Screening criteria

 Market Cap > Rs 500 cr

 Sales and Profit growth >10%
 Earnings Per Share(EPS) growth rate is increasing for past 5 years
 Debt to Equity Ratio <1
 Return on Equity(RoE) >20%
 Price to Book value(P/B) <= 1.5 or low compared to peer companies within the
same industry
 Price to Earnings(P/E) < 25 or low compared to peer companies within the same
industry
 Current Ratio > 1

RATIO ANALYSIS

P/E RATIO
The price-to-earnings, or P/E, ratio shows how much stock investors are
paying for each rupee of earnings. It shows if the market is overvaluing or
undervaluing the company.
One can know the ideal P/E ratio by comparing the current P/E with the
company's historical P/E, the average industry P/E and the market P/E. For
instance, a company with a P/E of 15 may seem expensive when compared to
its historical P/E, but may be a good buy if the industry P/E is 18 and the
market average is 20.
Sabyasachi Mukherjee, AVP and product head, IIFL, says, "A high P/E ratio
may indicate that the stock is overpriced. A stock with a low P/E may have
greater potential for rising. P/E ratios should be used in combination with
other financial ratios for informed decisionmaking."
"P/E ratio is usually used to value mature and stable companies that earn
profits. A high PE indicates that the stock is either overvalued (with respect to
history and/or peers) or the company's earnings are expected to grow at a fast
pace. But one must keep in mind that companies can boost their P/E ratio by
adding debt (thereby constricting equity capital). Also, as future earnings
estimates are subjective, it's better to use past earnings for calculating P/E
ratios," says Vikas Gupta, executive vice president, Arthaveda Fund
Management.
PRICE-TO-BOOK VALUE
The price-to-book value (P/BV) ratio is used to compare a company's market
price to its book value. Book value, in simple terms, is the amount that will
remain if the company liquidates its assets and repays all its liabilities.
P/BV ratio values shares of companies with large tangible assets on their
balance sheets. A P/BV ratio of less than one shows the stock is undervalued
(value of assets on the company's books is more than the value the market is
assigning to the company). It indicates a company's inherent value and is
useful in valuing companies whose assets are mostly liquid, for instance,
banks and financial institutions.
DEBT-TO-EQUITY RATIO
It shows how much a company is leveraged, that is, how much debt is involved
in the business vis-a-vis promoters' capital (equity). A low figure is usually
considered better. But it must not be seen in isolation.
"If the company's returns are higher than its interest cost, the debt will
enhance value. However, if it is not, shareholders will lose," says Aggarwal of
SMC.
"Also, a company with low debt-to-equity ratio can be assumed to have a lot of
scope for expansion due to more fund-raising options," he says.
But it is not that simple. "It is industry-specific with capital intensive
industries such as automobiles and manufacturing showing a higher figure
than others. A high debt-to-equity ratio may indicate unusual leverage and,
hence, higher risk of credit default, though it could also signal to the market
that the company has invested in many high-NPV projects," says Vikas Gupta
of Arthaveda Fund Management. NPV, or net present value, is the present
value of future cash flow.
OPERATING PROFIT MARGIN (OPM)
The OPM shows operational efficiency and pricing power. It is calculated by
dividing operating profit by net sales.
Aggarwal of SMC says, "Higher OPM shows efficiency in procuring raw
materials and converting them into finished products."
It measures the proportion of revenue that is left after meeting variable costs
such as raw materials and wages. The higher the margin, the better it is for
investors.
While analysing a company, one must see whether its OPM has been rising
over a period. Investors should also compare OPMs of other companies in the
same industry.
EV/EBITDA
Enterprise value (EV) by EBITDA is often used with the P/E ratio to value a
company. EV is market capitalisation plus debt minus cash. It gives a much
more accurate takeover valuation because it includes debt. This is the main
advantage it has over the P/E ratio, which we saw can be skewed by unusually
large earnings driven by debt. EBITDA is earnings before interest, tax,
depreciation and amortisation.
This ratio is used to value companies that have taken a lot of debt. "The main
advantage of EV/EBITDA is that it can be used to evaluate companies with
different levels of debt as it is capital structure-neutral. A lower ratio indicates
that a company is undervalued. It is important to note that the ratio is high for
fast-growing industries and low for industries that are growing slowly," says
Mukherjee of IIFL.
PRICE/EARNINGS GROWTH RATIO
The PEG ratio is used to know the relationship between the price of a stock,
earnings per share (EPS) and the company's growth.
Generally, a company that is growing fast has a higher P/E ratio. This may
give an impression that is overvalued. Thus, P/E ratio divided by the
estimated growth rate shows if the high P/E ratio is justified by the expected
future growth rate. The result can be compared with that of peers with
different growth rates.
A PEG ratio of one signals that the stock is valued reasonably. A figure of less
than one indicates that the stock may be undervalued.
RETURN ON EQUITY
The ultimate aim of any investment is returns. Return on equity, or ROE,
measures the return that shareholders get from the business and overall
earnings. It helps investors compare profitability of companies in the same
industry. A figure is always better. The ratio highlights the capability of the
management. ROE is net income divided by shareholder equity.
"ROE of 15-20% is generally considered good, though high-growth companies
should have a higher ROE. The main benefit comes when earnings are
reinvested to generate a still higher ROE, which in turn produces a higher
growth rate. However, a rise in debt will also reflect in a higher ROE, which
should be carefully noted," says Mukherjee of IIFL.
"One would expect leveraged companies (such as those in capital intensive
businesses) to exhibit inflated ROEs as a major part of capital on which they
generate returns is accounted for by debt," says Gupta of Arthaveda Fund
Management.
INTEREST COVERAGE RATIO
It is earnings before interest and tax, or EBIT, divided by interest expense. It
indicates how solvent a business is and gives an idea about the number of
interest payments the business can service solely from operations.
One can also use EBITDA in place of EBIT to compare companies in sectors
whose depreciation and amortisation expenses differ a lot. Or, one can use
earnings before interest but after tax if one wants a more accurate idea about a
company's solvency.
CURRENT RATIO
This shows the liquidity position, that is, how equipped is the company in
meeting its short-term obligations with short-term assets. A higher figure
signals that the company's day-to-day operations will not get affected by
working capital issues. A current ratio of less than one is a matter of concern.
The ratio can be calculated by dividing current assets with current liabilities.
Current assets include inventories and receivables.Sometimes companies find
it difficult to convert inventory into sales or receivables into cash. This may hit
its ability to meet obligations. In such a case, the investor may calculate the
acid-test ratio, which is similar to the current ratio but with the exception that
it does not include inventory and receivables.
ASSET TURNOVER RATIO
It shows how efficiently the management is using assets to generate revenue.
The higher the ratio, the better it is, as it indicates that the company is
generating more revenue per rupee spent on the asset. Experts say the
comparison should be made between companies in the same industry. This is
because the ratio may vary from industry to industry. In sectors such as power
and telecommunication , which are more asset-heavy, the asset turnover
ratio is low, while in sectors such as retail, it is high (as the asset base is
small).
DIVIDEND YIELD
It is dividend per share divided by the share price. A higher figure signals that
the company is doing well. But one must be wary of penny stocks (that lack
quality but have high dividend yields) and companies benefiting from one-
time gains or excess unused cash which they may use to declare special
dividends. Similarly, a low dividend yield may not always imply a bad
investment as companies (particularly at nascent or growth stages) may
choose to reinvest all their earnings so that shareholders earn good returns in
the long term.
"A high dividend yield, however, could signify a good long-term investment as
companies' dividend policies are generally fixed in the long run," says Gupta.
While financial ratio analysis helps in assessing factors such as profitability,
efficiency and risk, added factors such as macro-economic situation,
management quality and industry outlook should also be studied in detail
while investing in a stock.

Select only the companies that you understand

 Is the company’s business simple?

 Do I understand the product/service?
 Do I understand how the business works and makes money?

Look for companies with sustainable Moat (competitive advantage)

In business terminology, Moat is the competitive advantage that one company has over
the other within the same industry. The wider the moat, the larger the competitive
advantage of the company and more sustainable the company becomes.
Which means, it would be very difficult for the competitors to displace that company
and capture its market share.

Now, that’s a stock(company) you would want to select and invest in.

Examples of this Moat can be brand power, intellectual property rights and patents,
network effects, govt. regulations controlling barriers to entry, and many more.

For example – Apple has a strong brand name, pricing power, patents, and a huge
market demand that give it a wide moat which act as barriers against other companies.

No wonder that Apple is close to becoming a trillion dollar company and has generated
huge profits year after year, making great returns for its investors.

Another simple example of brands with strong moats is Maruti, Colgate, Fevicol which
have huge recall value in public memory.

Similarly, out of the 3 IT stocks that I earlier discussed, Vakrangee Ltd has a strong
moat. The company runs e-governance service in more than 41,000 digitally connected
kendras (outlets) across 18 states that take deposits, offer loans, collect taxes/bills, let
people apply for passport, enroll them for the Aadhaar biometric ID etc.

Given its huge distribution network across many states and the push for digitisation
from govt, it would be very difficult for a new competitor to displace them off the
market.

No wonder that the stock’s price soared from Rs 16 in 2010 to Rs 500+ in 2017. (Note:
The current prices may go up and down based on the short term pain in the markets)

So, look out and identify such companies with strong moats in the initial days.