Which
factors will determine how much you are willing to pay for a stock?
What makes one company worth 10 times earning
and another worth 20 times?
How can be reasonably sure that you are not overpaying
for an apparently rosy future that turns out to be a murky nightmare?
Benjamin
Graham feels that five elements are crucial. Those are
- The company’
s “general long-term prospects” - The quality
of its management. - It's financial
strength and capital structure - Its dividend
record - It's current
dividend rate.
Lets
have a brief about these factors in the light of today s market.
Firstly
The long –term prospects nowadays, the intelligent investor should get the previous five years Annual reports of the
company in which one wants to invest.
To
determine whether a company is an Other People’s Money (OPM) addict, read the
“Statement of Cash Flows” in the financial statements. The Cashflow Statement
of the company will segregate the cash inflows and outflows into “investing
activities” and “financing activities” if
cash from operating activities is consistently negative, while cash from
financing activities is consistently positive, the company has a habit of more
cash than its own businesses can produce-and you should not join the “enablers”
of that habitual abuse.
In
2002, Procter& Gamble spent about 4%of its net sales on R&D, While 3M
spent 6.5% and Johnson &Johnson 10.9%.In the long run, a company that
spends nothing on R&D is liable to higher penalties, either by convention or sale to that
spends too much on R&D.
Now
lets think about The quality and conduct of management A company’s executives should say what they
will do, and do what they said. Read the past annual reports to see what
forecasts the managers made earlier and if they fulfilled their words or fell
short. Managers should straightforwardly admit their failures and take
responsibility for the circumstances caused due to their negligence, rather
than blaming “the economy “uncertainty,” or “week demand.” Check whether the
tone and substance of the chairman’s letter stay constant.
The
investors are the owners of the company and the management will run the company
these two people’s interest should be the same to make the company profitable. These
questions will help you determine whether the management who run the company
will act in the interests of the people who are the owners of the company:
If a
company reprices (or “reissues” or “exchanges”) its stock options for insiders, stay
away. In this scenario, a company cancels existing (and typically worthless)
stock options for employees and executives, then replace them with new ones at
advantageous prices. If their value is never allowed to go to zero, while their
potential profit is always infinite, how can options encourage good maintenance
of corporate assets? Any established company that reprices option – as dozens
of high-tech Companies have –is a disgrace. And any investor who buys stock in such
a company is a sheep begging to be shear.
Government,
shows whether a Companies senior executives and directors have been buying or
selling shares. There can be lawful reasons for an insider to sell
diversification, a bigger house a divorce settlement but repeated big sales are
a bright red flag. A manager can’t legally be your partner if he keeps selling
while you’re buying. To regulate insider trading in stock markets SEBI has
Introduced the SEBI (Prohibition of Insider trading) Regulations 2015. These
regulations will restrict the trading of persons who are in possession of Price sensitive Information.
Executives
should spend most of their time in managing their company in private, not
promoting it to the investing public. All too often, CEOs complain that stock
is undervalued no matter how high it goes – forgetting Graham’s insistence that
managers should try to keep the stock price from going either too low or too
high. Meanwhile, all too many chief financial officers give “earnings
guidance,” or guesstimate of the company’s quarterly profits.
Finally,
ask whether the company’s accounting practices are designed to make its financial
results transparent and True and fair view. if “nonrecurring” charges keep
recurring “extraordinary” items appear so often that they seem ordinary, acronyms
like EBITDA take priority over net income, you may be looking at a Company that
still not in a position of looking over or planning according to the long term
interests of the shareholders.
The
next thing we have to discuss is Financial
strength and capital structure. The most basic possible definition of a
good business is this: it generates more cash than it consumes. Good managers
keep finding ways of putting that cash to productive use. In the long run , companies that meet this definition are
virtually certain to grow in value, no matter what the stock market does.
Whether the stock market index going too high or too low the profits and
prospects of the company should keep on growing.
In the
Annual Report of the company Start reading the financial statements with the
statement of cash flows. See whether cash from operation has grown progressively
throughout the past 10 years. Then you can go further. Warren buffett has popularized the concept of owner
earnings, or
Net income
+ Amortization
and depreciation,
- Minus normal capital expenditures.
“if
you owned 100% of this business, what will you think about the business at the
end of the day? The answer will be the amount earned by the business at the end
of the day” Because it adjusts for accounting entries like amortization and
depreciation these entries do not affect the company’s cash balances, this is
why the owner earnings will be a better approach for measurement than reported
net income in the financial statements of the company. To perfect the
definition of owner earnings, you should also subtract from reported net income.
- Any costs of granting stock options, which
divert earnings away from existing shareholders into the hands of new inside
owners. - Any “unusual,” “nonrecurring,” or
“extraordinary” charges - Any “income” from the company’s pension fund.
Because the above are not generated from the company
operations, hence not considered as the income of the company for the purpose
to calculation of owners earnings.
If
owner earnings per share have grown at a stable average of at least 6% or 7 %
over the past 10 years, the company is a generating a regular cash flows from
its operation, also its prospects for growth are good and the company can be
suitable for long term investment.
Next,
look at the company’s capital structure. Turn of the balance sheet to see how
much debit (including preferred stock )the company has; in general, long-term
debt should be under 50% of total capital including its reserves. In the
footnotes to the financial statements, determine whether the long-term debt is
fixed-rate with constant interest payments or variable with payments that
fluctuate, which could become costly if interest rates rise.
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