Equity investing: Five steps to evaluate which stock to bet on

As the price that investors are paying today is for the firm’s future performance, investors should be sure that the company they are investing in is moving in the right direction.

By P Saravanan and Sumit Banerjee
Of late, Indian stock market indices have been touching life-time highs on a daily basis. However, some people are still sitting on the fence; either because they are wary of the market or do not quite know how to decipher the numbers before they invest their hard-earned money. While we cannot influence the former much, we can help the latter by highlighting how to use numbers to their advantage while investing.
Industry averages

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The academic standards for ratios do not help here. A current ratio of 2:1 or a cash ratio of 1:1 should be relegated to the books. While investing, an investor should look at the numbers of the target company and compare the same with that of its peers as well as the industry averages. For example, the liquidity of a food delivery company can be very high, and of a construction company very low. One should always compare the ratios with its peers and understand the performance and the ratios cannot be interpreted independently.

Cash balance
A company’s cash position can be used as a ‘cashback’ offer while buying shares of a company. For example, a cash balance of Rs 3 per share of a company whose shares are currently being traded at a price of Rs 10 per share effectively results in the net price of Rs 7 per share. So, investors are paying a much lower price for this company than an identical company with no cash balance.

Debt position
The debt position of the company is the opposite of the cash position. Higher debt on the books indicates that outsiders have a higher encumbrance on the company’s assets. The lenders can also have stringent clauses (known as covenants) that may not allow the management to take advantage of riskier opportunities. It also means that a higher portion of its profits goes to serve the debt’s interest. So, generally a lower debt indicates a good signal.

Promoters’ share
One crucial indicator that helps investors to understand which way the company is moving is to look at the figure of the promoter’s share. Promoters are privy to information about the company’s prospects, which are not available to the general public.

So, if the promoters’ share increases, it is a soft signal that the company is on the path to greater heights and is a good investment opportunity.

Cash flows
Profits are the first indicator that one should look at to understand the company’s performance. But, they are accrued in nature. Management may manage the profit position through their discretionary actions, presenting an inflated picture of the performance. Investors should look at the cash flows to see if the management’s actions are supported by the cash inflow. An in-depth study of the cash flow statement helps to understand where the money is got from and where it is gone.

Investors should consider the above factors because invariably they make an impact on the performance of the firm. As the price that investors are paying today is for the firm’s future performance, investors should be sure that the company they are investing in is moving in the right direction.

P Saravanan is a professor of finance and Banerjee is a doctoral scholar at Indian Institute of Management, Tiruchirappalli