Five questions to ask while investing in direct stocks2 min read . Updated: 29 Dec 2018, 07:15 PM IST
Direct equity investors not only benefit from dividends but also from the share price appreciation
Where is the growth coming from?
Check for companies that have shown consistent growth in sales and revenues over time. It is always better if the growth comes from the core business, which is always more sustainable. There is also a futuristic aspect to growth. For example, Nokia was a great company in 2007 but in three years it had lost the mobile market to Apple and Samsung. Companies which have created an edge over competitors tend to do well over a period.
Does the company have too much debt?
While the optimal debt to equity ratio varies widely by industry, generally a debt-equity ratio of less and 2x is considered to be good. A high debt to equity ratio could be a bad sign for investors. Debt can also be measured by the interest coverage (IC) ratio. IC measures the extent to which the company’s earnings before interest and tax (EBIT) is sufficient to cover the interest cost. A higher interest coverage ratio is considered good and represents a healthy balance sheet. Focus on companies that have low debt in their books and a comfortable interest coverage ratio.
How much is the company generating for shareholders?
Direct equity investors not only benefit from dividends but also from the share price appreciation. Stock prices appreciate when the company is using its assets efficiently to generate profits which are higher than the cost of capital. The focus should be on consistency and continuous growth.
How is the quality of management?
This is slightly subjective but is an important consideration for investors. In the last few months, companies with weak corporate governance standards have been punished by the stock markets. Focus on companies that have quality managements, follow high disclosure standards and are transparent with shareholders. Shareholders need to be convinced that the board and the management are acting in the best interests of the shareholders.
Are the valuations are justified?
As an investor in direct stocks you must look at valuation comfort. Valuation is not just about P/E ratio alone but also related to growth. A stock may not be worth buying at 15X P/E if the company is growing at just 6%. At the same time, another stock may be worthwhile at 19X P/E if the company is growing at 25% annually.
Normally, you also look at Price/ Book and the dividend yield. If you find the stock under-priced, the next question is how much is it underpriced? If a stock is steeply underpriced then it offers a high margin of safety and is a stock to invest in. Don’t jump into a stock without looking at valuations.
Despite all the effort, you may not always find the right stock to invest. This is where equity advisory platforms can be of a good support for individuals looking to invest in direct equities. You can also take the help of expert fund managers by investing through mutual funds.
Ajay Menon, Chief Executive Officer, Broking and Distribution, Motilal Oswal