Table of Contents
13.1 – What to expect?
Now we will learn how to do equity research. Remember that when a common man like us and you do equity research, he has to do this work with limited means. To do equity research, we will have the internet, company annual reports, and Microsoft Excel as the only tools. When a company or organization does this equity research, then it has a separate person for this work, who gets a chance to talk to the management of the company, many types of financial data like industry reports, etc. are available, which She buys from Bloomberg, Reuters or any other such company by paying money. So we will try to find out how to do this work in the best possible way with our limited resources and take a good decision to buy shares of any company.
We will break down equity research into three distinct phases.
- understanding business
- checks according to the checklist
- Valuation of the company so that the correct price of the share can be known
At each of these stages, there will be several steps that we will have to take. There is no shortcut for this.
13.2 – Share price vs business health
Whichever company you choose for research, first of all, the more you can understand the business of that company, the better it will be. Most people jump directly into the analysis of a company’s stock price. If you enter directly into the stock price analysis from a short-term point of view, then it is still fine but it is very important to understand the company’s business from a long point of view.
You must be wondering why is this so important. The reason is very simple, if you know well about the company’s business, then you will not be worried about the stock price in a bear market. Remember that in a bearish market the price changes, or rather reacts, not the underlying business of the company. If you know and understand the company and its business, then you will have solid reasons to stay in the stock even in a falling market. It is said that there are opportunities to buy shares in the bear market, so if you know the company well, you have faith in the fundamental business of the company, then you will buy more stocks in the falling market and not sell. It is important to say here that it may take a long time to implement this approach properly.
Well, the best source of information related to the business of any company is the website of the company and its annual report. We should at least read the annual reports of the last 5 years to understand how the company has grown in different business cycles.
13.3 – Understanding the Business
To understand the business, first of all, we have to make a list or list of some questions, whose answers we have to find. Note that the answers to all these questions will be found on the company’s website and annual report.
Below is the list of questions that will help us to understand the business. I have also explained the reasoning behind each question.
|No||Question||the logic of the question|
|1||What does the company do?||To understand the condition of the business|
|2||Who are the promoters of the company and what is their background?||To find out whether there is a criminal record, whether there is a political connection|
|3||What products does the company manufacture? (if a manufacturing company)||By knowing the product of the company, it is known how much is the demand in the market and how much is the supply?|
|4||How many factories does the company have and where are they located?||This shows in which places the company is present. Also, if the company’s factories are located in very expensive areas, their value may not be visible on the balance sheet, but it is valuable information for the company.|
|5||Are all factories operating at full production capacity?||The working capacity is known, it is also known whether the company will be able to fulfill it when the demand increases.|
|6||What kind of raw materials are needed for production?||Doesn’t the government control the raw material of the company, doesn’t the raw material of the company have to be imported? This may affect the business of the company.|
|7||Who buys the company’s goods, or who are the company’s clients?||This shows the business cycle of the company, it also shows how difficult it is to sell the goods.|
|8||Who are the company’s competitors?||If there are many competitors, then the margin of the company can be affected. If they are less, then the margin of the company can be maintained for a long time.|
|9||Who are the important shareholders of the company?||If some big and successful investors have invested in the company then it is a good sign.|
|10||Is the company about to launch a new product?||This shows the company’s intent and willingness to innovate. If the company is bringing a new product out of its area of expertise, then the focus of the company may be questioned.|
|11||Does the company have plans to expand overseas?||This shows the company’s intent and willingness to innovate. If the company is bringing a new product out of its area of expertise, then the focus of the company may be questioned.|
|12||What is the revenue mix of the company? Which product sells the most?||It is known from which product the company is earning the most. This gives an idea of the future of the company.|
|13||Is the company in a business with too much control?||This can be good as well as bad. Greater control means that a new competitor may not come easily. But too much control reduces the company’s ability to innovate further.|
|14||Who are their bankers and auditors?||This shows that there is a possibility of any disturbance in the company.|
|15||How many employees are there in the company? Is there a problem related to workers and employees in the company?||It shows how dependent the company is on the employees and their skills. If there is a need for employees of a particular skill then it can become a threat to the company.|
|16||What are the barriers or hindrances in the entry of new players in the industry?||Will know how easy or difficult it is for a new competitor to come in front of the company|
|17||Can the company’s product be easily manufactured in other countries where labor is cheaper?||If yes, then the company can be in trouble anytime|
|18||Does the company have many subsidiaries?||If yes, then the question is whether it is needed or not. Has the company done this to embezzle money?|
These questions will help you to understand the company. Asking these questions and finding answers to them, many more new questions will come to your mind, whose answers you will have to find. If you are able to find the answers to these correctly, then now you will be able to know the company well. Remember this is the first stage of equity research, if you see danger signs in this stage then there is no need to work further on that company no matter how attractive the company looks.
I can tell from my experience that the first phase of equity research for any single company takes at least 15 hours. After this, I write all the important things on a page. This information should be very thoughtful and focused. If you are unable to do this, then assume that you do not have complete information about the company yet. Only after the completion of the first stage, did I proceed to the second stage of equity research.
Now we will move to the second step of equity research. The best way to understand this is to go through one company on our checklist.
We have talked about Amara Raja Battery before, it would be good to put our checklist on the same company and check it out. You can check that company by applying this checklist to any company.
Just remember that we are trying to learn here that further discussion and conversation will be around ARBL so that we can understand this company better. Whether the company is good or bad is not the issue here, but it gives you a framework through which you can go about the process of equity research in the right way.
13.4 – Use of Checklist
The first step of equity research helps us to understand the how what, who, and why of any business. In this way, we will be able to create a holistic view taking into account every aspect of the company. But after that, as much as the business looks attractive, the numbers of the business should also be equally attractive.
The purpose of the second stage of equity research is to help us understand the numbers and figure out whether the company’s line of work and its financial performance complement each other or not. If these do not complement each other, then we will consider that the company does not have the qualities required to invest in it.
We looked at checklists in the previous chapter. Let’s see him once again.
|serial number||which figure||Comment||what tells|
|1||increase in net profit||matching total or gross profit||Increase in income along with profit|
|2||EPS||EPS should also increase with net profit||If the company is increasing its equity shares then it is not good for the shareholders.|
|3||Gross Profit Margin (GPM)||> 20%||A higher margin indicates that the company has a higher margin|
|4||debt level||The company should not be in debt||High debt means that the company is not in a good condition, finance costs will also be high and this will reduce the earnings of the company.|
|5||inventory||for manufacturing companies||Inventories and PAT growing together is a good sign. Must check inventory number of days|
|6||Sales Vs Receivables||Increasing sales through receivables is not a good idea||This shows that the company is forcefully increasing sales just to show earnings.|
|7||cash flow from operations||must be positive||If the cash is not coming from the operation of the company, then it is a sign of pressure on the operation.|
|8||return on equity||>25%||The higher the ROE the better it is for the investor but check the debt level|
Let us now examine all the points in the checklist with reference to Amara Raja Batteries Limited. First let’s see the P&L items – Gross profit, Net profit, and EPS of the company
Revenue and PAT Growth – Revenue & Pat Growth
The first sign of any company being investible is that the company is growing, that is, it is growing. Growth here means that the income of the company is increasing and its PAT is also increasing. We look at it from two angles –
- Year-on-Year Growth – This tells us how much the company is growing every year. Sometimes the company is not able to grow due to any business cycle. So you have to see what kind of growth is happening in the company. Sometimes the growth of the company is very less or does not increase year after year. In such a situation, you must check what kind of growth is taking place in the rest of the competitors or industry of the company, if there is similar growth there too, then the growth of the company will be considered correct.
- Compounded Annual Growth Rate (CAGR) – This tells us whether the company is growing despite the business cycle being down or not. Companies that grow despite the business cycle being down are considered among the best companies to invest in. This growth is reflected in the CAGR.
Personally, I like to invest in companies whose earnings and PAT grow at 15% CAGR.
Let us take a look at how ARBL is doing…
|FY 09 -10||FY 10-11||FY 11-12||FY 12 -13||FY 13 – 14|
|Revenue / Income (Rs. Crore)||1481||1769||2392||3005||3482|
|PAT (Rs in crore)||167||148||215||287||367|
|Growth in PAT||(11.3%)||45.2%||33.3%||27.8|
5-Year Earnings CAGR 18.6% and 5-Year PAT CAGR 17.01%. These figures are looking very good. But we have to check them on other parameters of our checklist as well.
Earnings per Share – Earnings per Share (EPS)
Earning per share or Earning per share tells us how much profit the company is making per share. If EPS and PAT are increasing at a pace then it means that the company has not increased the number of its shares which is a good thing. This shows that the management of the company is good.
|FV Rs.1||FY 09 -10||FY 10-11||FY 11-12||FY 12 -13||FY 13 – 14|
|Share Capital (Rs. Crore)||17.08||17.08||17.08||17.08||17.08|
|EPS Growth||–||-11.35%||– 27.39%||33.28%||28.18%|
The 5-year EPS is growing at 1.90% CAGR.
Gross Profit Margin
The gross profit margin is always shown as a percentage. the formula to extract it is
Gross Profit / Net Sales
Here Gross Profit = Net Sales – Cost of Goods Sold – Cost of Finished Goods
Gross Profits = [Net Sales – Cost of Goods Sold]
Basically, the cost of finished goods is the amount that is spent in making the company’s product. We saw the way to calculate this while calculating Inventory Turnover Ratio. Let us see how the Gross Profit Margin of ARBL has been.
|in crore rupees||FY 09-10||FY 10-11||FY 11-12||FY 12 -13||FY 13 – 14|
|gross profit margin||30.7%||27.9%||28.7%||26.7%||28.0%|
Here the gross profit margin of the company is looking very good. According to our checklist, the company must have a gross profit margin of at least 20%. The gross profit margin of ARBL is much higher than this. it means that
- ARBL has very few competitors hence the margin of the company is very high.
- The company is working very well and the management is also working very well due to which the margin of the company is up.
Debt level – Balance sheet check
The first three points of the checklist were related to the profit and loss statement of the company. Now we will look at such points which are related to the balance sheet. One of the most important things to look at in a balance sheet is the company’s debt. The higher it is, the more difficult it will be for the company. If a company is taking more debt for its growth then it can be dangerous. High debt means that the finance cost of the company will be very high, which will reduce the retained earnings of the company.
The debt of ARBL –
The debt of the company is around 85 crores. The good thing is that the company’s debt has come down as compared to 2009-10. After checking the interest coverage ratio, I personally like to check the debt of the company as a percentage of Earnings Before Interest and Taxes (EBIT). This shows how well the company manages its finances. We can see that the debt/ EBIT of the company is continuously decreasing which means ARBL has done a good job in this matter.
If the company is into manufacturing i.e. making products then inventory data should be checked. This tells us several things:
- Rising inventory coupled with rising PAT indicates that the company is growing
- A stable inventory number of days tells us that the company is running its business properly.
View the inventory data of ARBL
|FY 09-10||FY 10-11||FY 11-12||FY 12 -13||FY 13 – 14|
|Inventory (Rs. Crore)||217.6||284.7||266.6||292.9||335.0|
|PAT (Rs in crore)||167||148||215||287||367|
The company’s inventory number of days is stable. In fact, it’s even going down a bit. We learned in the previous chapter to work out the Inventory Number of Days. Company Inventory and PAT are increasing together which is a good sign.
Sales vs Receivables Sales vs Receivables
Now let us look at the sales figures of the company. These figures will be viewed along with the receivables. If the sales of the company are increasing along with the receivables then it is not a good sign. This means that the company is selling its goods on credit and due to which many questions may arise. Are the employees of the company forcefully selling the goods? Is the company giving free credit somewhere?
|FY 09-10||FY 10-11||FY 11-12||FY 12-13||FY 13-14|
|Receivable – in percentage||16.5%||17.4%||13.5%||12.9%||13.3%|
This figure of the company is also looking stable. Looking at the above chart, it is clear that most of the company’s sales are not due to receivables. In fact, like the inventory number of days, receivables are also falling as a percentage of net sales, which is a good thing.
Cash flow from operations
The most important thing to look at while investing in a company is its cash flow from operations. The company should generate good cash flow from its operations. A company that is losing cash in its operations is in very bad shape.
|in crore rupees||FY 09-10||FY 10-11||FY 11-12||FY 12-13||FY 13-14|
|cash flow from operations||214.2||86.1||298.4||335.4||278.7|
Here the cash flow seems to be a little up and down, yet it has remained positive continuously in the last 5 years. This means the business of the company is running well and generating cash means the company is successful
Return on Equity (ROE)
We have discussed Return on Equity in detail in Chapter 9 of this module. I would like you to read it once again. ROE tells what percentage of profit the company has earned in terms of shareholders. In a way, it tells how much the promoters have earned by investing their money.
The last five years’ ROE of ABRL is shown below-
|in crore rupees||FY 09-10||FY 10-11||FY 11-12||FY 12-13||FY 13-14|
The above ROE numbers are pretty good. I myself like to invest in companies whose ROE is above 20%.
Remember we are in the second phase of equity research. ARBL has met all the criteria required in Phase II. Now, as an equity research analyst, you have to put the output of the second stage in the context of the information gathered in the first stage. If after both steps you are able to form a positive opinion about the company based on the facts, then the company has the qualities that make it worth investing in.
However, before buying the stock, do check that the price is correct. And that’s what we do in Phase 3 of Equity Research.
Main points of this chapter
- Equity Research “Limited Resource” can be done in 3 steps
- understanding business
- from the checklist app
- The purpose of the first phase is to understand the company’s business and gather the necessary information for it. And the best way for this is – the Q&A method i.e. question-answer method.
- In the Q&A approach, we start with simple and clear questions and seek answers.
- By the end of the first step, we should have all the business information.
- Most of the answers we are looking for in the first step will be found in the company’s annual report and website.
- In the first stage itself, if you ever doubt any information, or are not sure, then it would be better to stop the research there.
- In the first step, it is very important that you have strong faith in the company from the information you have gathered. This belief will give you a reason to stay in the stock during a downturn.
- In the second step of equity research, you have to check the performance of the company on different parameters.
- And it is obvious that only after completing the first two steps, you will be able to move toward the third step.