Six parameters to look for in a company before investing

Say you want to invest in a company. If you are an experienced investor, then you know how to proceed. But what if you are a budding investor? Or someone who wishes to know the parameters to look for before deciding whether to invest? What do you do?

First, you start by gaining an understanding of the company. This is not just about knowing what products and services the company offers. You need to understand the company's business segments, how it manufactures its products and how it markets them, who are its customers, how the company makes money and many more such things. If you find that you are unable to answer such questions, then move on to another company. Stick to companies that you can understand.

Second, understand the industry the company operates in. This would involve figuring out whether it is cyclical (i.e., moves in relation to the health of the economy), how many competitors the company has, what is the competitive intensity, is the competition purely on price, what are the operational differences between the company and its peers, etc. Here are the factors to analyse the competitive environment of a business.

Third, start looking at the numbers in detail. You should know how to interpret the financial statement. If you can't do this, then you shouldn't invest in equity on your own. However, if you have the required skillset, then start by conducting some financial reporting quality checks. This helps you avoid crooked companies. An example metric is cash flow from operations divided by EBITDA (earnings before interest, tax, depreciation and amortisation). This tells you whether operating profits are getting converted into cash. The higher the ratio, the better.

Once you have ascertained that the company is not crooked, then you can begin with a financial analysis. This entails delving deep into the financial statements of the company. Here you would calculate various ratios to get a grip on the company's performance. For instance, the asset turnover ratio tells you how much the company sweats its assets to generate revenue. Needless to say, you are performing all these analyses in comparison to the company's peers.

Just like you don't judge a book by its cover, you shouldn't judge the company's financials only by the condensed financial statements. Don't skip the notes to the accounts section. A lot gets revealed by reading the fine print. However, if you can't understand what is going on, then move on to another company.

So far, most of the analysis has been done to understand how the company has performed/evolved. But your investment will bear fruit if the company performs well in the future.

Fourth, management quality and growth strategies need to be evaluated. Is the company managed by the promoter or is there a professional management team in place? Does the promoter have interests outside of the company in question? What kind of related-party transactions is taking place? How well does the CEO allocate capital? How does the company treat the minority shareholders? Is there a formidable succession plan? These are the kind of questions that you'll need to answer to evaluate the management and/or promoter.

Fifth, you need to consider how the company plans to grow in the future. Is the company going to continue with its current segments or diversify into adjacent segments? Or, is it going to enter a completely new business? How will these strategies be funded? What's the profitability going to be like? Questions along these lines will help you figure out the growth strategies.

Sixth is valuation. You need to find (approximately) how much return will you make by investing in the company at the current price. If the number is above your minimum required return, then you should invest. If not, then keep the company on your watch list. Know how to assess stock valuations.

Finally, keep in mind that, all these analyses are not performed one by one. Every factor interacts with each other. Moreover, these factors and financial metrics can change with different sectors. Seems like a lot of work, doesn't it?

There is another option. And in this way, you get all fun and no work. You can subscribe to our stock advisory service at Value Research. We perform all the above analyses and more for our subscribers. By subscribing, you will get a ready list of companies that you can invest in for long-term wealth creation.

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