The first step to becoming a successful investor is to understand a company. You need to be able to predict how the company will perform in the present and in the future. As an example, a company’s future stock price can be predicted based on how it does through the year. Many investors, however, overlook this step. They assume that by examining the past, they can determine the future.
When searching for a company to invest in, sometimes investors will look for the right characteristics. It’s not enough to see that a company’s current price is lower than the 52-week high or that it has significant insider buying. Sometimes investors will look for other qualities, such as the quality of the management team or the company’s financial strength.
If you are a stock market investor, there is one company that you should understand—the company that you are buying or selling stock of. A company that you are considering investing in or out of, or even just following, is one that you should know more about. Understanding a company is critical for stock investors because it provides you with a sense of orientation, direction, and insight into the business and financial performance of the firm..
It is very important to understand a company before buying its shares. Why? This is because the shares represent a proportionate interest in the entity. So what is the purpose of these shares and company information?
Let’s illustrate this with an example. Let’s take the example of two companies: Nestlé India and Jet Airways. The former is a healthy business and the latter languishes in NCLT.
The question now is which company shares you will buy. Are you sure you’re not going to buy Jet Airways stock? Why? Because things are not going well at the moment.
Therefore, before buying shares of a company, you should evaluate the fundamental factors of the company. In Nestlé v. Jet Airways, the interpretation was clear. But in most cases, it is almost impossible to identify a weak company by its name alone.
How do you do that? To better understand a company by analyzing its activities. This process is called fundamental analysis. The emphasis here is on the financial health of the company.
The organizational chart above is a symbolic representation of how the company conducts its business. It all starts with a capital. The company must raise capital, either from shareholders/partners or from lenders.
The company then uses its capital to produce goods and services for its customers. These activities in turn generate revenue and profit.
From the profits of the company, the lenders receive a fixed return in the form of interest payments. A shareholder’s investment may also yield a non-fixed return. Income is generated in the form of dividends and price increases.
The risk profiles of shareholders and creditors are different. Borrowers receive a fixed rate of return whether the company makes a profit or incurs a loss. However, shareholders should not be rewarded for losses with dividends or a higher share price.
Conversely, a shareholder’s return may be negative if the company suffers a loss. How do you do that? Because of the decline in the stock price. So what does that mean? This means that the shareholders bear the risks of operating the company. You will suffer losses if the PAT is negative. You win if the PAT is positive and moving forward.
This explains another fact. Investors can put their money in other investments instead of stocks. Although investing in stocks is risky, experts still prefer it because it can provide higher returns.
There is a business that needs capital to grow and function. It will also require CAPEX resources (for expansion and modernisation of production facilities). The company is focused on making a profit. The profit brings income to its investors (shareholders and creditors).
So you would think that profit is the most important thing for investors. But something else is even more important. These are profitability and growth rates. Let me explain this with a hypothetical example.
What you see above is a symbolic representation of two companies, #1 and #2. Company No. 1 and No. 2 make a profit of Rs 1 crore and Rs 0.5 crore respectively. To the untrained eye, company #1 will appear fundamentally healthier than company #2.
But for professional investors, the profit to capital ratio is more important. This ratio is also known as return on equity (ROE). It is one of the most important profitability ratios used by investors to analyze a company.
In our example, company #1 has a profit of Rs. 1.0 million and a profit margin of 10%. Company No. 2 has a profit of Rs. 0.5 crore and a profit margin of 12.5%. For professional investors, company #2 will have a higher valuation than company #1.
In addition to profitability, investors want to buy shares in a growing company. Revenue and profit growth is the first thing investors see in a company. But even more important to them is the growth rate in earnings per share and the improvement in the company’s profitability.
Both creditors and shareholders are considered to be investors in the company. But there is a difference in the way the company treats them.
The shareholders are more like a family. You are entitled to a proportionate share of the company’s profits (if any). But shareholders must also make a profit if the company is making a loss. This is one of the reasons why shareholders are proportional owners of the company.
Lenders are usually family friends. They are also part of the company’s ups and downs. But they get preferential treatment. A business borrows money from a lender with a promise to repay the principal on time with interest.
Let’s understand the concept of balancing risk and reward through an example. Suppose two companies are active in the same industry. Historically, #1 has posted stable revenue and earnings (PAT and EPS). As a result, it becomes easier for analysts to predict future earnings. These companies are considered safe investments.
Since the company is considered safe, investors will want to invest in this company even though the potential returns (interest, dividends, price appreciation) are not very high. What kind of companies are there? We know them more as blue-chip companies.
Now let’s assume that there is a relatively new company. They strive for development. They actively spend money on marketing and sales. Expenses are also allocated to CAPEX for business development. These companies may not have regular profits. In some years, they may even suffer losses. In the short term, investing in such companies can be risky.
Therefore, most investors who do not know what goes on behind the scenes should not invest in these companies. But a company needs capital to do business. How did they get it? Promises its investors higher returns.
Recommended reading: How to analyze companies with less than a decade of financial data.
Investors value a company that manages its TAPs wisely. The company can do the following with its profits:
- Pay the interest: The payment of interest on the loan is an obligation of the company. The company must therefore pay its creditors on time. How much do they have to pay? Interest due and repayment of the debt. The interest is paid from the current year’s profits. The principal is paid from the company’s cash reserves.
- Distribution of dividend : The payment of dividends to shareholders is a form of immediate gratification. Companies that are confident about their future cash flows pay high dividends to their shareholders. Other companies pay less or no dividends.
- Save your income: The company may decide whether or not to pay dividends to its shareholders. In both cases, neither company will pay out its full net profits (PAT) as dividends. A portion of the unpaid TAP is retained earnings.
Retained earnings speak volumes about a company. How do you do that? Let’s assume a company has an ROE of 20%. This is a high OCR. Now suppose this company retains its PAT (say, Rs. 10 million). At a rate of 20%, ROC’s retained earnings of Rs 10 crore will yield Rs 2 crore to PAT next year.
It’s a phenomenal return on investment. Compare it to the return you would get on an annual bank FD, a corporate deposit, a liquid mutual fund or an equity fund.
So what can we deduce from this theory? A company with a high ROC should consider reinvesting its profits. For them, the distribution of profits in the form of dividends to shareholders does not make much sense.
Conversely, what should a company with a low return (say 5%) do with its TAP? When such a company reinvests its TAPs, it cheats its shareholders. Why? Because the 5% return per year is what people get from a fixed deposit. They should not invest their money in the shares of this company.
What can we learn from what we have read so far? Two lessons:
- First: We need to invest in companies with a high ROE. It is not wise to invest in companies that destroy assets (companies with a low ROE).
- The second one: In the short term, a company with a high CAR may not see its share price rise. We must remember that this is only a temporary phenomenon. The market will soon recognize the value of such a company and the stock will be rewarded.
It may take some time for the market to recognize the quality of the company. Therefore, some high-quality small- and mid-cap stocks can be traded at undervalued prices.
But we must also remember that good company cannot go unnoticed forever. In the long run, it is the fundamentally sound companies that have the upper hand in the stock market. The important thing is not to lose hope.
Identifying a good company, buying the shares at a reasonable price and then holding them for the long term is what stock investing is all about.
Buying shares in a company means that a person acquires a proportionate share in the company. It is therefore very important to understand a company before buying its shares.
There are certain risks and rewards associated with owning a business. Therefore, we, as investors, should adjust our expectations (for the stock) accordingly.
Equities are not like term deposits with banks, which continue to provide a fixed (albeit low) return even when the world is in crisis. But it’s also true that when the world is posting only average returns, shareholders of quality companies make a lot of money.
In the long run, healthy companies will dominate the stock market. In the short term, the share prices of these companies will also be volatile. But this is not the time to be scared/disheartened and sell the stock.
If we can remember only two things, the action will behave according to our expectations. First, the stock market ultimately rewards companies with a high return on capital (ROC). Secondly, it is very profitable to buy stocks at a fair price and invest for the long term.
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Frequently Asked Questions
Why is an understanding of stocks important?
Understanding the basics of stocks is important because it helps you to understand how the stock market works. It also helps you to make better investment decisions.
Why are investors important to a business?
Investors are important to a business because they provide capital to the business.
Why do companies care about shareholders?
The company’s goal is to make money. The company will only do this if they have a lot of shareholders.