What comes to your mind when you hear the word Value? Or you hear that this is a valuable thing. Have you ever given it a thought that what is in it that makes it special or valuable? Or differentiate it from others? It is special because it is rare in nature and is worth the money.
As we all know that diamonds are rare in nature as well as less in supply, that makes it valuable, but at the same time sand is worthless because of its abundance. This philosophy also works with the stock market. In context of stock, if the company has competent management, external opportunities, strong business model, good corporate governance and has blooming financial performance, without any account gimmick then the stock should be considered VALUABLE. Example:- Titan, D-Mart, Natco Pharma, Relaxo and many such other great companies.
We can say that any stock is valuable because of two things:
- Qualitative Aspects
- Quantitative aspects
Qualitative analysis is a stock analysis that uses subjective judgment based on unquantifiable information, such as ethical management, strength of research and development, networking & distribution, intangible assets, economies of scale, high switching cost, etc. Briefing about the few:
- Ethical Management: Management is the main part of any business because they look after the business operations on a regular basis. Ethical management makes the business more valuable. We can say that good management is always one of the reasons to invest in any business. It creates the trust factors among the investors.
- Networking & Distribution :The networking effect occurs when a particular product reaches large segment of potential buyers.
- Economies of Scale:Companies that can deliver their products at a low cost, typically from economies of scale, have a distinct competitive advantage because they can undercut their rivals on price. Likewise, companies with low costs can price their products at the same level as competitors, but make a higher profit while doing so. This kind of advantage creates a significant barrier to entry, since a large amount of capital is often required to achieve a size needed to be competitive in a market.
- Intangible Assets:This category incorporates intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage. It may be difficult to assess the durability of some of these advantages, so be sure you have a grasp of how long this type of advantage might last. Brand equity, for example, can be damaged or slowly erode over time, while government approval can be revoked.
- High Switching Cost:Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. Companies that make it tough for customers to switch to a competitor are in a position to increase prices year after year to deliver hefty profits. Companies aim to create high switching costs in order to “lock in” customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking customer loss to a competitor.
There are other qualitative points as well that make a stock more valuable like Monopoly of the business, types of business, business model, marketing skills etc.
Whenever we analyse a company on quantitative aspect we tend to look at the financial performance, and a trend of the business. There are various parameters that can be considered while valuing the company.
- Return on Equity(ROE):The Return on Equity ratio measures the rate of return that the owners of common stock of a company receive on their shareholdings. This ratio signifies how good a company is in generating returns on the investment it received from its shareholders.
- Return on Capital Employed(ROCE):Return on Capital Employed measures the earnings as a proportion of debt and equity required by a business to continue normal operations. In the long run, this ratio should be higher than the investments made through debt and shareholders’ equity. Otherwise diminishing returns shall render the business unsustainable. This is a better measure of financial health of a company than ROE, because it takes into account the contribution of debt while showing the company’s return.
- Free Cash Flow:Free cash flow represents the funds left over after the firm has already reinvested in its business to keep it running. Strong free cash flow comes from ongoing operations and not the one-time events.
- Profit Margin:Profit margins that need to be measured: gross, operating, and net profit margins. In nutshell, margins tell you how much of each type of profit a company is generating per rupee of sales.
Figuring out whether or not a company has an economic moat remains largely a qualitative exercise, but the numbers should confirm your observations
The two techniques, however, will often be used together in order to examine a company’s operations and evaluate its potential as an investment opportunity. Charlie Munger once said “It is far better to buy a wonderful business at a fair price than to buy a fair business at a wonderful price.”