Equity research: basic stuff

Financial analysts try to determine the value of a stock by calculating a company’s discounted “free cash flow”. This is based on a series of computer models with assumptions about future sales, earnings and growth rates. These models are only as good as the programmers and analysts that build them.

What you end up with is a highly subjective number about the growth of the company’s business and other performance measures. It’s little more than an educated guess. Moreover by the time the report comes to your hand it has gone to all the “news’ and “business” channels. After that you know how useful that report is, do you not?

So if following analyst reports isn’t the answer, what should we look at?

  • Cash Balances and Debt
    When the economy turns down, the highly leveraged firms are the ones that get in trouble first. This is part of the problem for GM and Ford right now, and it was the problem with Bear Stearns. In Indian conditions the amount of leverage is not so high. However a lot of foreign debt has been “hidden” as PE. We have no clue how much of this will hit us one the conditions worsen. If you have large debts, the interest payments alone are a constant drain. On the other hand, a company like TCS – with large stores of cash and no debt – can weather any storm. However you may have to worry about Tata Motors. Amazingly, sometimes a firm’s stock price won’t adequately value the cash it holds. This is because analysts do not understand the importance of cash in a bear market.
  • Cash Flow
    The market will – over time – value cash flow in similar ways. Look for times when the market undervalues a company’s cash by finding out how much cash a company is producing today. Cash flow is the lifeblood of a company. 2 great examples are Coromandel fertilizer and EID Parry. You can reasonably expect that analysts who look for sex appeal in shares will appreciate the value of free cash flow in the future, even if the firm is out of favor today. Therefore, keep track of the cash a firm generates.
  • Dividends
    Analysts at least in Indian conditions do not value dividends very highly. This is patently stupid. Given the quality of Indian reporting, dividends should be valued very, very highly. EPS is just an opinion, dividends are a reality. Reinvested dividends have contributed a big part of the total return. Favor a stock with dividends for this very reason. You’ll get paid to hold a stock while the market takes time to recognize its value.

These three simple guides have worked wonders when analyzing many different stocks.

Many of today’s stocks show large differences between their price and their historical earnings ratios. You may find the market is incorrectly valuing many companies in relation to their cash balances and its ability to generate cash flow and dividends.

So instead of listening to analysts, do your own research and ask the right questions, like these:

Can the company rebound to its historic price-to-earnings ratio?

Is the market undervaluing a company?

Can it continue to generate healthy cash flow and earnings?

Will it be able to pay dividends and interest payments on debt?

In short, cash and cash flow can be a more reliable predictor of the future of a company’s stock price than your gut… and especially an analyst’s educated guess. Especially if he is peddling his wares “free” in the pink papers or the idiot box. Use your brains.

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