Down in the dumps. Will it rebound?

Investors often press the sell button as soon as a stock's price starts falling. However, it is always advisable to find the reason behind a falling stock price before acting in a hurry. The following qualitative and quantitative checks are useful to ascertain whether the nature of the fall in a stock price is temporary or permanent.

Track record:
If the company has a good track record of navigating downturns, then it is likely to survive tough times.

Motherson Sumi, an auto-ancillary company, for example, faced a big blow in 2015 when its major client, Volkswagen, was banned from selling diesel cars in the US. Its stock price crashed by more than 35 per cent within two months. However, the company and its stock prices were able to recover quickly.

Return on equity (ROE):
If the company has a consistent track record of generating a return on equity of more than 15 per cent even in tough times, this indicates the strength of its business and its ability to generate consistent profits during downturns.

Free cash flow:
A company generating free cash flow (cash received during the year after paying for capital expenditures and normal working capital requirements) consistently for years has a high likelihood of recovering from a downturn. Free cash flow provides a company with the ability to fund its capital needs using its own funds, even during difficult times. Sun Pharma, for example, has been going through a tough phase for the last three years. Still, it was able to generate free cash flow of more than Rs 2,000 crore in 2018.

Cash flow from operations (CFO):
A company should generate cash flow consistently over a long period. Although it can be volatile at times, there should be a direct relation between CFO and operating income of the company in the long run.

Net debt:
If a company has huge debt or short-term borrowing on its balance sheet, then it can be a big overhang for the company, especially at a time of crisis. The recent downfall of ADAG stocks is a prime example of this.

Market share and tangible product:
If a company commands a very healthy market share, with a recognisable tangible product, investors can stay confident even if the stock price is declining. For instance, the ongoing slowdown in the auto sector has sent Maruti's stock price lower by around 25 per cent in the last one year. However, it still remains a leader in the segment and its cars are still the first choice of many customers.

Corporate governance or pledging:
If a company is not going through any corporate-governance issues, that should be a huge relief for investors. Otherwise, such issues can spell trouble, with the recent cases of IL&FS, Manapasand and 8K Miles being examples. Besides, an investor should also check for pledging and the reason behind it. High pledging can be a huge problem for a falling stock.