We continue with this series of questions you need to ask when evaluating a stock purchase.
Part five looks into the measurement of the operating and financial health of a business.
21. What are the fundamentals of the business?
“Fundamentals” is a general term used to indicate the overall financial health and general conditions surrounding the business.
Investors can take this to mean the revenue, margins and net profit trends, financial ratios and also prospects for the business.
It is a catch-all term that allows investors to take a sweeping look at the various characteristics of a business to determine what affects it and how would it perform over time.
22. What are the operating metrics of the business that you need to monitor?
Operating metrics refer to non-financial aspects of the business such as market share, plant utilization rates and same-store-sales growth.
These metrics may have significant implications for the business and investors should do their best to keep track of them.
Each industry has its own unique operating metrics.
For instance, retail stores measure same-store-sales growth to have an idea of like-for-like sales for existing stores that excludes newly-opened stores.
The banking industry also has specialised terms such as loan book growth, net interest margin and non-performing loans ratio that investors can use to assess the health of the business.
23. What are the key risks the business faces?
The topic of risks is an important one and should always factor into an investor’s investment thesis.
There are different areas of risk you should watch for.
Ideally, you should build up a list of key risks the business faces and review them to assess if there are mitigating factors.
Based on the identified risks, you can then make a more informed decision as to whether you would want to invest in the company.
24. How does inflation affect the business?
Inflation refers to a sustained rise in prices for products and services consumed and is considered by economists to be a necessary evil for businesses and the economy to do well.
The rise in prices affects businesses in two ways – on one hand, it allows businesses to price their products higher over time to account for inflationary effects, and on the other hand, it also makes raw materials and supplies more expensive to purchase.
If a business can increase prices more than the increase in its cost of goods, then it will be able to capture the gross margin gain.
In recent months, inflation in the US has reached four-decade highs while in Singapore, core inflation is nearing a 14-year high.
Hence, you should assess if a stock has sufficient pricing power to ensure it can overcome inflationary effects and still book a decent net profit.
25. Is the business’s balance sheet strong or weak?
A strong balance sheet is one with a lot of cash and very little, or no debt.
Conversely, weak balance sheets are usually filled with all sorts of debt along with very little cash.
A strong balance sheet implies that the business can weather downturns and recessions much better compared with companies that owe money to bankers and bondholders.
26. What is the return on invested capital for the business?
The business’s return on invested capital (“ROIC”) is computed as follows – operating profit minus taxes divided by the invested capital of the company.
Operating profit can be obtained from the income statement, and the investor has to deduct the effective tax rate of the company to arrive at the numerator.
Invested capital refers to the total value of all the debt and equity within the business.
The ROIC measures the total return shareholders enjoy as a percentage of the capital deployed into the business.
A usual rule of thumb for a good ROIC is 15% and higher, though this would vary from industry to industry.
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Disclaimer: Royston Yang does not own any of the companies mentioned.