What are the Factors to be Considered Before Investing in a Company?

When we purchases shares in a company, it is important to seriously consider the question, "What are the Factors to be Considered Before Investing in a Company?", as such an introspection will surely be useful to buy stocks and results in the best share buy.

Step 1: Knowledge

First and foremost is to learn investing. Without sound investing knowledge people may face unnecessary pitfalls and may get disheartened early in their investing careers. Warren Buffett says “Risk comes from not knowing what we are doing”. Therefore, please read the book “Intelligent Investor - The Investors' Bible” by Benjamin Graham. You may also learn investing for FREE at my blog, Value Investing.

Step 2: identification and Shortlisting of companies for detailed scrutiny

Using a stock filter, “Kotak Securities” which appear as follows:

Using two parameters ‘market cap’, which shall be between 1000-99999 crores and ‘PE Ratio’ between 1 and 10, filter all the stock. It should yield about 20-30 stocks for further study.

Step 3: Analyze the company’s past performance as far as once can go but bare minimum of five years and recommended at least 10 years, under various heads as follows:

Profitability Ratios: 

These include margins or profits under the various ‘Gross Profit’, ‘Earnings Before Depreciation, Interest, Tax and Appropriations (EBDITA)’, ‘Earnings Before Tax (EBT)’, ‘Profit Before Tax (PBT)’ and ‘Profit After Tax (PAT)’. All these various ratios evaluate the profitability of the operations of the company or organization.

EBT, which reflects the operating profits before tax, is the most important profitability ratio. All the companies I have listed in the educational ‘Portfolio Y2K15’ have had healthy EBT of 25 to 50% when they were selected for investment.

Liquidity Ratios: 

Liquidity ratios assess the ability of the organization to meet its short term liabilities, maturing within one year, like trades payable or sundry creditors, outstanding expenses, etc. out of current assets like inventory, customer receivables, cash and bank balances. Even though the operations may be profitable, unless the organization ploughs back adequate amount of profits into current assets, the organization will become sick. ‘Current’ and ‘Quick’ ratios are usually used.

Selected companies must have a current ratio of not less than 2 and quick ratio not less than 1. 

Solvency Ratios: 

Solvency ratios measure the ability of the corporation to meet the long-term commitments. This is measured by comparing the long-term debts with the net worth (equity capital and reserves). One to one is considered adequate, more the better and lower than one shows weakness.

We should prefer companies that have no debt or very low debt. Such companies will have very low interest burdens and will be able to weather worst economic better than others.

Efficiency Ratios: 

These evaluate how efficiently various assets are turned around in the business. Inventory and receivables ratios measure how many these are rotated during the year and obtained by dividing annual sales turnover by amount of inventory and receivables.

Similarly, ‘Fixed Assets Turnover Ratio’ is obtained by dividing sales by value of fixed assets. More the turnover number better is the efficiency.

Cash flows: The cash flow statement describes how cash is generated and how it is used, judging the judiciousness of cash, the most valuable resource.

The company should clearly demonstrate that it has been generating healthy and positive operating cash flows in the last 10 to 15 years.

Dividend Track Record:

Dividends are the wages of investors. A company shall certainly qualify under this parameter and should have had an un-interrupted dividend paying record as far as possible but of at least of 15 years.

The company should not be stingy in distributing dividends. Private companies are generally miserly, only distributing about 12-15% of the net profits as dividends, whereas government/ public sectors companies in India are bound by an internal directive to distribute a minimum 30% of the net profits as dividends.

The dividend yield shall also be reasonable and shall be at least around 4-5%.

Step 4: Ranking the qualifying companies

The companies that have passed the stringent qualification tests as described above are ranked under two parameters company performance and market condition. The parameters under each of these two broad categories are as follows:

Sl. No.	Company Performance	Market Condition
1	EBT %	PE Ratio
2	CAGR in EPS	Price to Book Value Ratio
3	CAGR in Book Value Per Share	Dividend Yield
4	Percentage of net profits distributed as dividend	Distance from 52 Week Low (shorter the distance better it is)
5	Number of times recurring non-operating income covers the average dividend pay out.	Returns measured by increase in stock price. This return is preferred to be negative and as high a negative return as possible.

 Conclusion:

In order to answer the question, "What are the Factors to be Considered Before Investing in a Company?, it goes without saying that the various profitability, liquidity, solvency, and market conditions described above need to be carefully analysed. Such an analysis will be useful to buy stocks right and will result in the best share buy.