Which Parameters Should Be Looked at While Selecting Stocks?

Summary

• Investing could be quite complex for new investors, and they shall emphasise on basic fundamental investment approaches while starting investments, especially when they have a lot of options.
• Selecting stocks for your portfolio will require reading and analysis of the businesses, including business models, management, products and services, revenue, profits, and price of an investment.
• It is important to stick with the process at times of distress and panic, and constantly learn from mistakes while enhancing investment process over time.

Let’s start with business models.

Business models

Valuations are required to test the fair value and cost of the investment, but the business model assessment is perhaps the primary step investors start with. It is important to ascertain how the company makes profits and how it generates revenue.

Understanding the business model is imperative to assess the quality of business, which is often reflected by market position, competitive advantages, among several other factors. Results of past capital allocation decisions also exhibit the quality of management.

Analysing asset base of the business, including products and services, is crucial to test the sustainability of its quality, access value accretive opportunities in the future, and ascertain value of tangible assets.

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Over time, good businesses continue to grow assets, which also result in the superior quality of business, competitive advantages, scale, bargaining power, production experience, profits, etc. But business models are also susceptible to disruptions that could well prove to impact going concerns in some cases.

Disrupting business models is perhaps the favourite hobby of say game changers, innovators and likeminded people. For instance, entry of the lowest cost alternative in a product market can force many small players to shut shops.

Short story, the business model study will give answers to the questions on the sustainability of the business at current state over a period of time.

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Capital allocation

Capital allocation decisions of a firm make or break the outlook, but they also closely depend on capital structure and business model. Specifically, in growing businesses, it is favourable to accurately project capital needs of the business and manage liquidity.

Large businesses have already invested a fair amount of capital in becoming a large business, while small/growth enterprises need to stress on long-term value creation through investments and generating a maximum return.

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Efficient capital allocation decisions by firms are a precursor for a sustainable business. Even in large businesses, capital applications must be monitored and tested, as some could trigger structural changes, for instance, large-scale mergers that failed to realise the expected outcome.

Management’s track record of previous years becomes imperative to ascertain the quality of decisions, performance as well as shortcomings. Since business environment continues to evolve, firms also make sure adequate investments are undertaken to ensure competency.

By stages, assessment of capital allocation decisions of mid-sized companies remains crucial since the challenge of growing business from a mid-size entity to a large-size entity is perhaps more extensive and time taking.

Market participants and analysts continue assessing capital utilisation of firms and price those adjustments to fair value, but there always remains an execution risk in terms of operational capabilities of firms or leadership. For instance, a merged entity failed to deliver expected outcomes or synergies.

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Management quality

Great investors also pay attention to people who run the company and their track record over the past. Leadership and their ambitions are very important components of a successful organisation, especially for small businesses.

An investor is more interested in the performance of the business and people who are driving such results. Conducting background checks of the leadership and Board, which may include historical results, behaviour, education, family, ownership, etc., will enable to gain further insights.

Checking pending court proceedings against the company and how management have incurred any potential financial losses are equally important. Whether it is how they had treated their employees when business performance surpassed expectations, such answers will reflect the behaviour of the leadership.

As Boards seek a perfect match for their strategy and senior executives continue to jump ships, investors monitor these transitions of the leadership within companies, and sometimes even competitors scan incoming person and approach, which are very important when a business intends to pick up pieces with a new boss.

There have been many incidents in history when new leaders have sailed new heights with the enterprise, but some fell short of recognition. Moreover, it is essential to actively monitor the instincts, accountability, ambitions, and results of the leadership.

Must Read: 5 Traits of a Good Management Team

Numbers, indicators and valuations

Investors need to recognise what they are paying in investments since the cost will impact the propensity of potential returns. Financial performance and balance sheet resilience of the business are important considerations for investors.

Arriving at a fair value of business comes at a later stage after the business fits into the approach of any investor. Revenues, costs, investments, and profits are analysed across business conditions to evaluate business performance.

Mainstream standards like Return on Invested Capital (ROIC) are widely used parameters along with EBITDA, EBIT, Return on Equity, free cash flows, debt, asset base, intangible assets and others. Most of the times, it depends on the type of business model that indicates which measures can be appropriate.

ROIC helps to ascertain the capital efficiency of the business, and its pattern over the years may also indicate the decision-making abilities of management. Investors affirm that companies with high ROIC have competitive advantages and management quality.

ROIC allows to evaluate the output of the business, cost of producing output, and check what is driving the business whether it’s product, cost or perhaps both. Moreover, these metrics enable investors to set the expectation from the firm.

Future expectations from the investment play a crucial role in evaluating its fair value since expectations will shape your forecast revenue, profits and cash flows. It again depends on the type of business model that indicates the appropriate valuation.

For instance, investors usually expect large free cash flows from technology companies, and price/earnings multiples-based approach may appear stretched for such a business as well as for a business that has high growth expectations.

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