My 8-Point Stock Analysis Checklist

Online Value Investing Workshop – August 2024 Cohort: I recently opened admission to the August 2024 cohort of my Online Value Investing Workshop, which has already been taken by 1800+ students ever since I launched it two years ago. Here is what you get when you sign up for this workshop – 

30+ hours of pre-recorded lectures and Q&A videos

60+ questions answered in the Q&A

Live Q&A session of 3 hours on Sunday, 25th August 2024 (7 PM IST Onwards)

One-year unrestricted access to the entire content

7 readymade screens to filter high quality stocks (and avoid the bad ones)

Bonus 1: Stock analysis spreadsheet (otherwise priced at ₹1999)

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I am accepting 100 students for this cohort, and more than half the seats have been booked by now. Click here to read the details of the workshop and sign up.

Identifying stocks is not an easy task. You are not just ‘picking a stock’ but ‘investing in a business’ that is a complex entity driven by multiple variables.

The complexity of the task is what keeps many investors from analysing businesses who instead depend on easily available tips from strangers, especially those handing out stock names for free on social media.

I believe that rather than obsessing over the bewildering fusion of news and noise, you should concentrate on a few key elements in stock selection, like the 8-10 most important things to know about any business you are invested in, or are about to invest in.

Of course, if I knew the exact answer I would have retired long ago! 🙂

Even if I could know all the facts about an investment, I would not necessarily profit. This is not to say that fundamental analysis is not useful. It certainly is.

But information generally follows the well-known 80/20 rule: the first 80% of the available information is gathered in the first 20% of the time spent.

So, if I were to list down eight questions that, I believe, would help me do an 80% analysis of a business, they would be the follows.

My 8-Point Stock Analysis Checklist

1. Is the business simple to understand and run?This question is crucial because simplicity often translates to clarity and efficiency. A business that’s easy to understand allows you to better assess its prospects and risks.

Simple businesses are typically easier for management to operate, leading to fewer operational hiccups. Complex businesses, on the other hand, may face challenges in various areas, such as supply chain management, regulatory compliance, or technological adaptations.

For example, a company selling basic consumer goods might be simpler to understand and run compared to a complex conglomerate with numerous, intricate product lines.

Check out these illustrations below for an example of some simple businesses (these are just examples and not recommendations) that I drew to explain to my daughter about stock markets a few years ago. We have a lot of such, and many like these, simple businesses around us. We just need to observe.

2. Has the company grown its sales and earnings per share consistently over the past 5-10 years?Consistent growth is a key indicator of a company’s stability and management’s ability to execute their business plan.

I am not talking about rapid growth here, because while it can be exciting, it is often unsustainable and may come with higher risks. ‘Consistent’ growth suggests that the company can perform well across different economic cycles and market conditions.

So, as an investor, look for steady, year-over-year increases in both sales and earnings per share (EPS). This consistency indicates a reliable business model that has a good grip over the market and competitors, and an effective management.

3. Will the company be around and profitably better in 10 years?This forward-looking question requires you to assess the company’s long-term viability and growth potential.

Consider factors like the industry’s future prospects, the company’s competitive position, and its ability to adapt to changing market conditions. A company that’s likely to not only survive but thrive in the next decade often has strong brand loyalty, diversified revenue streams, or operates in an industry with long-term growth potential.

Also check the balance sheet – things like debt/equity and working capital situation – for that shows a business’s capacity to suffer bad times. And only companies that can suffer bad times well, survive and create value in the long run.

4. How has the company performed on Buffett’s $1 test?This test, popularized by Warren Buffett, evaluates how effectively a company uses its retained earnings to create value for shareholders.

Ideally, for every rupee of earnings retained (not paid out as dividends), the company should create at least one rupee of market value over time.

This metric indicates that the company is investing its profits wisely, generating returns that benefit shareholders.

To calculate this, compare the change in the company’s market value over a period to the cumulative retained earnings over the same period. (My automated stock analysis spreadsheet can help you do that.)

Also, I recently wrote a detailed article on this, which you can read here.

5. Does the company have a sustainable competitive moat?A competitive moat refers to a company’s ability to maintain its competitive advantages and protect its market share and profitability. This can show up in various ways:

Pricing power: Can the company raise prices without significantly losing customers?

High gross margins: Indicating strong value proposition and efficiency.

Lead over competitors: In technology, market share, brand recognition, etc.

Entry barriers: Factors that make it difficult for new competitors to enter the market.

Warren Buffett wrote in a 1999 Fortune magazine article –

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

A strong moat suggests that the company can sustain its profitability over the long term. This competitive advantage acts as a protective barrier, shielding the company from market pressures and rival encroachment.

Businesses with robust moats often enjoy higher profit margins, more stable market share, and greater resilience during economic downturns. Their unique position allows them to fend off new entrants, maintain customer loyalty, and potentially command premium pricing.

Over time, this translates into consistent financial performance and the ability to reinvest in the business, further widening the moat. However, it’s also important to regularly reassess a company’s moat, as technological changes, shifting consumer preferences, or regulatory alterations can erode even the strongest competitive advantages (think Kodak, Nokia, MTNL, etc).

A truly enduring moat not only protects current profitability but also provides a platform for future innovation and expansion, ensuring the company remains relevant and profitable in an ever-changing business landscape.

6. How good is the management given the hand it has been dealt?Assessing management quality is crucial but can be subjective. Look at:

Capital allocation: How wisely does management invest the company’s resources? Check for return on equity, return on incremental invested capital, etc.

Corporate governance: Are there strong oversight and ethical practices in place? Is there a history of corporate misgovernance?

Performance against competition: How does the company fare compared to its peers? Market share, profit share, etc.

Remember that a good management can navigate challenges effectively and capitalize on opportunities, even in difficult circumstances.

7. Does the company require consistent capex and working capital expenditure to grow its business?Capital expenditure (capex) refers to the funds a company uses to acquire, upgrade, and maintain physical assets such as property, buildings, technology, or equipment.

Working capital, on the other hand, is the money needed to fund day-to-day operations, including inventory and accounts receivable. Both of these can significantly impact a company’s financial health and investment attractiveness.

Companies that require high and consistent capex and working capital to grow face several challenges, including –

Cash flow pressure that can potentially lead to increased debt or reduced dividends,

Reduced flexibility in the ability to adapt to market changes or economic downturns,

Lower returns on invested capital,

Heavy reliance on external financing for growth that can increase financial risk, and

Competitive pressure due to the need to continually invest to keep up with competitors, even if returns are diminishing.

On the other hand, companies with lower capital intensity often enjoy several advantages, like –

Higher free cash flow as less money is tied up in assets or working capital. Such free cash can be used for dividends, share buybacks, or investments.

Greater flexibility, that can help the business more quickly to market changes or economic cycles.

Higher ROIC (mostly, because ROIC also depends on other factors)

Lower financial risk, as there is less reliance on debt financing for growth.

However, it’s important to note that capital intensity varies greatly by industry. Some sectors, like power and heavy manufacturing, inherently require high capex, while others, like IT services typically have lower capital requirements.

8. Does the company generate more cash than it consumes?Strong cash generation is a hallmark of a healthy business. Companies that consistently generate more cash than they use have several advantages, which include –

Financial flexibility to invest in growth opportunities

Ability to weather economic downturns

Potential to return value to shareholders through dividends or buybacks. Look at the company’s free cash flow trends over time. Positive and growing free cash flow is generally a good sign.

Check for free cash flow (FCF), which is the cash from operations minus capital expenditures.

Companies with consistently positive and growing FCF have several advantages. They possess the financial flexibility to invest in growth opportunities without relying heavily on external financing. This self-funding capability allows them to capitalize quickly on market opportunities or weather economic downturns.

Additionally, excess cash enables companies to return value to shareholders through dividends or share buybacks, or to pay down debt, improving their overall financial position.

Look at FCF trends over time, comparing them to revenue and earnings growth. Also examine the efficiency of working capital management and capital expenditure patterns.

Strong cash generation is particularly valuable in capital-intensive industries or during periods of economic uncertainty. However, the interpretation of cash flow metrics can vary by industry and a company’s stage in its growth cycle. For example, young, high-growth companies might temporarily consume more cash than they generate as they invest heavily in expansion (I learned this lesson late!).

Stock Analysis Made Easy

Before I end, here’s a plug for my comprehensive automated stock analysis spreadsheet, which can help you easily perform a comprehensive financial and business analysis of listed Indian companies.

Here are some key things this automated stock analysis spreadsheet can help you with –

Pre-Built Analysis Models: So you don’t have to waste hours entering data and maintaining your spreadsheets. The automated spreadsheet does it all and lets you customize it.

Graphs: Visually see the historical performance of the business across various key parameters.

Valuation Models: DCF, Ben Graham formula, Dhandho Framework, and Expected Returns Model – to help you identify a stock’s intrinsic value range.

Quick Analysis: Across key areas like growth rates, earnings stability, financial strength, capital allocation, and efficiency.

Key Metrics: Easily check key metrics like ROE, ROCE, Gross Margin, Debt to Equity, Free Cash Flow, etc. to determine the quality of the business.

Explanations: Explanations of key terms and ratios to help you understand nuances of financial statement analysis.

How to Get this Spreadsheet?

Multiple ways –

Click here to pay a small fee to get the spreadsheet on a standalone basis (till 15th August 2024, it’s available at a discounted fee).

You can get it for FREE by joining Mastermind – my most comprehensive value investing course and membership.

You can get it for FREE by joining the August 2024 cohort of my online value investing workshop.

That’s all from me for today.

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Thank you for your time and attention.

~ Vishal

P.S. Additional Reading