Let us start with a scenario where you have stumbled upon a potentially brilliant stock idea. It is a potential multi-bagger story.
Some of your friends have bought it and told you about it or you have read about it somewhere or you have information from sources that a big investor has recently bought into the company.
You need to build the conviction that this is indeed a very good stock/company that can be held for the long-term to create wealth.
Now the question is where do you start researching the stock idea and how do you decide in the lease possible time whether this is a potentially good company to invest in.
To effectively solve the above problem, let us turn this problem upside down.
How do I decide quickly whether the particular stock I have heard of is not worth my time? – The answer to this challenge lies in creating a set of questions -(a checklist) which can be quickly answered to determine whether to spend more time with the idea or not
In this article, I will enlist the set of questions (checklist) I use to filter the ideas that I work on. The beauty of the checklist approach is that it is a comprehensive tool to quickly address the question – “Should I spend more time researching this idea?”; “Am I better off researching some other idea rather than this one?”
The place to start is basic Financial Analysis
|Sr No||Parameter||Criteria||Value||Remarks / Judgment|
|1||Sales Growth||CAGR (10 yrs)> 15%|
|2||Profitability (NPM)||NPM > 8%|
|3||Tax Payout||> 30%|
|4||Interest Coverage||> 3|
|5||Debt to Equity||< 0.5|
|6||Current Ratio||> 1.25|
|7||Cash Flow||CFO > 0 (all years)|
|8||Cum PAT Vs Cum CFO||cCFO ~ cPAT|
|9||Self Sustainable Growth Rate (SSGR)||SSGR > Sales Growth|
|10||FCF generation over 10 years||FCF (10 yrs) > 0|
The next step is to do some basic business analysis – return ratios and some Industry and Peer Analysis
|1||ROCE (10 yr avg)||ROCE > 20%|
|2||ROE (10 yr avg)||ROE > 15%|
|3||Comparison with Industry Peers||Sales Growth > Peers|
|4||Increase in Production Capacity & Sales Volume||Capacity/Volume CAGR ~ Sales CAGR|
|5||Profitable Growth||Profit Growth >= Sales CAGR|
|6||Creation of value for shareholders from retained earnings over 10 years||Increase in Mcap in 10 yrs / Retained Profits in 10 yrs > 1|
It is not necessary that a company qualifies excellent on all the above 16 parameters.
However, a potential multi-bagger company will in all probability will in all likelihood qualify on most. The most critical of the parameters are
- cCFO ~ cPAT (10 yrs) – This is most important barometer of the ability of the company to convert accounting profits to cash and a lead indicator of presence/absence of accounting fraud
- SSGR (Self Sustainable Grwoth Rate) – SSGR must be greater than Sales Growth. This indicates whether the company can keep growing for a long time in the future with internal accruals without taking external debt.
Dr Vijay Malik beautifically describes this concept over here.
- Free Cash Flow over 10 years – This parameter tells us whether this business is a cash guzzler or a cash generator
- ROCE (10 years) – Return on Capital Employed over a period of 10 years over a upward and a downward business cycle
Once the stock ideas passes this basic analysis, next we do some analysis for accounting fraud and management integrity
PS – www.screener.in is the best available free online tool to check financials of any company listed on the Indian stock exchanges