This Article was originally published in The Global Analyst

There is a need for a new template, which combines both quantitative as well as qualitative aspects of a firm’s performance, but, unlike the existing valuation models, does not box a company in terms of a target price.

Analyzing a stock is like analyzing a person. There are too many moving parts, and it is complex. Hence, the profession of research and analysis when it comes to capital markets is always a sought-after profession! Of course, our opportunity set will be listed companies in India and even here the focus will always be on the stocks that move the index (mainly large caps and to an extent mid-caps). If we believe in the Efficient Market Hypothesis (EMH), then the current market price of a stock is the best reflection of its value since all information is already and instantly embedded in the price. However, in real life, we know that this is not true. There is a huge information gap between the people that run a company and people that invest in that company. Financial information about a company does come to the market at regular intervals but still with a lag and they are mostly backward looking. Hence, the task of an analyst is to use that information and project the future in terms of profitability and cash flows. Based on this, one can use several valuation models to get a fair value of a stock and conclude if it is attractive based on the gap between fair value and the current market price. Sell-side analysts are also trained to provide target prices based on this fair value estimates. However, this exercise at best is a long shot at the future and analysts love to revise their estimates every quarter based on the new flow of information. While that time-tested model can still be useful in parts, what I am proposing as a template here is a combination of several metrics both quantitative and qualitative. Also, the idea is not to box a company in terms of a target price but measure them on a scale by giving weightage to both quantitative as well as qualitative factors.

Also, the assessment will differ based on whether a stock is a financial stock or non-financial stock. The reason why this distinction is important is that in the case of financial stocks, money is the raw material and hence high debt should be viewed favorably whereas in case of non-financial stocks it should be viewed unfavorably. Hence, the framework proposed here will be two i.e., one for financial stocks (which includes banking and financial services companies), while the other one is for non-financial.

The framework has four major tracks:

1.     Financial metrics (40% weight): This includes key aspects like top line (sales) growth, bottom line (net profit) growth, debt to equity ratio, etc. While analyzing the metrics for top line and bottom line, we have considered both the short term and long term. The idea is to capture the financial performance of the company.

2.     Non-financial metrics (30% weight): This includes aspects like foreign ownership, CEO tenure, research analysts’ coverage, etc. The idea is to analyze qualitative aspects of a company.

3.     Valuation metrics (20% weight): This includes the most followed p/e ratio, p/b ratio, Enterprise value as a % of sales, etc. The aim is to see if a good stock is also available at a good price,

4.     Others (10% weight): This includes liquidity and Beta.

While the broad framework remains the same for both financial and non-financial stocks, we have considered different metrics to measure financial stocks when it comes to financial evaluation.

Methodology:

We define parameters for each metric and score them on a scale of 0-5 based on how they fare.

For example, if the long-term top line growth is 5% or lower, it scores 1 whereas if the growth exceeds 25% it will score 5. Since this is for financial stocks, the top line would mean revenues. Also, for financial stocks the higher the debt equity ratio, the higher the score.

In all we have considered 23 parameters and provided the formula and rationale for choosing them. The flow chart provides the drill down including the weights that should be applied to get the overall score.

A word about qualitative parameter can be in order here. By nature, qualitative parameters are not easily quantifiable and hence many analysts will ignore them. However, if we can succeed in identifying enough qualitative parameters that can be quantified in some way, it will go a long way in deciphering investment opportunities. A good example can be CEO tenure. Leadership defines the fortunes of a company and hence the tenure of a CEO can be a good gauge. Indian landscape is bound with CEO stories, both success and failures. The longer a CEO stewards a company’s ship, the better it is as it provides strategic continuance of business plan. Deepak Parekh, who steered the HDFC ship for a very long time is a classic example.

Regarding actioning the scores, investors can do well to form portfolios of stocks with high scores and regularly prune the list as it is quite possible that companies may gyrate within the band and what was considered good sometime back may have deteriorated and hence would warrant exclusion and vice-versa.

Score Calculation – An Example

Cipla

As we can see from the example of Cipla, a listed pharmaceutical stock, we arrive at a total score of 3.16 on a scale of 0-5. The upside to the score stems mainly from a recent surge in profits, low debt, long CEO tenure, good research coverage by analysts, attractive P/E ratio, and low beta. However, the stock scores poorly on several other parameters such as top line growth (both long-term and short-term), bottom-line growth (long-term), return on capital employed, return on assets, foreign ownership, and some valuation parameters. Hope this helps you arrive at your own list of stock stories that help you identify the next potential candidate for investment.

Happy investing!

(Disclaimer: This article is for information purposes only and is not intended to be, and must not be, taken as the basis for an investment decision. The readers must consult certified experts before making any investment-related decisions.)