As I mentioned in the introductory post, it is better to invest in company that you understand. Industries that you have an understanding of and within your circle of competence. You will be able to differentiate good and bad investment opportunities if you understand the industry’s nuances. These will be written in 2 parts and the points listed below are not in any specific order as all are of equal importance. These are some of the key focus areas when I analyse companies for investing.
It is hard for all companies to match all the criteria, so it’s better to give them a score if they qualify the criteria. You will be able to shortlist the companies in your watch list with these steps and review them at a later time. I’m also adding a link in the tools section for you to download and use if you like.
Good Company Management
Good Company management is the foundation for a great company. If the company management is capable and trustworthy, they will follow through with the growth plans by the company. Thus, increasing the shareholder’s value in the long run.
Look out for the details of the founders and other key persons of the company. Check if the founders and cofounders are still in the company. Qualifications of the people who run the company. The board of directors and it’s chief of different departments.
If the key people have a bad reputation with financial management or other fraud cases. The chances of the company being led in the wrong direction are very high.
Profitable Companies
Check and make sure that the company is making money. This May is not applicable if you are an investor in high growth companies. For someone who is a little more conservative, look out for only profitable Companies. If the company you are interested in is still not making profits, wait for them to turn profitable. By doing so, you may not be able to get in at the cheapest levels. But, you reduce some risk exposure of a company failing to scale up.
The more profits the company makes, they can put more money into the company for future growth. And not dilute the shareholder value and also not take unnecessary debt. Profits can be also distributed as a dividend if the company is saturated in growth. Profits also can be used to acquire more companies and diversify into other business ventures.
Revenue, Income And Free Cash Flow
Lookout and make sure that the company’s revenue is increasing year over year. This is to make sure that the company is in the prime position to grow and reach out to more customers. Another key matrix to look at is the income generated from the total revenue received. Income is the amount that’s left after paying the cost of revenue, paying tax and other expenses. Make sure that the company management focuses on cutting costs. And not increasing expenses as the revenues increase. Make sure that there are enough cash flows to sustain.
An increase in these amounts will also tell you that the company and its products are not in a sunset industry. There are many sectors that will go out of business in the future. If you look closely at the top 10 companies in the S&P index 30 years ago vs now, you will see a significant difference. 30 years down the line from now, you may also see totally different companies and sectors dominating.
Low Debt In Balance Sheets
As debt is bad for us individuals. Too much debt that is not manageable is a threat to companies sustainability. Debt is something that may not be unavoidable for companies that are growing rapidly. The more debt that the company takes up, remember that there is a cost of debt. This is usually paid in interest or as coupons.
Having lots of debt can also affect badly when the interest rates are high. Currently, we are facing high inflation and government plans to curb inflation by raising interest rates. So, if you have a choice, choose companies with less or manageable debt. If there is too much debt; the chances of the company can become significantly high.
Recent examples of Chinese real estate giants are some examples of companies with too much debt. These include companies like Evergrand who defaulted on bond payments.
Assets > Liabilities
Always ensure that the company has more assets than liabilities. This is to make sure that in the event of any forced liquidation, you may get back a part of your shares. If the company sells its assets and pay back its debtors and shareholders.
This is also called the current ratio which can be seen as the ratio of current assets and current liabilities. The more the assets and the little the liabilities the better. While it’s impossible to find companies with no liabilities, look for the ones with fewer.
Short Term Debt < Cash And Cash Equivalents
Ensure that the short term debt is lesser than its cash and cash equivalents. This is to make sure that the company has enough runway to pay for the short term financial needs. Companies will have a huge problem when they miss on short term payments due.
Defaulting on payments can affect the company’s credit score and it will impact the share price and ability to raise money in the future. This is why it’s important to pay closer attention to these numbers.
Sometimes companies park their extra money on investments that can be liquidated in a short span of time. These are usually on money market instruments or on other assets that can be converted to money real quick.
Great Business Models
Make sure that the company you invest in has a great business model. Definition for a great business model also changes over time. These are companies in the digital economy that can make money without having to spend a lot of money on capital expenditures. Companies with high-profit margins and fewer competitors.
While most companies without a proper business model fail at youth. Some of the bad business models are only revealed at a much later stage. If the company can pivot to a better model in a short time, there are chances of survival and turnaround stories. Otherwise, you may be playing with fire. While monopoly may be bad for the customers, this is good for the company profits.
Durable Moat
Check if the company has a great platform and also a durable moat. These will help the company to fend off its competitors and make it very hard to replicate. Make sure that the company has a superior product from the other market offerings. The better the best.
Companies like Apple are an example of a great companies. It’s time tested and the company has a huge fan base. They have the necessary pricing power too. Google is another company with a great moat and has a huge pie of the entire search and advertising market.
Companies with durable moats also tend to have great products that customers really love to use. They also recommend these products to friends and family and bring in more customers.
Dividends
Yup investors who are in the game for the constant cash flow may want to pay closer attention to this point. Dividends are profit shares that are distributed to the shareholders. These can be once a year or with other frequencies that the company management feels suitable.
If you want short term cash flow, you may want to fill your portfolio with companies that pay dividends and increase dividends over time. This is a sign of the increased ability of the company to make money.
Ability To Grow And Scale
Look out for the company’s ability to grow and scale. Typically these plans will be outlined in the company’s communication to the stakeholders. Some business models cannot be scaled due to poor design or the nature of business.
When we say scaling, it’s the process of increasing manufacturing/customers and revenue. When there is more revenue, the profits and profits margin will also increase. Software and services companies are easier to scale. When compared to let’s say a grocery chain that operates physical supermarkets.
Promising Industries
There are many industries that are blooming and others are sun setting. Blooming industries are the technology and innovation companies. Also, companies that move in the trajectory of the future needs of customers. Since I choose to invest in technology companies, AI, ML, IOT, Robotics and Cloud computing are some of the key trends in this industry.
This doesn’t mean that companies outside of information technology are not promising. This simply means that this is my focus. Space tourism, gene editing are some other areas where I see some promising returns in the many years to come.
Asset lite Companies
I like companies with less physical assets, that’s companies that do not need a factory and machinery to make products. The more dependent on these items, the capital expenditure and cost to set up a business increases too. Companies need to spend a lot of money in these areas. Petroleum companies and car manufacturing are some examples of asset-heavy companies.
Software companies are generally asset lite companies as they do not need lots of capital to set up. In the past, companies were required to buy servers and other equipment to host the applications and infrastructure. With the help of cloud computing and shared hosting services, companies can start up on this infrastructure without paying a heavy sum of money upfront. These platforms generally offer pay per use models.
Company’s Financial Ratios
Another key aspect that I look into is the financial ratios of the company. This needs to be in a separate post. I will continue about the financial ratios in the next post.
Conclusion
The above mentioned may not be an exhaustive list of due diligence you can perform when analysing a company. These are the top priority for my own framework. You may already be looking at these and other checks too. Let me know in the comments what other methods you use to analyse companies.