Investing in a company requires careful analysis of its financials, management quality, competitive strengths and growth potential.
The easiest way to shortlist high-quality stocks is to look for the standard red flags that signal underlying issues with a company's fundamentals. Here's how to identify them.
When you look at a company's financial statement, look at the growth rate of revenue/income. A fundamentally strong company will have a consistent increase in revenue and profits too.
While there can be a few bad years when the revenue and profits drop, overall, there should be a consistent increase.
If you find revenues highly inconsistent, you must treat it as a red flag and investigate further. The exception here is commodity companies. Commodity companies often face inconsistent revenues due to the volatility in commodity prices.
An increasing debt-to-equity ratio
A company needs funds to stay operational and grow. The company is expected to use its profits for these purposes. However, on most occasions, companies have to opt for debt to finance their growth plans.
As an investor, it is crucial to understand that some amount of debt is acceptable. As long as the company can service its debt obligations and has enough cash flows, a high debt-to-equity ratio should not be an issue.
However, if you find that the company has a constantly increasing debt-to-equity ratio, then chances are that it is financing its growth aggressively using debt.
It can be a counterproductive and high-risk strategy. Hence, you need to assess other aspects carefully before investing.
Legal or tax issues faced by the company, directors
This should be an obvious red flag but many investors tend to miss it since there is so much to analyse. A company is required to display all information about pending lawsuits to investors. You can find this information on the company's website.
If you find that there are any pending lawsuits against the company or its directors, it should serve as a red flag and demand a detailed understanding of the case.
Price volatility in market price
The market price of the shares of a company depends on a range of factors that influence investor sentiment. These need not necessarily indicate a problem with the company but deserve some investigation since investors react to a market condition.
It is important to know the factors that are contributing to the volatility and analyse them thoroughly.
Financial results that seem too ornate
While most investors skim through these results, numbers can sometimes seem too ornate. For example, you might see a sudden jump in revenues or profits.
Also, if you compare peers, you might find a particular company reporting exceedingly high profits compared to its peers.
This needs to be investigated further. If your investigation reveals that the numbers are true, the company has a competitive edge that can make it a good investment option.
Poor corporate governance
This is a little more subjective than analysing the financial statements of a company. Here are some red flags that you should look for that indicate problems in the governance of a company:
● Revenue leakage
● Companies where there is suspicion of attempts to influence stock prices
● Unethical business practices
● Lack of alignment with the interests of minority shareholders
● Aggressive accounting policies to 'window-dress' the financial statements
When you evaluate a company, it is essential to consider all aspects to get a comprehensive view. One approach that works best with most investors is thinking like a partner in the company.
Understand its business, competition, revenue model, expenses, loans, and assess if it all adds up. Determining whether a company is worth investing in or not requires time. These red flags can help weed out the underperformers and help you build a high-quality portfolio.Disclaimer
: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.