Analysing a Company’s Financial Statement
1) Growth – It can be organic (Selling more goods, raising the prices, selling new goods) or inorganic (buying another company). Growth can come from company specific or by Industry Specific (Industry is growing so your company is growing) and also check Incremental Market share how much your company can take from a pie. Here we need to look at four things –
Historical growth
2) Sources of growth – There are various reasons like company can increase it product price or by selling more volume. Increasing price can come from various reason niche products/No Substitute Available/Higher Quality product etc. Company has to grow from selling higher volumes when there game of cost cutting because manufacturing more volumes can lead to lower cost.
3) Quality of growth – If earnings growth outpaces its sales growth over a long period of time, you need to dig in the numbers to see how company keeps squeezing out more profits from stagnant sales. (by company power to control which cost)
Sustainability of growth in the future
Profitability
4) ROA – It shows much return the business is making on its assets. It has two components – Net margin and Asset turnover. There are businesses like grocery stores which have low margins but then they try to turn over their assets quickly which can help them to have superior ROAs. On the other hands, businesses like luxury retailers, have low asset turnover but high margins.
5) ROE – It measures the efficiency with which the company uses shareholders equity. It has three components (Du pont) – Net margin, Asset turnover and Financial leverage. Here we need to look out for the third components i.e. financial leverage. Companies can boost their ROEs simply by taking on more debt (financial leverage). In the current years ROE will shoot up but in latter years due to very high interest outflow Net profit margins will get affected and can lead to Lower ROE.
6) Free Cash Flow (FCF) – It is arrived at by deducting Capital expenditure as well as Lease Payments (If company has lease liability) from ‘Cash flow from Operations after Working capital changes’. It is the excess cash that really belongs to the shareholders. To analyze it, we can divide FCF by Sales to see how much free cash flow the company is generating from every Re.1 of sales. This can be negative and positive also but for one two years negative is reasonable is company is heavily doing CAPEX but after some years it should be positive.
7) Return on Invested Capital (ROIC) – ROIC improves on ROA and ROE because it puts debt and equity on equal footing by removing the debt because ROE can look good due to Heavy financial Leverage. It is calculated as – “Net operating profit after taxes (NOPAT) divided by Invested Capital(Core FIxed Assets plus Working Capital)”, where NOPAT is Net income after taxes but before interest.
Other metrics to check financial health of a company –
1) Debt/Equity – It is calculated as Average Total Debt/Total Equity. Average Total Debt ( Long term Debt plus Short term Debt Divide by 2) It helps us to measure how much company has Debt per dollar of Equity.
2) Interest Coverage Ratio – It is calculated as Cash flow from Operations Divided by Total Interest Expense. It helps us to understand how much times company can pay its Debt obligations.
3) Current Ratio – It is calculated as Total Current Assets divided By Total Current Liability. It helps us to understand how much cash company can raise in order to pay its liabilities.
Bear Case
Construct a convincing a Bear case
1) List all the possible negatives of the company/business
2) What could go wrong if a company is not able to grow?
3) What if no one buying there are only seller for this company.
By doing this you will have the confidence to hang on to the stock during a temporary correction patch.
Analysing A Company Management
Excellent Management can make the difference between Mediocre business and outstanding one, a poor management can run a great business into the ground. There are few examples A great management of Garware Technical Fibres this company was taken over by the son of the old management. He than just turn the company into a outstanding business. Sometimes it is better to check how much is management skin in the game by taking look at ESOP structure. Management can be analysed as following:
1) Compensation
Bonuses should be preferred over big base salaries because bonuses are dependent on certain performance targets being achieved.
These performance targets should be clearly disclosed. They should make the company bigger with better.
Compare the company’s management compensation with its peers after due regard to the size of the firm and its financial performance. (Management compensation as % of PAT is an important metric to check)
Is the company loaning the money to its managers? If yes, at what interest rate? And is the loan finally repaid? Also check if management is giving loan to company reasonable rate or higher rate than Bank.
Does the management excessively use the stock options and dilute the equity of the company?
Does the management immediately sell the shares of the company after they have been granted options?
Also check the relatives of management are using luxurious travelling at Company expenses.
Check if a company is taking huge amount of bonus and salary and not dividing them between shareholders.
2) Character
Study related party transactions in detail because here the game is really confusing company is doing transaction with promoter fully owned company also.
Is the board stacked with managements family/friends?
Does the management honestly discuss its poor decisions and performance?
Does the management provide enough information to properly analyze the business?
3) Operations
Look for high and increasing ROAs and ROEs. Are ROEs increasing due to excessive leverage?
Does the management allocate its capital efficiently over the years? Because company can allocate or acquire another company and paying goodwill but in next two years company declares the acquired company is not worth it so writing off goodwill. This can happen one two times but again again doing this stuff by management should be studied.
Is the management diluting too much equity?
Do the actions of the management match with what they claim to do? For example company is saying there are planning to build a new plant are they achieving their target as per their time they disclosed over the years.
Consumer goods
Companies that are into selling consumer goods are defensive during economic downturn because people will use soap and toothpaste. Consumer Sector is considered of Foods & Beverages, household , personal products, Affordable housing and habitual goods. Like it economy is doing great or not this companies are never been seen down but it grows slowly. Consumer goods companies manufacture their products and sells to distributor and they sell to retailers and finally it reaches to consumer.
Key Strategies for Growth- Because of Maturity this sector has gone through periods of consolidation. Most industries are dominated by higher volume and sales. Companies try to gain market share by introducing new products. And if your company is selling to another company like for retail store if they see that this category of products is selling more so they try to manufacture this kind of similar products and keep them in shelf and not keeping the old products so this can be a risk also.
Growth can also come from Acquiring other Consumer goods company. This can prove to be successful of a company or it may not work like the expectations. Like Pepsi Co acquired Quaker Oats turned out be best investment for them. But Gillette bought Duracell battery did not worked out form them.
The main game in Consumer goods companies is the distributors and retailers. They should have very good relation with them and distributors should be across regions. Another important metric to look at is operating cost. Is company being able to reduce their operating cost like company hiring more contract labours can be a good signal. Costing cutting can also be sometimes lead to downturn of company because there are certain cost that cannot come down to zero. Company should also focus on Marketing & Advertisement expense to increase their revenue.
There are various risk investors should look in this sector
Increasing power of Retailers: Because it is the retailer that finally sell products. Lets say Walmart now everyone wants their products to be in Walmart stores which means they have complete control on pricing. And also the local retailers cannot buy in huge volumes so they cannot buy at what Walmart is buying and cannot pass the cost to customers.
Litigation Risk: This risk is mainly with Tobacco companies, government has full authority to shutdown such business. But ITC enjoys this because other companies cannot sell tobacco due to government not giving license to other players.
Economic Moat in Consumer Goods
Despite the risk , one very attractive feature of this is competitive advantage that helps in preserve pricing power.
1) Economies of Scale
2) Big powerful Brands
Distribution channel and Relationships
Hallmark of Success in Consumer Goods
3) Market Share – Companies that hold dominant position are likely to stay the same just small shifts year on year.
4) Free Cash Flow – In The mature sector company has tons of FCF. Companies because of their wide MOAT.
5) Belief in Brand Building – Firms that consistently make Advertisement expense and other non-sales communications and giving high quality will build up a perceived value. Check out whether companies is giving huge discounts to gain market share. Companies should not cut advertisement expense when sales aren’t going well.
Innovation – Companies should have great order pipeline to stay competitive. Check out whether the company is introducing new substitute or a Revolutionary product that never existed.
Industrial Materials
Industrial Material companies buy raw material and manufacture product/machinery so that other firm can use it to fulfil customer demand. Industrial material are of two types 1) Commodity product – Steel , Cooper 2)Value Added product – Heavy machinery , speciality chemicals. In commodity product no one has control over its price but in value added product one can charger higher price.
Some industries perform according to the economic performance of the company because of which many companies are unable to survive during the recession. Some of the economic moat for basic material industry can be value added products, pricing, brand effect, etc and for industrial materials might be how efficiently the company is able to use their assets, technology advancements, competitive advantage, etc but the economic moat can be different from industry to industry. Some industry are cyclical when there is boom in industry all the price of inputs, revenues just go up when a downturn comes only those companies survive that has lowest cost to manufacture product in commodity products. Some cycle are long and short depending industry to industry Rise of capital through debt which might have a negative impact during a downturn, pension during the slow/no growth of the company can might have a negative impact on the company, the attempt to capture large market size with due to which low total asset turnover and fixed asset turnover can be bad indicator. To Indentify best industry in industrial material look for which industry has gone through major consolidation. Then look for lowest cost producers and additional revenue streams through valued added category.
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