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Part 3. Fundamental Analysis: Judging the Business

Fundamental analysis asks one question: is this a good business, and is the price sensible for what it is? Everything in this part is a way of answering it from published numbers, without meeting the management or visiting the factory.

3.1 The Core Idea: The Shop, Not the Price Tag

Suppose a shop earns ten lakh rupees a year, has no debt, and is offered to you for fifty lakh. You are paying five years of earnings. Now suppose an identical shop on the same street is offered for two crore. You are paying twenty years of earnings for the same ten lakh.

Neither number is right or wrong by itself. The question is what you believe happens next. If the second shop is about to open three branches and triple its earnings, twenty years of today’s profit may be cheap. If it is going to earn the same ten lakh forever, it is expensive. Every valuation argument you will ever read is a version of this.

3.2 The Three Statements, In Plain Language

Every listed company publishes three statements each quarter. Beginners are told to read them and are rarely told what each one is for. Here is the short version.

The profit and loss statement, from top to bottom

Read it as a waterfall. Revenue at the top, and each line takes a bite until what is left at the bottom belongs to shareholders.

Two lines deserve attention. Operating profit, often called EBITDA, is what the business itself produced before the effects of borrowing and accounting. Net profit is what is left after the lenders and the government have been paid. A company can have a healthy operating profit and almost no net profit, and the entire difference will be interest. That is a company being run for its lenders rather than its owners.

The balance sheet, which must always balance

On one side sits everything the company owns: factories, stock, money owed to it by customers, cash in the bank. On the other sits how all of that was paid for: money borrowed from lenders, and money belonging to shareholders. The two sides are equal by construction, which is where the name comes from.

• Assets are what it owns. Watch the receivables line, which is money customers owe but have not paid. When it grows much faster than sales, the company is selling to people who are not paying.
• Liabilities are what it owes. Separate short term borrowings, which must be repaid within a year, from long term ones. A company with large short term debt and little cash is one bad quarter from a crisis.
• Equity is what remains for shareholders if everything were sold and every debt paid. It grows every year that profits are retained rather than paid out.

The cash flow statement, the one that is hard to fake

Profit is calculated. Cash is counted. A sale becomes profit the moment the invoice is raised, even if the customer never pays. Cash flow from operations only counts money that actually arrived.

3.3 The Ratios That Matter, and What Each Really Says

Price to Earnings: how many years of profit you are paying

The P/E ratio is the share price divided by the earnings per share. A P/E of 25 means you are paying twenty five rupees for every one rupee of annual profit, or twenty five years of current earnings.

A high P/E is not automatically expensive and a low one is not automatically cheap. A high P/E says the market expects strong growth; if that growth arrives, the shares can still do well. A low P/E often says the market expects trouble, and frequently the market is right. The cheapest looking companies on any Indian screen are usually cheap for a reason.

Return on Equity and Return on Capital Employed

ROE answers: for every hundred rupees of shareholders’ money in this business, how many rupees of profit does it produce each year? An ROE of eighteen percent means eighteen rupees. It is the closest thing to a report card on management.

ROCE asks the same question of all the capital in the business, borrowed money included. The difference between the two is where the useful information hides.

Debt to Equity: how much of the business belongs to lenders

This is total borrowings divided by shareholders’ equity. A ratio of 0.5 means fifty paise borrowed for every rupee of owners’ money. Under 0.5 is comfortable for most industries, over 1 needs a reason, and over 2 needs a very good reason.

The exception is banks and finance companies, whose entire business is borrowing at one rate and lending at a higher one. Their debt to equity is enormous by design, and judging them by this ratio is meaningless. For lenders, look at Net Interest Margin and at gross non performing assets instead.

Operating profit margin, and why the trend beats the level

Operating margin is operating profit divided by revenue. A margin of twenty two percent means twenty two paise of every rupee of sales survives the cost of running the business.

The level tells you what kind of business it is. Software and branded consumer goods run high margins because the product costs little to reproduce. Trading and construction run thin ones because they mostly move other people’s goods. Comparing across those is pointless.

The trend, however, is genuinely informative. Margins expanding for several years usually means the company has pricing power, meaning it can raise prices without losing customers. Margins contracting usually means competition has arrived or raw material costs are winning. Over five years, a company whose sales grow ten percent while margins expand is compounding far faster than the sales line alone suggests.

Cash conversion: profit on paper versus money in the bank

Divide cash flow from operations by operating profit, and average it over three or four years. Consistently above eighty percent means profits become money. Consistently below fifty percent means they do not, and you should want to know why before you invest.

The other numbers worth knowing

3.4 Reading the Annual Report Without Reading All of It

An annual report runs to three hundred pages and almost none of it needs reading in full. Five sections carry most of the information.

1. The auditor’s report. Look for the word "qualified" or any emphasis of matter. An unqualified opinion is normal. Anything else is the auditor saying, in the only language they are permitted, that something is not right.

2. Related party transactions. This lists business done with entities the promoters control. Large or growing amounts here deserve a very sceptical read. Money leaving a listed company for a promoter owned private one is the classic mechanism by which minority shareholders are quietly diluted.

3. Contingent liabilities. Debts that are not on the balance sheet yet, such as disputed tax demands and guarantees given for other companies. If this figure is large against equity, it is a real risk hiding in a footnote.

4. The management discussion. Compare this year’s promises against last year’s. A management that explains what went wrong and what they changed is worth more than one that reissues the same optimism annually.

5. The shareholding pattern. Covered next, and the single fastest quality check available to a retail investor.

Promoter holding and promoter pledging

Promoter holding is the percentage of the company owned by the founding family or group. Rising or steady promoter holding means the people who know the business best are keeping their money in it. Falling promoter holding over several quarters is worth investigating, though it is not always negative, since founders do have legitimate personal reasons to sell.

Promoter pledging is different, and it is one of the most useful warning signs available to a small investor. It means the promoter has borrowed money personally and given company shares as collateral. If the share price falls far enough, the lender sells those shares into the open market, which pushes the price down further, which triggers more selling.

3.5 What Multibaggers Tend To Have In Common

Nobody can identify these in advance with certainty. But the companies that multiplied ten times in India over the last two decades share a small number of features often enough to be worth knowing.

A moat that widens as the business grows

A moat is whatever stops a competitor with money from taking the customers. A trusted brand people pay more for. A distribution network reaching six lakh villages that would take a decade to rebuild. A regulatory licence. Switching costs that make leaving painful, which is why banks and enterprise software keep customers who complain constantly and never leave.

A long runway

A company with two percent of a huge and growing market can compound for twenty years. A company with sixty percent of a small and static one has already won and has nowhere left to go. Ask how big the opportunity is, not just how good the company is.

Profits growing faster than sales

If sales grow fifteen percent and profits grow twenty five percent, the business is becoming more efficient as it scales. Sustained over a decade, that gap is the difference between a good return and an extraordinary one.

A clean balance sheet

Almost every long term compounder went through at least one brutal downturn. Low debt is what allowed them to survive it and buy assets cheaply from competitors who could not.

Management that does what it said it would

Read three consecutive annual reports before buying. It costs an evening. A management that met its stated plans three years running has told you something no ratio can.

3.6 The Red Flag Checklist

None of these alone proves anything. Two or three together in the same company is a reason to move on and find another idea. There is no shortage of companies.

© Vipin Nair. This guide is for reading online only. Copying, downloading, printing and redistribution are not permitted. For study and general reference; not legal, tax or investment advice.