Published Article Details

How to learn the ropes of equity analysis and investing

Posted by: Uma Shashikant on Mar 27, 2017, 06.30 AM IST

By Uma Shashikant

A group of young students wanted to know if equity analysis was too tough a subject to pursue. They told me about the stock market games they played in college. While they found it fascinating, they knew that it was not a dependable way to make money. They then participated in equity analysis competitions and found that cases being discussed at the forum were very complex.

The approaches seemed too many, the data too immense to deal with, and the accepted truisms about multi-baggers seemed to have a significant hindsight bias. Is there a simple approach to equity analysis for a beginner? And how should someone who is not a student of finance begin to learn equity analysis?

Equity analysis does encompass a vast range of factors and requires processing of information with intensity. But the fundamental concepts are still simple and straightforward. Does the business hold an earning quality that will sustain over a long time? That is the central question.

Every relevant factor of analysis should be able to answer that question. It could be about the market opportunity for a new business; or the strategic acumen of its promoters; or an innovative approach to products that captures large markets over short periods of time. All these activities should finally converge into an earnings stream that is clearly discernable, growing and of the quality that an investor can trust.

Consider a business that begins with equity capital contributed by its promoters. To be able to manage a return to investors, the business builds assets to sell a product or service. It plans to put the capital to use and make a profit trying to do so. We can thus begin with the sales that the business achieves and whether such sales result in a profit. The post-tax margin is what is left for the equity investors. The first number to look at is the post-tax margin or PAT/sales.

Then, one asks how this sales number would grow. If it is a trading business, for example, it would use the capital to buy stocks of goods, and as the stocks sell, the business would make profits. The capital of the business is turned over from stocks to cash and back to a fresh lot of stocks that it would buy and sell.

In a manufacturing business, there would be fixed assets bought with the capital, deployed to produce goods, and then sold for a profit. Some capital is thus always locked in the assets of a business. However, more the sales generated from the assets, better the return to the investor.

Let us assume that a business began with a capital of Rs 100. It deploys this capital in fixed assets, stocks and materials, and in costs incurred to make goods. At the end of the year, it managed to achieve sales of Rs 150, of which costs amount to Rs 125, leaving a post-tax profit of Rs 25.

The return to the investors is 25%, which comes from the ability of the business to make something more valuable than the money first invested and sell it for a profit. Assume that the business achieves annual sales of Rs 300 with the same capital, because it was able to produce and sell twice over in the year. The return to the investors doubles.

A business that can utilise capital so that more sales are achieved for the same investment in assets, returns more to its shareholders. The turnover of assets to sales, multiplies the return to the investor. Sales/assets is a number that tells the investor whether the asset productivity of the business is such that it would enhance the benefits from being a profitable enterprise.

The third element is leverage. If a business deploys capital such that it earns 25% on it, the promoters would see that it makes sense to borrow funds at say 10% to fund the assets. Assume that they fund 50% of the business with equity and 50% with borrowings. What happens when they do this? The profit comes down from Rs 25 to Rs 20 after paying interest.

But, Rs 20 is the return on equity of Rs 50, which is a 40% return, and is better than the earlier 25%. Funding assets with borrowings has resulted in better returns to the equity investor, the benefit we call as leverage. Assets/net worth is the number we want to look at, to see how much of the assets are funded by equity.

The return on equity is a simple function of these three variables: PAT/sales (profit margin), sales/assets (asset turnover) and assets/net worth (leverage). It is easy to see that multiplying these three numbers will result in PAT/net worth which is the return on equity. This analysis made famous by DuPont many years ago, is a simple but robust framework to understand the quality of earnings of businesses and think about how the future earnings will pan out. It also helps understand the business model of enterprises around us.

Telecom businesses worry about ARPU, value-added services, and revenues from data usage. They have made the investment in assets and in bandwidth, with the hope of making more money from subscribers. If they find that sales are not expanding, or even if they did, margins are dropping from competition in the industry, their ability to borrow falls. They consolidate with the intent to reduce costs and investments and enhance sales.

Real estate businesses enjoy a high margin as they can add value to the land parcels they buy and develop. They do not worry too much about leverage, as they have enough margins. But their undoing would be a falling asset turnover. If they are unable to sell what they have built or can do so only at a lower and lower sales price, they will find that the borrowings become too heavy to sustain.

When one sees e-commerce businesses making a large volume of sales but losing money consistently, it is easy to see that they will need more and more equity capital to sustain the assets they have. Businesses with low margin and low leverage need a very high asset turnover to sustain. Hence the everyday sales tactic to push goods off the godowns.

Equity analysis and investing is both intense and interesting, and one should desist from trivialising the process. The return on equity (RoE) framework is a good starting point for investors to understand the fundamental factors that drive the earning quality of a business.

(The author is Chairperson, Centre for Investment Education and Learning.) This article appeared in Economic Times dated Mar 27, 2017, 06.30 AM IST

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