Financial indicators to gauge a company’s underlying health

WITH MARKET valuations having fallen drastically, many investors seem to be rummaging for value picks. But they must remember, all that glitters is not gold. An investor must have the skill to spot the good stocks from the bad ones. ETIG thought it a good idea to lay down the basic framework so that investors can zero in on the right stocks. Investors can consider certain financial indicators to gauge the underlying health of a company, which may not be adequately represented by its stock price.

BUSINESS MODEL:

One of the basic features of a stock is the business model of the company, which makes it a defensive or aggressive bet. A growth stock is likely to perform very well in a bull run, while a defensive bet may pay off in a bearish market. When buying stocks of commodity-based businesses, an investor should be aware of the specific commodity cycle and hence, the consequent cyclicity in the company’s earnings.

POSITIVE OPERATING CASH FLOW:

The net cash that a business generates through its operations, as reflected in the company’s cash flow statement, is also a critical feature. It is important for a company to have a positive cash flow from its operations. A company can report net profit in its profit & loss account without generating a positive cash flow from the socalled ‘profitable’ growth. Another parameter to be considered is free cash flow, i.e. the cash left with the company after capital expenditure (capex). Any company may have negative operating cash flow (OCF) for one or two years, but a good company with a sustainable business model cannot have a history of negative OCFs. Similarly, a well-managed company should not have negative free cash flow for many years in a row.

RELATIVE VALUATIONS:

The price-to-earnings (P/E) multiple of a company cannot be an important indicator by itself, unless it is considered in comparison with the P/E multiples of other companies in the same sector, or against the company’s own historical P/E, or against the market’s P/E.

DEBT-EQUITY RATIO:

This is a critical tool to measure a company’s leverage. A low debt-equity ratio is generally preferred, but is not always necessary. Companies in capital-intensive sectors like infrastructure, real estate, cement, steel and oil & gas typically have high debt-equity ratios, while those in sectors like FMCG, IT and pharmaceuticals generally have low debt-equity ratios.

The phase of a company’s growth is also an important factor to be considered. A company in a growth phase may, at times, choose to leverage itself more than ideally required, against a company that has an established business. Higher debt increases the finance costs, which can be costlier to service in a high interest rate regime. Conversely, raising money through equity can be difficult during a bear phase.

INTEREST COVERAGE RATIO:

The company’s ability to service its debt is another important criterion to judge its health. The lower the interest coverage ratio, the more difficult it is for the company to service its debt. Investors should consider the debt-equity and interest coverage ratios simultaneously. Suppose a company has high debtequity ratio, but it also has high interest coverage, then it is in a good position to service its debt.

PRICE-TO-BOOK VALUE (P/BV):

This ratio of the stock’s market value to book value helps in knowing its relative under or over-valuation. A lower P/BV multiple typically indicates that the stock is under-valued, but this may not always be the case. Again, this ratio varies from industry to industry. A capital-intensive industry will typically have a lower P/BV multiple. Banks generally use this ratio, because unlike manufacturing companies, they measure their assets at market value. Since book value takes into account only tangible assets and liabilities, this ratio may not be useful for companies holding a significant intellectual property, or an FMCG company with many brands.

RETURN ON CAPITAL EMPLOYED (RoCE) & RETURN ON NET WORTH (RoNW):

For a company, RoCE and RoNW should be significantly higher than the prevailing interest rate. If a company’s RoCE is consistently lower than say 15%, that is not a healthy sign and it indicates an economically inefficient operation. However, any good company may report lower RoCE or RoNW during an economic downturn or high investment phase. So it’s always helpful to compare RoCE or RoNW on a historical basis. But it doesn’t make sense to compare RoCE of two companies in two different sectors. It’s best to compare it with peers in the same or related industries.

DIVIDENDS:

A company which consistently pays dividends implies it’s rewarding its shareholders. Preference should always be given to a company with higher dividend yield. Higher the yield, more is the investor’s return on his/her investment. However, long-term investors should be wary of companies which dole out dividends at the cost of growth. It is also important to compare growth in dividend to growth in profit. A corresponding growth in dividend and profit indicates that the business model is sustainable and the company is confident of its cash flows. It also signals the management/promoter’s willingness to share the growth with the company’s shareholders.

MANAGEMENT OR PROMOTERS’ CREDIBILITY:

Last, but not the least, while fishing for a good stock, investors must also scrutinise the promoter’s credibility. A corrupt and fly-by-night management can inflict greater damage on a company than any other factor. This explains why companies owned by reputed and well-regarded business houses are widely sought-after on the bourses.