Parameters to check when selecting stocks to buy

For you to best invest your money in stocks, there are parameters that you must check when analyzing the stocks.

Here we take a look at factors that you should check, when doing financial analysis, valuation analysis, business & industry analysis & management analysis.

Financial analysis

• Sales growth – Growth should be consistent year on year. A growth of >15% for say last 7-10 years. Ignore companies where sudden spurt in sales in one year is compounding the 10 years performance. Very high growth rates of >50% are unsuitable.
• Profitability – Look for companies with sustained operating & net profit margins over the years. A Net profit margin >8%
• Tax Payout – Tax rate should be near general corporate tax rate unless some specific tax incentives are applicable to the company.  Tax payout of >30%
• Debt to Equity Ratio – Look for companies with D/E ratio of as low as possible. Preferably zero debt.  D/E ratio should be <0.5
• Interest Coverage should be >3
• Current ratio >1.25
• Cash Flow – Positive CFO is necessary, CFO >0
• Cumulative PAT vs. CFO – Cumulative PAT & CFO should be similar for last 10 years i.e. cPAT∼cCFO

Valuation analysis

• Ensure P/E ratio <10, companies with such a P/E ratio provide a good margin of safety.
• P/E to Growth ratio <1
• Earnings Yield (EY) >10 year G-sec yield – EY should be greater than long-term government bond yields or bank fixed deposit interest rates.
• P/B ratio <1 especially for financial services sector
• Price to sales ratio (P/S ratio) <1.5 – For example you can buy when the P/S ratio is <1.5 and sell if >3
• Dividend Yield (DY) >0% The higher the better. DY of > 5% is very attractive. But do not put much focus on DY for companies that are in a fast growth phase.

Business & Industry analysis

• Comparison with industry peers – The company should show sales growth higher than peers. If its sales growth is similar to peers, then there is no competitive advantage.
• Increase in production capacity and sales volume – Company mush have shown increased market penetration by selling higher volumes of its product/service.
• Conversion of sales growth into profits – A more competitive firm would show increased profits with increasing sales. Otherwise, sales growth would  only be a result of unnecessary expansion or aggressive marketing push, which can erode value in the long-term.
• Conversions of profits into cash – if cPAT>>cCFO then either the profits could be fictitious or the company isn’t collecting money from its sales.
• Creation of value of shareholders from the profits retained – The company should show increase in Market Capitalization in the last 10 years. Increase in retained profits in the last 10 years. Otherwise the company is destroying the wealth of its shareholders.

Management analysis

Subjective parameters

• Background check of promoters & directors – You can do a web search on this. There shouldn’t be any information questioning the integrity of promoters & directors.
• Management succession plans – Good succession plan should be in place. Salaries being paid to potential successors should be in line with their experience.

Related: Key Principles to investing in a stock

Objective parameters

• Salary of promoters vs. net profits – No salary increase with declining profits/losses. The promoters should not have a history of seeking increase in remuneration when the profits of the company declined in the past.
• Consistent increase in dividend payments – Dividends should be increasing with increasing profits of the company.
• Project execution skills – The company should have shown good project execution skills with cost and time overruns. Exclude capacity increase by mergers & acquisitions.
• Promoter shareholding should be >51% the higher the better.
• Promoter buying the shares – if the promoter of the company buys its shares, investors should buy too.
• FII shareholding ∼0% the lower the better.

Other parameters

• Product diversification – Company should be either a pure play ( only one business segment) or related products. Pure play model ensures that the management is specialized in what they are doing.  Refrain from buying into companies offering entirely different unrelated products/services. An investor should rather buy stocks of different companies, if he/she wants diversification.
• Government Influence – There should be no government interference in profit-making. No cap on profit returns or pricing of product. No compulsion to supply to certain clients.

The Bottom line

If you diligently follow these parameters by investing in stocks that promise good fundamentals, and doesn’t spend so much on them then you can be assured of good returns from your investments over time. However, the above parameters aren’t the complete list of what should look for when picking stocks. You should read further about investment analysis and you can add or even remove some of the above parameters per your understanding.