Stock Shastra #3: You just need to look at 6 Financial Parameters to shortlist a wonderful company!
We said in Stock Shastra #2 that a wonderful business worth investing in has 3 important characteristics: An Excellent Financial Track Record, A Sustainable Moat and Respectable Management. The first one – An Excellent Financial Track record – is a Go/No-go criterion and hence is critical. It will prevent you from investing in the wrong companies and losing money.
So, what comes to your mind when we talk about company financials?
A big, fat, 100-page Annual Report with reams of data that leave most of us confused! It seems too difficult, too complex, needing too much time – which you don’t have! However, truth is always simple. Let us now see a simple and powerful lens through which we can identify companies with an Excellent Financial Track record. The answer is Stock Shastra #3: You just need to look at 6 Financial Parameters to shortlist a wonderful company!
From all the 100+ parameters, all you need are just 5 of them! Earnings per share (EPS); Net operating cash flow; Net Sales; Book Value per share (BVPS); Return on Invested Capital (ROIC); and, Debt-to-Net Profit ratio. Seen together and over 10 years these 6 reveal the truth. Let’s see how!
The truth-revealing 6 Financial parameters
What is the first thing that you will look for in a company before investing? You will check whether it is making Profits, consistently! Since we will be shareholders, we need to look at the profit it earns per share. Hence the first parameter to look for is EPS – Earnings per Share.
However, it is said ‘Cash is king’. Hence, to verify that profits earned by the company are leading to an inflow of cash, you have to look at the second parameter that is, operating cash flows. Net Operating cash flow is the actual cash generated by a company from its business. If a company cannot generate adequate operating cash flow, it may need to rely on outside funding to meet its financial obligations and even to run the day-to-day operations
Now, how can a company continue to earn profits year after year? By selling more and more every year. Hence, the third parameter to look for is Net Sales.
To increase its sales in the long run, a company will need to expand its capacity. Book Value per Share, BVPS tells us how much a company is investing in expanding its capacity. That’s the fourth parameter.
Companies in the most basic sense are money-using and money-making machines. How do we rate a machine? Simple, we look at what it produces in relation to what it uses i.e. efficiency. Companies produce profits using the capital invested (both equity and debt). Hence to know the efficiency with which a company uses its capital, we need to look at Return on Invested Capital (ROIC). That’s the fifth parameter
Finally, if a company borrows money, it should be able to repay it without serious difficulty over a reasonable period of time. Debt-to-Net Profit ratio tells us the number of years in which the company will be able to repay the debt. Hence the sixth parameter to look for is its Debt-to-Net Profit Ratio.
Apart from these, you can also look at the company’s past performance with regards to its profit margins (OPM & NPM), Return on Equity (ROE), Debt/Equity ratio and the working capital management. These will help you guage the profitability and efficiency of the company.
How can you be absolutely sure if a company’s financial track record is great or not?
We have checked over 1500 companies and arrived at a gold standard that only the best meet: A company that has been growing its EPS, Net Sales and BVPS by 12%+ year-on-year; has a ROIC of over 12% every year; and can pay off its debt in less than 3 years i.e. a Debt-to-Net Profit ratio of 3 or less – has a great Financial Track Record. Companies meeting this gold standard are wonderful companies worth short listing.
Such companies are quite likely to have a moat – a sustainable competitive advantage, which has allowed it to post great numbers. So, now you know how important these 6 parameters are!
We are sure your next question now is ‘Where do I get these 6 Financial Parameters, without wasting any time?’ It was ours too earlier. So we searched high and low and found that it was not available anywhere. And, we chose the road less travelled – we decided to make it available These crucial 6 parameters, over 10 years are now available as a simple and powerful 10 YEAR X-RAY at MoneyWorks4me.com
Write to us for any clarifications. We will be glad to be of help
The next Stock Shastra will outline the importance of sustainable competitive advantage, i.e. moat, for any business. See you soon with Stock Shastra #4….