The Joys of Compounding by Gautam Baid
Checklists are helpful when making decisions. They also assist us in avoiding overconfidence in our abilities. When it comes to investing, investors must ask the right questions. Good answers will only come from asking the right questions, which will aid in decision-making.
Learn about the company and its competitors from company websites, filings, and information on the Internet. Read the past ten years’ worth of annual reports, proxies, notes, and schedules to the financial statements, and management discussion and analysis also observe the recent trends in insider shareholding.
After the investor has concluded the initial groundwork, the author advises studying the following parameters in a checklist fashion.
1. Income Statement Analysis
Sales growth - The higher sales growth is, the better (provided it is profitable). Over the long term, stock returns are highly correlated to sales growth. Organic growth driven by internal accruals is most desirable. Be cautious of high growth driven primarily by big-ticket acquisitions.
Gross profit margin - Focus on the trend over the years. If it fluctuates a lot in a cyclical manner, it means that the company does not have pricing power over its customers and cannot pass on the increase in raw material costs.
On the contrary, if it is high and stable or improving over the years, the company in question may have an economic moat.
Interest income (usually shown as “other income”)- Check the cash and investments figure on the balance sheet. If the interest income is not at least equal to the bank’s fixed deposit return, then analyze it deeper to see where the company has invested its cash.
Interest expense - A low-interest expense or a high-interest coverage ratio should never be taken at face value. Always check whether the company has been capitalizing on the interest cost.
Multiply the total debt figure by the prevailing rate of interest for similarly
rated corporations and compare that figure with the total interest expense number used to calculate the interest coverage ratio.
Employee cost - The reported figure may be grossly out of line in fraudulent companies when evaluated against the existing number of employees stated in the company filings or on the website.
Other expenses - Several miscellaneous expenses are aggregated under this heading, making for a rich conduit for leakage. A sharp rise in “other expenses” in a depressed market or slowing economy could symbolize money is being siphoned off.
Taxes - The tax payout ratio should be near the standard corporate tax rate. If it is low, check whether the company has accumulated losses from the past or is enjoying tax incentives from operating out of a special economic zone or other tax-advantaged jurisdictions.
Net profit margin - The higher this margin is, the better. Be aware of companies that show high sales growth with declining profit margins. Companies that chase growth at the cost of profitability usually do not create sustainable wealth for shareholders.
2. Cash Flow Analysis
Cash flow from operating activity (CFO) - The higher the CFO is, the better. Compare the CFO with net profit over the years to see whether the funds are getting stuck in or released from working capital.
Capital expenditure (CAPEX) - Compare CAPEX with the CFO to see whether the company can fund its capital expenditures from its operating cash flow. Companies that show high sales growth without much CAPEX potentially could be capital-light compounders.
Total debt - The lower the debt is, the better. High debt (for non-finance businesses) signifies living beyond one’s means. Avoid companies that heavily depend on the kindness of strangers.
Cash balances - Extremely high cash levels in companies that do not pay dividends should be viewed with caution. The cash shown on the balance sheet may be fictitious.
Free cash flow (FCF)- It is the discretionary surplus that can be distributed to reward shareholders. The higher the proportion of FCF out of the CFO, the better. If FCF is negative and the dividend is continuously funded by debt, the investor should not take any comfort from a high dividend yield. If a company cannot generate FCF, then it may be the equivalent of a perpetual Ponzi scheme.
Remember, intrinsic value is derived from the cash taken out of a business during its lifetime. When a company reports profits but bleeds money, believe the money. The most common symptoms of falsified earnings are negative free cash flow accompanied by rising debt, increasing shares outstanding, and bloating receivables, inventory, non-current investments, and intangibles.
3. Return Ratios Analysis
Self-sustainable growth rate (SSGR) - This represents the debt-free SSGR potential of a company. Companies growing at a higher rate than SSGR use more resources than their inherent operations generate, and they experience increasing debt levels.
An SSGR higher than the sales growth rate is desirable.
Profit before tax/average net fixed assets
The higher this ratio is, the better. A company should earn more on its tangible assets ( tangible equity and capital employed) than the bank’s fixed deposit rate.
Pretax Return on tangible equity
The higher the pretax return is, the better. Tangible equity is calculated by subtracting intangible assets and preferred equity from the company’s book value.
Be cautious of companies for which the high return on equity figure is being primarily driven by higher leverage.
Return on capital employed
The higher this return is, the better. This is calculated as earnings before interest and taxes, divided by capital employed.
4. Operating Efficiency Analysis
Net fixed asset turnover ratio - The higher this ratio is, the better. A high ratio shows that the company efficiently sweats its fixed assets.
Receivables days - The lower the number of days, the better. A higher number means that the company is giving customers a more extended credit period to generate sales. In the case of fictitious sales, in which cash is not received from customers, the number of receivables days will constantly increase.
Inventory turnover ratio - The higher this ratio is, the better. Lower inventory turnover means that the company is accumulating a lot of inventory (which might become obsolete later).
5. Balance Sheet Analysis
Net fixed assets
Look for sharp increases in this figure on the balance sheet. These increases signify that the company has completed a CAPEX program, which could drive higher sales and profits in the future.
Capital work in progress
Look for sharp increases in this figure on the balance sheet. These increases signify that the company is currently undertaking a CAPEX program, which may be on the verge of completion.
Ideally, the share count should be constant over the years or decrease because of buyback. An increase in share capital that is not due to bonus shares represents a dilution of existing shareholders.
Keep in mind that stock splits and bonuses affect only the liquidity of a stock, not its intrinsic value.
Debt-to-equity ratio - The lower this ratio is, the better. Check for off-balance sheet exposures like underfunded pension liabilities, disputed legal claims, non-cancelable operating leases, and contingent liabilities like corporate guarantees for loans taken by promoter-owned group entities.
Test the debt serviceability through interest coverage (earnings before interest and taxes/interest) and FCF. A company may have a low debt-to-equity ratio but still face financial stress if the cash is insufficient to meet the near-term payment obligations.
6. Management Analysis
Study the background and credentials of promoters and search the Internet for any corporate governance issues.
Management red flags include exorbitant salaries, perks, and commissions (most worrisome if paid during a period of losses); a high percentage of insider holdings being pledged; promoters merging their weaker privately-owned companies into their publicly listed company; engaging in significant related-party transactions; appointing relatives who lack adequate qualifications; using aggressive accounting practices; frequently changing auditors; changing the company name to include buzzwords from the hot sectors currently in high demand; and engaging in overly promotional activities, such as quoting broker reports for its revenue or profit guidance and issuing frequent but meaningless press releases and announcements.
Always read the “Liquidity and Capital Resources” section in annual and quarterly SEC (Securities and Exchange Commission) filings to assess the capital-raising needs of the business you are researching.