What One Should Look For In A Company When Evaluating a Business?

When I invest in a business, what points to consider? Of course, the stock should pass my investment checklist and fundamental analysis before getting into these business details.

So without much ado and in no particular order, let me share what I look into a stock for investment:

Debt to Equity Ratio

Most of the companies that collapse often have the reason for debt and so it is one of the most important factors to consider when investing. Ideally, I prefer the debt-equity ratio to be under 0.25 but if it is higher, I see if the loan and interest have the coverage to be paid off easily in the near future.

Sector Leadership or Market Share

Once I am considering any stock for investment, I prefer it to be the market leader. Often small-cap companies may not be market leaders in the broader sense, but being a market leader in the niche segment is a must.

If a company isn’t the market leader, it needs a significant market share of its products for sure.

Operating History

You need to have few hiccups and often failure under your belt to know what will work and what won’t. Being in the business for long enough will make the management more efficient in the core business and more knowledgeable about its operations.

Management Pedigree

When the business isn’t doing good, how well the management is transparent to its minority shareholder. What steps management is taking to bring the business right on track.

As a side note, when the business isn’t doing good, there will be huge price erosion in the stock market and so is management willing to invest in their own stock?

Loss Making Subsidiary

A company shouldn’t be loss-making in its operation for sure but if you want to consider a subsidiary company, it shouldn’t be loss-making either. If it is, how much of impact it has on the overall business and if there is anything management is doing to turn things around in the subsidiary company.

Tata steel was planning to offload its UK business was the reason for me to consider it in my portfolio.

Entry Barriers

Are there any entry barriers for a business? I always prefer a business that can’t be started by any tom dick or harry.

There can be various types of entry barriers and it need not be the product based entry barrier only. Some business has entry barriers of time which mean, anyone if wants to start doing the same thing as other company, will need few years down the line to set up the distribution and retail channels to disrupt the existing business.

Capex

I don’t like a business that demands incremental capital to grow. Often such business is assumed to have entry barriers but actually aren’t. Sectors like infrastructure or power sector where if one has a setup will deliver returns. But it can’t be made to deliver 2x or 10x volume. Do not misjudge it as entry barrier because the entry barrier isn’t capex in nature but is more specific to the business and its operation.

Sustainability of Growth

I prefer to invest in a high growth business. Yes, temporary growth issues are fine but management should be capable enough to fix the growth issue in the long-run.

The important aspect to consider growth is for an elongated period of time. The high growth for a quarter or year doesn’t interest me if I don’t see the growth sustainability.

I don’t believe in turn-around

I am not a fan of investing in the turn around stories and avoid them totally. If a company has been in distress, often people want to be investing with the assumption that that turn-around is around the corner.

Turn-arounds are too rare to focus on. There is a difference between a turnaround and investing in a business that has problems. Turn-arounds are for companies that are on the verge of bankruptcy.

In the Unusual billionaires, you will find there was a turn-around in Astral Poly and it is a classic turn around case but I prefer to avoid such turn-around stories.

If a business has an issue in the short-term and if it can be fixed in the longer-term, I prefer investing in it if I am convinced the management has the experience and the expertise in the business but still it shouldn’t mean the business has reached a point of bankruptcy for sure.

Size of the Company

I like to invest in small cap companies knowing fairly well the risk and the price volatility. Once you know what you are doing in the market, it is all good.

I prefer a market leader and still a small company that makes my task tough and often means, I may need to narrow down the segment where a small company can be a market leader. When the focus isn’t too much on capex heavy business, one can always find a small cap company as a market leader in a niche business.

Government Regulations

I don’t invest in PSU and I don’t even consider sectors where I see too much of Government regulations.

This is one of the reasons for me to avoid Real Estate as a sector in 2017 because there are too many regulations being introduced to my liking. I know these regulations are needed for builders taking undue advantage but it is better to be a customer than an investor in such a sector.

Cash Flow

Sales growth is important but more important is cash flow from sales growth because if companies are setting up too many distributors, it may sound like there is huge sales growth for the company but actually the company is just pushing its products to the distributors without actually making sales.

So it is important to understand the growth in sales via the cash flow of the company and not only by the sales number.

PE Ratio

The last but an important factor to investing is at what multiple of the earnings is the price too much?

Investing in companies at 50 or 60 PE won’t be very fruitful because much of the growth of the company is already in the price. When the market falls, the high PE stocks will have a steep fall and if you can’t handle such volatility, avoid them. Even if you are fine with the volatility, have only a small percentage of your portfolio in such high PE stocks.

Over to You

Do you consider any of the above points? Did I miss anything you want to add to the list? What points do you consider the most when investing in a stock?

Share your thoughts in comments.