It not so easy to pick the companies for investment that can produce good returns for year and years. But it is comparatively easy to reject the bad ones that can destroy the wealth. Not investing in a super good company will not destroy your capital but investing in a bad company can definitely destroy capital. Therefore it’s necessary that we do not invest our hard earned money in bad firms
Below are some quick ways to filter out the bad companies.
1. Reject the company which doesn’t keeps investors updated
It’s the duty of the company to regularly update the investors by publishing quarterly and annually reports. These reports are available on the company website and also on BSE. If the company is not publishing its performance reports, its hiding valuable information, reject such companies. Castex Technologies is one such company which has not publically published annual report since 2013
2. Reject initial public offerings
All IPOs are overpriced. A company sells share to the public only when they think, they will get the high price. IPOs are rarely bargains. Moreover most of the new listings are young firms which has short track record. Investment is safe in companies that have solid track record of good performance for years. Only exception are the firms that are spun off from larger parent companies.
3. Reject the companies with negative operating profit
Why should we invest in a firm which is not making profit? Of course there can be turnaround companies, many companies turn profitable after being in loss for years. The probability of any company to turn profitable which is in loss from years is very less. Also you have to do a lot of research to make sure that the company can actually turn profitable which is not possible for a common investor. On the safer side its better to reject such companies. Also avoid companies whose profits are going down year on year.
4. Reject companies with negative cash flow from operations
Cash flow is the actual number which tells how much cash the company has generated from its business. There can be some good companies whose cash flow becomes negative when they are heavily doing capital expenditure in projects that can generate good returns in future. In such case you have to carefully study how fruitful its capex has been in the past. Be specially sceptical about the cyclic companies not having positive cash flow. Companies with negative cash flow requires additional funding, which is done through debt or by selling additional shares. More debt makes the business risky and additional share selling dilutes your ownership skate as a shareholder.
5. Reject companies with ROE consistently below 10
We invest in equities to generate more income than risk free fixed income assets like bonds or fd. Return on equity is a financial ratio every investor should know This ratio tells the return company is generating on the shareholders money. For financial firms minimum ROE should be 12 as their business is leverage based.
The formula for ROE is
ROE = Net margin x Asset turnover x financial leverage
Therefore a company can post a better ROE either by selling its goods or services at higher margins or by making efficient use of its assets or by putting leveraged money into business. A 15% ROE generated with minimal leverage is a much higher quality result than the one generated with more leverage.
6. Reject companies with volatile earning growth
Best companies are stable and post consistent profit growth. If the earning are fluctuating then the company might be either operating in an extremely volatile industry or is regularly getting hit by competitors.
7. Reject companies with very high financial leverage
Firms with lot of debt requires extra care because their capital structures are often very complicated. I prefer to reject the companies having financial leverage ratio above 4. Its good to reject companies with interest coverage ratio below 5. Companies whose debt is increasing but sales and earnings are reducing should be avoided.
8. Reject companies consistently diluting shares
If the company is issuing continuously new shares or granting stock options to employees and executives in good amount its a red signal. If the number of shares outstanding are consistently increasing by 2% per year and it is not doing any big acquisition avoid it. Increase in number of shares is good for shareholders.
9. Not paying taxes
A company whose profits are increasing but its not paying taxes or paying too less is avoid because the probability of the earning being fake is high in such cases.
Above are some of the quick ways to filter out the bad companies. There is always the possibility that a bad company of today may become a good company of future. Finding such companies is tough for a common investor. So to have a good marging of safety in your investments its better to go with the ones which have a good track record of profitability.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.