Stock Analysis | Learn to analyse a stock in-

depth

Learning stock analysis can be a daunting task for newbie investors. Heres a complete
step by step, do-it-yourself template for conducting in-depth stock analysis

Contents1.Analysing a Company- stock analysis basics, step-by-step

2.Growth1.Sources of Growth

2.Quality of Growth

3.Profitability1.Return on Assets (ROA)

2.Return on Equity (ROE)

3.Free Cash Flow

4.Profitability Matrix

5.Return on Invested Capital (ROIC)

4.Financial Health1.Financial Leverage

2.Debt to Equity

3.Interest Coverage

4.Current Ratio

5.Quick Ratio

5.The Bear Case

6.The Management1.Character
Analysing a Company- stock analysis basics, step-by-step

Learning to do an in-depth stock analysis is not rocket science. Here's a step-by-step

process that can be followed by any beginner stock enthusiast.

Pat Dorsey, Director of Stock Analysis, Morningstar Inc. in his very useful book -The
Five Rules for Successful Stock Investing - suggests breaking down the process of
evaluating the quality of a company into five areas -Growth, Profitability, Financial
Health, Risks/Bear Case, and Management. These are the key areas to focus on when
you are looking to do a stock analysis. His writings are the primary source for this
article.

One word of caution, the following discussion is concerned only with evaluating the
quality of the company. However, this is only half the story because even the best
companies are poor investments if purchased at too high a price. Estimating the right
price to pay for a company's shares- or Stock Valuation is the other half of the story.

Growth

Anyone looking to do a stock analysis for a company is probably attracted to it because

of its Growth. The allure of growth has probably led more investors into temptation than
anything else. High growth rates are heady stuff - a company that manages to increase
its earnings at 30% for five years will triple its profits, and who wouldn't want to do that?
Unfortunately a slew of academic research shows that strong earnings growth is not
very persistent over a series of years; in other words a track record of high growth
earnings growth does not necessarily lead to high earnings growth in the future.

Why is this? Because strong and rapidly growing profits attract intense competition.
Companies that are growing fast and piling up profits soon find other companies trying
to get a piece of the action for themselves.
You can't just look at a series of past growth rates and assume they'll predict the future -
if investing were that easy, money managers would be paid much less!. And this stock
analysis much shorter. Its critical to investigate the sources of a companys growth rate
and assess the quality of the growth. High-quality growth that comes from selling more
goods and entering new markets is more sustainable than low-quality growth that's
generated by merely cost-cutting or accounting tricks.

Sources of Growth

Investigating the sources of growth is an important element in any stock analysis

framework. How to look for sources of growth? In the long run, sales growth drives
earnings growth. Although profit growth can out pace sales growth for a while if the
company is able to do an excellent job of cutting costs or fiddling with the financial
statements, this kind of situation isn't sustainable over the long haul - there's a limit to
how much costs can be cut, and there are only so many financial tricks that companies
can use to boost the bottomline. In general, sales growth stems from one of four
areas:1. Selling more goods or services2. Raising prices3. Selling new goods or
services4. Buying another company

Quality of Growth

There are many ways of making growth look better than it really is, especially when we
turn our attention to earnings growth rather than sales growth. (Sales growth is much
more difficult to fake).

In general, when you are doing a stock analysis - any time that earnings growth
outstrips sales growth by far, over a long period - for over 5-10 years - you need to dig
into the numbers to see how the company keeps squeezing out more profits from
lackluster sales growth. Stock analysis for sustainability of that growth becomes that
much more critical. A big difference in the growth rate of net income and operating
income or Cash flow from Operations can also hint at something unsustainable.
Any time you can't pinpoint the sources of a company's growth rate - or the reasons for
a sharp divergence between the top and bottom lines, you should be wary of the quality
of that growth rate.

Profitability

Now we come to the second-and in many ways, most crucial-part of the stock analysis
process. How much profit is the company generating relative to the amount of money
invested in the business? This is the real key to separating great companies form
average ones. The higher the return, the more attractive the business.

Return on Assets (ROA)

We know the first component of ROA. Its simply Net Margin, or Net Income divided by
Sales. And it tells us how much of each dollar of sales a company keeps as earnings,
after paying all the costs of doing business. The second component is Asset Turnover,
or Sales divided by Assets, which tells us roughly how efficient the firm is at generating
revenue from each dollar/rupee of Assets.

Multiply these two, and we have Return on Assets. Net Income/Sales =Net Margin and
Sales/Assets =Asset Turnover

ROA = Net Margin x Asset Turnover

Think of ROA as a measure of efficiency. Companies with high ROAs are better at
translating Assets into Profits. ROA helps us understand that there are two routes to
excellent operational profitability. You can charge high prices for your products (high
margins) or you can turn over your assets quickly.

Rough benchmarks for stock analysis - ROA

All things being equal, the more asset-intensive a business, the more money must be
reinvested into it to continue generating earnings. This is a bad thing. If a company has
a ROA of 20%, it means that the company earned $0.20 for each $1 in assets. As a
general rule, anything below 5% is very asset-heavy [manufacturing, railroads], anything
above 20% is asset-light [advertising firms, software companies].

Return on Equity (ROE)

Just using ROA would be fine, if all companies were big piles of Assets, but many firms
are atleast partially financed with debt, which gives their returns a leverage component,
which we need to take into account. ROE lets us do this.

Return on Equity is a great overall measure of a company's profitability because it

measures the efficiency with which a company uses shareholders' equity. Think of it as
measuring profits per dollar of shareholders' capital.

Multiply ROA by the firms Financial Leverage ratio, and you have its Return on Equity.

Financial Leverage =Assets/Shareholders' Equity and Return on Equity =Return on

Assets x Financial Leverage. Because Return on Equity =Net Margin x Asset Turnover

ROE = Net Margin x Asset Turnover x Financial Leverage

Financial Leverage is essentially a measure of how much debt a company carries,

relative to shareholders' equity. Unlike Net Margins & Asset Turnover, for which higher
ratios are almost unequivocally better, financial leverage is something you want to
watch carefully. As with any kind of debt, a judicious amount can boost returns, but too
much can lead to disaster.
So, we have three levers that can boost ROE - net margins, asset turnover and financial
leverage.

Rough benchmarks for stock analysis - ROE

In general, any non-financial firm that can generate consistent ROEs above 15 percent
without excessive leverage is atleast worth investigating. As of mid 2008, only about
10% of the non-financial firms in ValuePickr database were able to post an ROE above
15% for each of the past 5 years, so you can see how tough it is to post this kind of
performance. And if you can find a company with consistent ROEs over 30%, there's a
good chance you are really onto something.

Two Caveats when using ROE for stock analysis

First, Banks always have enormous financial leverage ratios, so don't be scared off by a
leverage ratio that looks high relative to a non-bank. Additionally, since banks' leverage
is always so high, you want to raise the bar for financial firms - look for consistent ROEs
above 18% or so.

Second caveat is about firms with ROEs that look to good to be true, because they are
usually just that. ROEs above 50% or so are often meaningless because they have
probably been distorted by the firm's financial structure. Firms that have been recently
spun off from parent firms, companies that have bought back much of their shares, and
companies that have taken massive charges of ten have very skewed ROEs because
their Equity base is depressed. When you see an ROE over 50%, check to see if the
company has any of these above-mentioned characteristics.

Free Cash Flow

Cash Flow from Operations measures how much cash a company generates. It is the
true touchstone of corporate value creation because it shows how much cash a
company is generating from year to year. As useful as the Cash Flow statement is, it
does not take into account the money that a firm has to spend on maintaining and
expanding its business. To do this, we need to subtract Capital Expenditures, which is
money used to buy fixed assets.

Free Cash Flow =Cash Flow from Operations - Capital Expenditure

Free Cash Flow enables us to separate out businesses that are net users of Capital -
ones that spend more than they take in- from businesses that are net producers of
Capital, because its only that excess cash that really belongs to shareholders. Free
Cash Flow is sometimes referred to as "Owners Earnings" because that's exactly what it
is: the amount of money the owner of a company could withdraw from the treasury
without harming the company's ongoing business.

Rough benchmarks for stock analysis - Free Cash Flow

As with ROE its tough to generalise how much free cash flow is enough. However its
reasonable to say that any firm that is able to convert more than 10% of Sales to Free
Cash Flow (just divide Free Cash Flow by Sales to get this percentage) is doing a solid
job at generating excess Cash.

Profitability Matrix

One good way to think about the returns a company is generating is to use the
Profitability Matrix, which looks at a company's ROE relative to the amount of free cash
flow it's generating. This Matrix can tell us a great deal about the kind of company we
are analysing.
Companies such as Microsoft, Pfizer, and First Data Ltd all have consistently high
ROEs. People write books about how to manage a business as well as these
companies do, and its easy to see why - they are all money machines.

If you follow these companies at all, you'll notice that they have another thing in
common besides high ROEs -their stocks all had valuations that were very high during
the bull market of the 1990s. Again its easy to see why. A company that can earn a high
return on its shareholders money is worth more to those same shareholders.
Looking at the other axis, we see that these companies are also very good at
generating free cash flow. Pfizer for example, generated more than $8 billion in free
cash flow in 2002. That's $8 billion Pfizer made after spending whatever it needed to
invest in the business.

On the bottom half of the matrix we have companies like Amazon.com, Jet Blue,
Comcast and Lowe's which generate low or negative free cash flow. Companies like
these aren't generating much free cash because they are using all the cash their
businesses generate -and then some- to invest in expansion. They are investing heavily
because they hope that these expansion efforts will pay off in the form of fat profits in
the future.

Jet Blue and Amazon are like young entrepreneurs. They have taken out loans and and
maxed out their credit cards, and they are ploughing every cent that they have into
building and expanding the business. Folks are investing in their business because they
expect these businesses to be very profitable sometime in the future. Asian Paints on
the other hand is more like a successful middle-aged businessman. He's already proven
he can earn a good return on shareholders money, so folks line up outside his door to
for the privilege of investing in his ventures.

You would be taking a lot less risk investing with the older businessman than you would
with the young entrepreneur -though that entrepreneur might just pay you back many,
many times over. Just remember that for every Jeff Bozos or Steve Jobs, there are
literally hundreds of entrepreneurs who never paid their investors a dime. There's
nothing wrong with investing in the entrepreneurs of the world, as long as you know
what you are getting into. A profitability matrix can help you separate your long shots
from your core holdings.

Return on Invested Capital (ROIC)

Return on Invested Capital is a sophisticated way of stock analysis for return on Capital
that adjusts for some peculiarities of ROA and ROE. Its worth knowing how to interpret it
because its overall a better measure of profitability than ROA and ROE. Essentially
ROIC improves on ROA and ROE because it puts debt and equity financing on an equal
footing. It removes the debt related distortion that can make highly leveraged
companies look very profitable when using ROE. It also uses a different definition of
Profits than ROE and ROA, both of which use Net Profits. ROIC uses Operating Profits
after taxes, but before interest expenses.

Again, the goal is to remove any effects caused by a company's financing decisions
-does it use debt or equity?- so that we can focus as closely as possible on the
profitability of the core business.

The true operating performance of a firm is best measured by ROIC, which measures
the return on all capital invested in the firm regardless of the source of the capital. The
formula for ROIC is deceptively simple

ROIC = Net Operating Profit after Taxes (NOPAT)/Invested Capital

Invested Capital =Total Assets - Non-Interest bearing Current Liabilities - Free Cash
Flow

(Non-interest bearing current liabilities usually are Accounts Payable and other Current
Assets)

You may also want to subtract Goodwill, if its a large percentage of Assets.

What does all this mean to you if you hear someone talking about ROIC? Simply that
you should interpret ROIC just as you would ROA and ROE - a higher Return on
Invested Capital is preferable to a lower one!

Rough benchmarks for stock analysis - ROIC

In general, any non-financial firm that can generate consistent ROICs above 15 percent
is atleast worth investigating. As of mid 2008, only about 10% of the non-financial firms
in SPH database were able to post an ROIC above 15% for each of the past 5 years, so
you can see how tough it is to post this kind of performance. And if you can find a
company with consistent ROICs over 30%, there's a good chance you are really onto
something.

Financial Health

Once we have figured out how fast (and why) a company has grown and how profitable
it is, we need to look at its financial health. Even the most beautiful home needs a solid
foundation, after all. Financial Health is the 3rd element in our stock analysis framework.

The bottom line about financial health is that when a company increases its debt, it
increases its fixed cost as a percentage of total costs. In years when business is good,
a company with high fixed costs can still be extremely profitable because once those
costs are covered, any additional sales the company makes fall straight to the bottom
line. When business is bad, however, the fixed costs of debt push earnings even lower.

For illustration, check out the volatility in Earnings for a fictitious company Acme, below

Financial Leverage
A common measure of leverage is simply the Financial Leverage ratio.

Financial Leverage = Assets/Shareholders' Equity

Think of financial leverage like a Mortgage - a homebuyer who puts Rs. 200,000 down
on a Rs. 1,000,000 house has a financial leverage ratio of 5. For every Rupee in Equity,
the buyer has Rs. 5 in assets.

The same holds true for companies. In 2008, a retailer like Trent has a financial
leverage ratio of 2.1, meaning that for every Rupee in equity, the firm has Rs. 2.1 in total
assets. (It borrowed the other Rs. 1.1.)

Rough benchmarks for stock analysis - Financial Leverage

A financial leverage ratio of 2.1 is fairly conservative, even for a fast growing retailer. Its
when we see ratios of 4, 5 or more that companies start to get really risky.

Debt to Equity

This is just what it sounds like - long-term debt divided by Shareholders' equity. It's a
little like the financial leverage ratio, except that it is more narrowly focused on how
much long-term debt the firm has per Rupee of Equity.

Debt to Equity = Long-Term Debt/Shareholders' Equity

Rough benchmarks for stock analysis - Debt to Equity

The lower the better. Companies with Debt to equity less than 1 are conservatively
financed.

Interest Coverage

Look up pretax earnings, and add back interest expense and taxes (EBIT). Divide EBIT
by interest expense, and you will know how many times (hence the name) the company
could have paid the interest expense on its debt. The more times the company can pay
its interest expense, the less likely that it will run into difficulty if earnings should fall
unexpectedly.

Interest Coverage = Earnings before Interest & Taxes (EBIT)/Interest Expense

Rough benchmarks stock analysis - Interest Coverage

It is tough to say how low this metric can go before you should be concerned -but higher
is definitely better. You want to see higher Interest coverage for a company with a more
volatile business than for a firm in a more stable industry. Be sure to look at the trend in
Interest coverage over time as well. Calculate the ratio for the past 5 years, and you will
be able to see the company is becoming riskier -Interest coverage is falling - or, whether
its financial health is improving.

Current Ratio

The current ratio simply tells you how much liquidity a firm has - in other words, how
much cash it could raise if it absolutely had to pay off its liabilities all at once. A low ratio
means the company may not be able to source enough cash to meet near-term
liabilities, which would force it to seek outside financing or to divert operating income to
pay off those liabilities.

Current Ratio = Current Assets/Current Liabilities

Rough benchmarks for stock analysis - Current Ratio

As a very general rule, a current ratio of 1.5 or more means the firm should be able to
meet operating needs without much trouble.

Unfortunately, some current assets - such as inventories - may be worth less than their
value on the balance sheet. (Imagine trying to sell old PCs or last year's fashions to
generate cash - you would be unlikely to receive anything close to what you paid for
them.)

So there's an even more conservative test of a company's liquidity, the Quick Ratio.

Quick Ratio

Current assets less inventories, divided by liabilities equals Quick Ratio.

Quick Ratio = (Current assets - Inventories)/Liabilities

This ratio is especially useful for manufacturing firms and for retailers because both of
these types of firms tend to have a lot of their cash tied up in inventories.

Rough benchmarks for stock analysis - Quick Ratio

In general, a quick ratio higher than 1.0 puts a company in fine shape, but always look
to other firms in the same industry to be sure.
The Bear Case

After assessing growth, profitability, and financial health, your next task is to look at the
bear case for the stock you are analysing. Creating the Bear Case is the 4th element of
our stock analysis framework.

Start by

1. Listing all of the potential negatives, from the most obvious to the least likely

2. What could go wrong with your investment thesis?

3. Why might someone prefer to be a seller of the stock than a buyer?

Constructing a convincing bear case is especially important for those who like to buy
high-quality companies that have hit temporary speed bumps, because what looks like a
speed bump may very well be a roadblock on closer inspection.

Equally important, your bear case will be a great reference point even if you do decide
to buy the stock. You'll know in advance what signs of trouble to watch for, which will
help you make better decisions when bad news comes down the pike in the future.
Having already investigated the negatives, you will have the confidence to hang on to
the stock during a temporary rough patch as well as the savvy to know when the rough
patch might really be a serious turn for the worse.

The Management

Excellent Management can make the difference between a mediocre business and an
outstanding one, and poor management can run even a great business into the ground.
Your goal is to find management teams that think like shareholders - executives that
treat the business as if they owned a piece of it, rather than as hired hands. Evaluating
Management is the fifth and final element of our stock analysis framework.

People buy stocks all the time without checking out the folks in the executive suite.
There are many ways to get a feel for the folks running a company that have nothing to
do with looking the CEO in the eye.

The Management assessment process can be broken down into 3 parts:

Compensation

First and foremost, how much does management pay itself? Usually, it is preferable to
see

* Big bonuses to big base salaries

* Restricted stock grants to generous option packages.

Bonuses mean that a good portion of the pay is at least theoretically at risk, and
restricted stock means the executive loses money if the share price declines.

* CEO packages not more than 40x-50x that of average employee

* Look at competing firms to see what their CEOs are paid

* CEO pay tied to firms operational performance

In general the larger the firm and the better its financial performance, the more an
executive should be paid. The bottom-line is Executive pay should rise and fall based
on the performance of the company. After reviewing the company's historical financials,
read the past few years' proxies to see whether this has truly been the case.

Some other Red Flags

* Does Management hog most of the stock options granted in a year, or do rank-and-file
employees share in the wealth?

* Does Management use stock options excessively?

* If a founder or large owner still around, does he also get a big stock option grant each
year?

* Do Executives have substantial holdings in the company, or they tend to sell shares
right after they exercise options?

Character

Compensation by itself is a often a good litmus test for character - anecdotally, there's a
pretty strong relationship between management teams that are in it for the money and
management teams that treat shareholders poorly. However, there are some other
important questions to ask to get a handle on whether a firm's management deserves
your trust.

* Does Management use its position to enrich Friends & Relatives?

* Is the Board of Directors stacked with Management's family members?

* Is Management candid about its mistakes?

* How promotional is Management?

* Can the CEO retain high-quality talent?

* Does Management make tough decisions that hurt results but give a more honest
picture of the company?
Running the Business

In addition to management who are paid reasonably and are honest, you also want folks
who can run the business well.

Performance

The first stop is simply the financial performance of the company during the tenure of
the current management team. Look for high and increasing ROEs and ROAs dont
forget to check whether increasing ROE was driven by higher leverage as opposed to
improved margins or asset efficiency.

Are there big jumps in revenue? If so, probably they did an acquisition. Was that
reasonably priced and proved value accretive subsequently?

Finally look at stock analysis for its share count over a long period of time. If that has
increased substantially because of aggressive options programs or frequent equity
issuance, the firm is essentially giving away part of your stake without asking you.
That's not a great recipe for long term share performance.

Follow-Through

When Management identifies a problem and promises a solution, does it actually

implement the plan, or does it hope you forget about it? Same goes for any new
strategic initiatives announced. One way to vet this is to look at past annual reports and
see what new strategic initiatives were discussed 3-7 years ago. Where are they now?
Or, have the initiatives just disappeared from the radar screen?
Candour

Does the firm provide enough information to properly analyse the business, or does it
clam up about certain issues? Its entirely proper for firms not to report certain things, but
selective reticence about problem areas is never a good sign.

Self-Confidence

Firms that do something markedly different from their peers or from conventional
opinion, is to be generally applauded. Maintaining research and development spending
during an industry downturn is another good example of self-confidence that shows
management is more concerned with beating competitors over the long haul than
beating quarterly earnings guidance.

Flexibility

Has management made decisions that will give the firm flexibility in the future? These
include simple decisions such as not taking on too much debt to more strategic
decisions such as issuing equity when the stock is high, retiring high-rate debt when the
opportunity presents itself and buying back stock only when the price is low are also
good examples of sound capital allocation decisions giving evidence of a strong
operational hand on the tiller.