Important Parameters for Stock Selection in Investing

Important Parameters for Stock Selection in Investing :

1. Sector/Business : Businesses which have natural demand, monopoly or some form of competitive advantage normally provide superior returns to shareholders in the longer run. Businesses like food products, alcohol, condoms, paint, pharma etc. fall in the above categories. Capital intensive businesses like energy, telecom, defense, steel, mining etc. generate relatively lower returns in their business and so shareholders value increases at a slower rate in such business.

2. Promoters: Shareholding of promoter greater than 51% in the business shows the interest of promoter as well as it helps in proper implementation of business decisions due to majority ownership. Avoid companies where promoters have pledged substantial part of their stake to raise funds. Integrity on the part of promoters is very important and any corporate governance-related issues shall be a red flag.

3. Returns : Average nominal GDP growth rate of India was around 12% for the past 5 years. A return on capital in excess of that can be considered as a good return. Return on Capital Employed (ROCE) helps an investor understand what is the level of profitability with respect to total capital employed in the business. Return on equity and return on assets are also important ratios to asses the efficiency of the business with respect to owners fund and assets deployed respectively. The higher these ratios the better.

4. Valuation : Price-earnings ratio (P/E) and price to sales (P/S) ratio are important ratios to assess valuation that is being paid to purchase the business. There is no hard and fast rule for P/E ratio as well as P/S ratio but lower the better. Normally it is advisable to invest in companies with P/E ratio lower than 20 and Price to Sales less than 1.50. Some companies may have high P/E ratio and/or high P/S ratio which indicates that market is commanding higher pricing due to actual high growth rate or expected high growth rate of the business. If the company fails to deliver high rate of growth as anticipated then investor might have a very low return or negative returns too on the investment.

5. Expansion of Activity : Sales and profit are main drivers of shareholders wealth creation. Expansion/addition to fixed assets normally results in increased sales and profits thereby leading to higher share prices. Companies which carry out expansion from internal accrual of existing business instead of using debt or equity dilution are better. If majority of expansion is funded by debt then interest expense reduces the profit as well as cashflow is impacted due to repayment of borrowed fund via periodical installments. Companies which are functioning at maximum capacity utilization and do not carry out expansion have less scope of superior shareholder wealth creation.

6. Operating Profit Margins : OPM is derived when direct expenses are reduced from total sales. OPM in excess of 10-12% is considered to be good. Higher the OPM the better. In business environment lot of factors keep on changing in real-time which affects the margin of the business. If a company has higher OPM it will be able to withstand and sustain adversity due to change in business environment. Regulatory changes, demand-supply changes , currency fluctuations, commodity cycles, change in rate of interest etc. are some of the changes that can affect a business.

7. Debt/Borrowing : Debt is normally procurred when business is expecting that it will be able to generate return in excess of cost of debt. Debt is procurred either to obtain fixed assets or to meet working capital needs.From an Investors perspective, Debt to equity ratio upto 2 is considered to be safe. If a company has excess debt then it can affect the cash flow as well as the profitability of the company. Many instances have been observed where companies have gone into liquidation/insolvency due to excessive debt.