How to select a stock for investment - Cheatsheet

Articles > Submitted by DynamicInvestor on 5/14/2020 | Views: 681

In this post, I am going to simplify stock investing with the help of a cheatsheet. This cheatsheet contains 21 checklists that we can use to easily select good companies for investment. I would also explain how and where to get the references of those checklists.

Table of Contents

    Here is the cheatsheet containing 21 checklists and all these checklists are explained below with the reference of Screener.in website screenshots (Thanks to Pratyush Mittal, the owner of the website for allowing this).

    How to select a stock for investing - cheatsheet

    Cheatsheet - How to select a stock for investments.

    Company Ratios highlighted that are explained below.

    Picture 1 - Screenshots of LTTS taken from screener.in on May-14-2020

    1. Debt to equity

    Debt to Equity ratio tells us how much of total funds are brought by shareholders and how much are borrowed from lenders. D/E of 1 means 50% of funds are of shareholders and remaining are borrowed. Ideally this should be 0 however at least < 0.5.

    Lesser value is better.

    2. ROCE

    % return on capital employed. Return on capital should be greater than Cost Of Capital to generate meaningful returns as a business in long run for stakeholders. The ideal value should be > 20%.

    Greater value is better.

    3. P/E ratio

    Price to Earnings ratio. Different sectors has different standards of P/E ratio. However, lower the ratio, the better is margin of safety. Many great companies are almost impossible to find at lower PE ratio. When these rare opportunity comes, one should buy after validating the checklists. < 10 is a steal if all checklists points are good however we can go up to 50. 

    If P/E is high, very careful analysis of other checklist points and detailed company analysis are required before investing in that particular stock.

    As said, great businesses are almost impossible to find at low P/E.

    Lesser value is better.

    4. Dividend yields

    Dividend being paid by the company. The ideal dividend yields can be greater or equal to bank fixed deposits rate however growing companies can't pay good dividend otherwise they will not have money to expand and grow. There are companies that takes loan to give dividends, we should avoid buying these companies. Almost every company should pay dividend as apart from price appreciation a normal shareholders doesn't get anything from the company. So > 0% dividend yield is always good.

    Greater value is better.

    5. Interest coverage

    It indicates whether operating profits of the company is sufficient to pay interest on debts or not. It should be greater than 3 at least that shows that in a low time, company will not be struggling to pay even the interest on debts.

    Greater value is better.

    6. Sales growth

    Sales growth of the company should be consistent, very high sales growth is generally not sustainable so anything > 15% is good however > 50% can be one of chance and it is not sustainable at long run. If sales growth is 50% or more, we should dig further into annual report and see why the sales growth is this much and whether it is going to sustain or not.

    Greater value is better.

    7. PEG ratio

    Price Earning to Growth ratio. PEG ratio 1 means the stock price is in equilibrium with its anticipated future earning growth. < 1 is considered undervalued however great companies are hardly available at < 1 PEG.

    Lesser value is better.

    8. Current ratio

    Ratio of current assets of a company to the liability (Current Assets / Current Liability). The current ratio measures company's ability to pay short-term (due within one year) obligations. It should be > 1.25.

    Greater value is better.

    9. Pledged shares %

    % of pledged shares by promoters of the company. Ideally it should be 0% however it is seen that even great companies promoters sometimes pledge 3 to 5% of their shares. However consistent pledging to shares by promoters should be considered as red signal.

    Lesser value is better.

    10. Promoters holdings %

    % total shares held by promoters. The ideal promoters holding % should be > 74% (currently max limit by government authorities is 75%) however anything > 51% can be considered good.

    Greater value is better.

    11. Profitability

    Net profit margin, growing at almost consistent growth rate most of the years. Ideally it should be > 10%, more is better.

    Greater value is better.

    12. Tax payout

    % of net profit paid by the company as tax consistently (should be current corporate tax rate approximately, it is 25% currently). > 24% and few % here and there are good as govt gives some tax incentives to corporate companies.

    13. Cash flow

    Cash from Operating (CFO) Activity of the company. Ideally, CFO should be greater than CFI (Cash from Investing) + CFF (Cash from Financing).

    Picture 2 - Screenshots of LTTS taken from screener.in on May-14-2020

    In above case CFO is greater than CFI+CFF combined for most of the years apart from 2015 and 2016. Consistent positive CFO shows that company is able to expand with its profit earned.

    FCF (Free Cash Flow) is by far biggest driver of shareholder value.

    What is FCF?

    Operating Cashflow that a company generates less the money that it spends on investing in property, plant, equipment and other assets that it acquires. The formula for FCF we have used is “Operating cash flow – (Capex+ Advances for capex) – Investment in subsidiaries & intercorporate deposits”. In plain English, FCF is a true measure of how much money a company makes after paying not just for its expenses but also paying for various assets & equipment.

    FCF is nothing more than ROCE less the cost of capital. Therefore, healthy growth in FCF necessarily implies equally healthy growth in ROCE.

    How to calculate cost of capital?

    Cost of Capital can be calculated by combination of the cost of debt & equity which we call as WACC (Weighted Average Cost of Capital).

    14. CCFO vs CPAT

    Cummulative (sum) of Cash from Operation (CCFO) and cummulative of Profit after Tax (CPAT) of last 10 years should be either equal or CCFO > CPAT.

    Picture 3 - Screenshots of LTTS taken from screener.in on May-14-2020

    Net profit is also called Profit After Tax (PAT)

    In this case, cummulative Proft After Tax (CPAT) is 0+6+315+436+449+489+700 = 2395 and CCFO is 0-14+289+525+402+340+737 = 2279. The difference is of 116 crores that is 4.83% less than CPAT. The conversion rate of CPAT to CCFO is 100-4.83=95.15%. Anything above 90% is good.

    15. Earning Per Share

    Consistent growth in EPS year on year. Refer to Picture 3 for EPS growth numbers.

    Greater value is better.

    16. Market cap to Sales

    Price to Sales ratio, lesser is better. Compare with other companies in the same sector.

    Lesser value is better.

    17. Corporate governance issue

    Any issue about promoters like scam, penalty, regulatory actions, frauds etc. To find any issues, google with scam, penalty, regulatory action along with company name like 'xyz ltd fraud, xyz ltd scam'. Ideally there should not be any corporate governance issue with the company.

    18. Reliable promoters

    Generally foreign promoters or Multi national companies are good to invest however Indian corporate groups like HDFC, Bajaj, L&T and others are also good to invest in.

    19. Related Party Transactions

    This is the most common things that companies tend to do to inflate their performance which can include sales, leases, service agreements and loan agreements with its subsidiaries or other companies owned by the promoters etc. Thus this raises a red flag, higher the related party transaction in proportion to sales, higher the possibility that the company might be involved in cooking its books.

    E.g- Any Unsecured, interest-free loan to a wholly owned subsidiary.

    If Provisions made for receivables as a percentage of debtors are increasing, this shows that the company is not able to convert its sales into profits. In simpler terms, the customers to whom it sold on credit are not paying up. Related party transactions can be verified in the annual report of the company.

    Ensure that these type of transactions are very minimal and within arms length (an arm's length transaction refers to a business deal in which buyers and sellers act independently without one party influencing the other)

    20. Futuristic business / Non Cyclical business

    Company should be in futuristic business models or futuristic products developments. Its business should not get disrupted by changing technologies and innovations. Company must have a supply side excellence or an inherent moat. The business should not be cyclical.

    21. Low equity/capital

    Equity capital of the company. Generally, low equity capital is preferable. 

    Disclaimer: I am not SEBI registered, this post is for educational purpose. Thanks to @chiragdashj for support while preparing this checklist.

    Website disclaimer: The views, opinions, investment advices (if any) expressed by author on Sharefunda.com are their own and not that of the website or its management. Users are advised to contact certified financial advisor before making investment decisions.

    Submitted by DynamicInvestor on Thursday, May 14, 2020

    Be dynamic, change your stance based on the situation. This is the mantra of Investing.

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