes to the accounts. I am listing out some of the considerations to be taken into account while making a share purchase decision:
1. Understanding the company and its share
(a) When was it incorporated
(b) What is the business of the company
(c) Address / location
(d) Who are the promoters and what it their holding in the company
(e) Investor returns
i. Dividends
Company should be giving regular dividends over the last 5 years or if not they should be having great alternative investment opportunities
ii. Bonus shares
iii. Right shares
(f) Stock movement over the last 10 years.
All this would give you a feel for the company, it products and the share price movements
2. Profit and Loss account Over last 5 years minimum
(a) Income is increasing regularly
(b) Profit before depreciation, interest and taxation growing
(c) Profit after tax growing
(d) Profit after tax to income
Profitability should be more than that of its peers.
3. Buisness Fuel Over last 5 years minimum
(a) Working Capital to Sales
The lower the better
Retail 10-15%
Heavy manufacturing 25-35%
(b) Current Ratio
Current Asset / Current Liabilities
It gives an idea of the company’s ability to pay the short term liabilities (sundry creditors and short term debt) with is short term assets (cash, inventory and receivables)
If the ratio is less than one, it means that the company cannot meet its short term liabilities. Normally should be around 2:1. Sudden spike in ratio shows a problem with efficiency
(c) Quick Ratio
Cash + Marketable securites / Current liabilities
(excludes inventory)
It is a measure of the company’s liquidity to meet the short term liabilities
Should be one. Less than one shows liquidity problem and too high shows efficiency problem,
4. Investments
Always check out this schedule in the accounts. See whether the company is investing in group companies
May or may not be a good thing.
5. Debt of the company
(a) Debt / Equity Ratio
Indicates how the company is financing its assets or how leveraged the company is.
2:1 debt equity ratio is desirable
(b) Interest Coverage
Earnings before interest and taxes / interest
This ratio is used to determine how easily a company can meet its debt obligations, if the earnings fall
Ideally should be in the range of 3-4 times
(c) Profit after Tax to Long Term debt.
According to Warren Buffett this should be less than 5 times, except for banks and financial institutions.
6. Bang for the Buck Over the last 5 years minimum
(a) Earnings per share
Profits divided by number of shares
Should be increasing every year.
(b) Profit after tax / Capital Employed (Equity + Reserves)
Should be more than 15%
(c) Historical Price Equity
PE ratio is calculated by dividing the share price by the earning per share.
Check the last 5 years PE ratio and the current PE ratio should be less than the average of the last five years.
(d) Beat Treasury returns
EPS divided by current share price gives the returns earned by the share at the current price.
Should be more than 8% which is Government security returns.
(e) Price to Book Value
If the company is trading less than the book value, it means the market believes the asset value of the company is over stated or the company is earning very poor (or negative) returns on its assets
According to Warren Buffett, you should understand the company’s business. You have to look for companies which have a durable competitive advantage. You need a product that wears out quickly or a service that you need to use again and again. If the company re-purchases its shares, it would be a positive.
This analysis is done by a layman without looking at future earnings, which is an unknown, or technicals of the market. It anyone has further points to add to this, please do add to the discussion on the subject to veena@veenamalgonkar.com or malgonkar@vsnl.com
Next week, I would look at when to sell the shares, although according to Warren Buffett the best holding period is forever.
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