Check the cash flow statement first.
· See how much cash the company is generating
· How efficiently the cash is being used.
Then look at the balance sheet
· Apply some basic ratios and find out where the company is and
· The related stock price
Now the income statement
· See how the income is being generated
If the income outstrips the revenue, watch out the income growth will not
sustain in future. ( this happens, when company reduces its SGA, or sells
a part of company, takes lot of tax deduction on tax options, etc
What to look into a company when screening:
Look for a company that is growing (revenue) at 25% or more in last two year - top line
Now where the revenue is coming from
Selling more goods or service
Selling new goods or service
Buying another company
How long the revenue is sustainable?
What are the reasons for future sustainable growth?
How are the competitor doing?
Company that has 15% profit growth can double its profit in 5 years
Look for a company that is generating profit – bottom line
How is the company generating the profit, not so sustainable tricks are
Changing tax rate
Changing share counts
One-time gains and
Rampant cost cutting
Anytime earning growth outstrips sales growth over a long period of time – you need to dig more.
ROA = Net margin x Asset turn over
= Net income/sales x sales/asset
= Net income/asset
Net margin = company can boost its profit by charging high prices (unique or high end products)
Asset turnover = turn over your asset quickly (grocery store – commodity items, dell)
ROE = ROA x financial leverage
= ROA x assets/shareholders equity
= net income/shareholders equity
this measure company’s profitability on shareholders equity.
Be wary of a high financial leverage ratio if a company’s business is cyclical or volatile.
not so for banking industry ( it should have > 12% ROE)
ROE above 40 – there is something wrong here.
Free cash flow = cash flow from operations – capital spending
Capital spending = building new facilities etc.. (minimum required to sustain the business)
Well establish companies do have pile of cash and they are generating more.
e.g. Pfizer, Microsoft -- very safe investments but less growth
Where as companies like Lowe’s, Cheesecake Factory, Southwest Airline has high
ROE but less cash flow, as they are still expanding.
A company with fixed cost can flourish in good time, but get the same reverse effect in bad time.
Debt/Equity = Generally debt should not be more than equity.
Debt/Equity <.05 is good
Times Interest Earned: How many multiples of interest payment a company earned.
(EBIT- Earning before interest expense and tax)