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….

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43 Responses to “Stock Shastra #3: You just need to look at 6 Financial Parameters to shortlist a wonderful company!”

  1. Hi,
    You have not told about PE ratio. it is a important parameter without doubt.

  2. sanjoychatterjee Reply 19. May, 2010 at 2:52 pm

    good i,hv learned a lot, ur efoort is good, tell some stock name,which small investor can earn.

  3. It is good but please let me know that how a small invester can find these details and where.

    • One option could be to calculate it on your own, which could be a bit difficult. The other option, as mentioned in the Stock Shastra, is to log on to MoneyWorks4me.com where you will get a 10 YEAR X-RAY with these parameters for more than 1500 companies.

  4. Team_MoneyWorks4me Reply 20. May, 2010 at 7:20 am

    Thanks a lot Sanjoy. The Company Shastra in the newsletter, gives you information about some very good companies. However, you will have to invest in them at the right price.

  5. Team_MoneyWorks4me Reply 20. May, 2010 at 7:25 am

    Yes, Anuj. PE ratio is a important ratio but from a valuation perspective. A company with a low or high PE does not necessarily mean that it is a great company. For more on this read http://bit.ly/98D1Rp.

  6. Sir,
    Thank U for U R 5 benchmarks for investment. Sir, kindly explain these 5 things with an relistic company financial figures example.
    kindly, mail U R answer to sachin_glowing@rediffmail.com.

  7. how to calculate the BVPS and ROIC of stock from the balance sheet/financials of the company?

    • BVPS is calculated as Book value/No of shares. Book value is equal to shareholders fund. It can be found in the balance sheet under the heading ‘Shareholders fund’. Number of shares can be found in Schedule 1 under the heading ‘Share Capital’.

      ROIC is calculated as Earnings before interest and depreciation/ Total capital. To read more on this click http://bit.ly/cJtpxa .

  8. from where can we get the net profit debt ratio?

  9. your explanation on bookvalue per share and the debt-to-netprofit ratio is simpler and more understandable than the usual things I have read.

  10. Would you be able to provide this data even for a company which got listed in the last 2-3 yrs? 

  11. very simple and great.
    pl update me on my email id- sudhir_crystal@rediffmail.com

  12. wonderful

  13. your website is fantastic

  14. what does ROIC and BVPS mean? and how to check that?

  15. any site where these all funda. parameter filter & we get stock list?

  16. I am investing in Unitech currently at 20 per share market price. Pls. let me know this is a good bet.

  17. Excellent basic information for the young investors.Worth reading and implementing..

  18. DEAR SIR
    I AM NEW IN THIS FIELD I WNAT TO KNOW PER MONTH LUMSUMP HOW MUCH AMOUNT I HAVE TO INVEST FOR GOOD RETURN WITHIN 10 YEARS

    • Alam, a good return does not depend on how much you invest. It will depend on what and when you invest. No hard feelings, but at this point, the best thing for you to do would be to invest in educating yourself about the stock market. Take courses, read books, go to seminars. That will give you a better return than blind investing.

  19. how cane be Certain about the Financial Data provided by Company? They could release false data to increase hype in the market…i would love to know your thoughts on this…Thank You for this Article!

    • Sir,
      How to know whether Financial Statements are made up to a certain extent.
      Thanks,
      Virgil Williams

  20. Very good

Trackbacks/Pingbacks

  1. Nikhil Kale - 19. May, 2010

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  2. Stock Shastra - 20. May, 2010

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  3. MoneyWorks4me - 20. May, 2010

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  4. anand mulgund - 20. May, 2010

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  8. MoneyWorks4me - 30. Jul, 2010

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