Wednesday, September 06, 2006

Five Steps to Follow Before Buying a Stock

When analysing company, one should do both a qualitative and quantitative analysis of the company before deciding whether to buy its stock. Here are the things to consider:

A. Qualitative Analysis

1. Market Environment - An ideal company is competing in a market that is growing. This allows the company to participate in sales growth without necessarily having to take away market share from its competitors. Furthermore, in the same way that a rising tide lifts all boats, so a rapidly expanding market is a boon to most companies in the market.

2. Competitive Dynamics - A rapidly growing market is ideal, but a company will have much greater success if it is able to create a competitive environment where it is able to maintain its profits and fend off competitive threats from its suppliers, buyers, substitute products and potential competitors, in addition to dealing with its existing rivals. A favourable competitive environment, coupled with a favourable market environment, often give a company a high chance of success. For more on this, click here.

3. Internal Capabilities - In many ways, a company's own resources, strengths and capabilities help to shape its competitive environment. Companies with strong capabilities in areas such as branding, product development, research & development and human resources can often create very strong barriers to entry in their industry, as well as dimishing supplier and buyer power. The quality of management often plays a big role in determining a company's capabilities, so understanding the key officers of a company can be crucial to analysing a company's prospects.

For an in-depth example of a qualitative analysis of a company, peruse Blackmores - A Strategic Analysis

B. Quantitative Analysis

4. Financial Statement Analysis - This involves breaking down the various components of the balance sheet, income statement, and cash flow statement to determine the various characteristics of the business. Various ratios can be calculated to determine financial strength, asset utilisation, profitability, and the quality of the projects the company is pursuing. These ratios include debt/equity ratio, return on assets ratio, return on equity ratio, asset turnover ratio, and gross and net profit margin ratios. A comparative analysis of a company's ratios with others in the same industry can help to identify who are the market leaders and who are the market laggers.

5. Investment Valuation - Valuation involves using various valuation technologies to decide on how much a stock is worth. These tools include, the dividend discount model, the discounted cash flow models, residual income model and abnormal earnings growth model, amongst others. When valuing a company, one has to bring together the analysis in the preceding four steps to project the future revenues, costs, cash flows and other financial numbers, before inputting these numbers into the valuation tool to arrive at the intrinsic value of the company.

Making the Decision

After one has gone through steps 1-5, the investor compares his valuation of the company with the market price. If the market price is above the intrinsic value, the investor does not purchase the stock. On the other hand, if the market price is significantly below the intrinsic value, then it may be an opportunity to buy the stock. For example, suppose one decides that the intrinsic value of a company is $1 per share, and the market is trading at $0.70 per share, this represents a 30% margin of safety, and looks like an attractive buy. In general, I look for at least a 25% discount to intrinsic value.

Valuation in Practice

Analysing a stock often involves making many subjective judgment calls about the market, the competition and the company. Even after making these subjective judgments, one has to translate this analysis into numbers, which can also involve many estimates and educated guesses. By insisting on a strong margin of safety, one can err on the side of caution, and avoid the cost of expensive mistakes that investing can often bring.

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