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27 June 2009

THE ART OF SELECTION - PART 2

In the previous article of this series we had discussed the Price Earning Ratio and how to use it to filter stocks. I got a few very searching questions in the comments section. So I would request readers to go through those too. 

We now take the second step forward and one which could be a major stumbling stock for many an aspiring portfolio picks. If a stock fails this test, I would need towering logic to overrule it. 

All business is margin and it is the bottom line - the profit margin. The last word in the financial statement analysis and hence a major filter for us. Profit margins are of three types.

Gross Profit Margin
When a firm does business it gets paid for it(Revenue). For earning this revenue it spends some money which is called as Cost of Sales. Revenue - Cost of Sales is the Gross Profit. And Gross Profit divided by Revenue is Gross Profit Margin(GPM).

It is in percentage terms and hence normalised, permitting comparison across firms. A caveat - do not compare apples and oranges - try and compare two companies of the same kind. It may not be necessary that two firms in the same sector are compareable - e.g Infosys and TCS are compareable, Infosys, Helios & Matheson and Financial Technologies are not.

The comparison will reveal how effective is the company in keeping its costs in check. Are its executives playing around with shareholder value? (A sure shot indicator of this is - to what is executive compensation pegged to - Revenue or Profits). 

Operating Profit Margin
Mathematically it is Profit Before Interest and Taxes(PBIT or EBIT) divided by Sales.  Also termed as Return on Sales.

It is a very good indicator of the operating health of the company. It shows how well the firm is carrying out its core businesses. It disregards ( for the denominator) any revenue generated by non-core business activity like sale of asset or financial transaction gains. For the numerator, it omits expenses like taxation and interest which may skew the earnings due to say, a tax holiday given by the govt for a few years or a large debt on the books during initial years after setting up.

So I use it to evalute the following:-
  • New firms which are not yet profitable. eg. Cairn. 
  • A firm with an abnormally large debt.
  • A firm divesting part of its business or assets during the financial year.

Net Profit Margin (NPM)
Mathematically it equals the Net Proft(After taxation, interest etc) divided by the total revenue generated, multiplied by 100. 

This basically tells you how much money goes into the hands of the actual owners i.e, the shareholders after deducting all kinds of possible expenses per Rupee of revenue. It varies from industry to industry. A lower NPM does not necessarily mean a weak business - it could well be a conscious business strategy like for a discount retailer . A prime example in the indian context is Pantaloon Retail which operates on wafer thin margins. (For a detailed analysis of Pantaloon Retail read here)

A comparison between GPM and NPM can give you a good understanding of the cost structure of a company. However, all else being equal, the higher the NPM, better the firm.

In the next part of the series we shall delve into the Return on Equity - metric very close to the heart of many an equity investor.

Happy hunting !

7 comments:

RK said...

The post on PE was really informative esp the one on the reported and adjusted which was new to me. Pls keep it going, will help lots of newbies like me.

rk
http://thedumbinvestor.blogspot.com

Puneet said...

@ Rk,
Thank you. I hope this one helps you too.
Liked the concept of your blog.

income.portfolio said...

What are you thoughts on cash flow?

Puneet said...

@ TIP
When they say "Cash is King", it is true in more ways than the obvious. A very significant metric but with some inherent limitations.

Ronak said...

Hi Puneet,

It was indeed a nice article!

just a query, I am not sure how to calculate the fair value/ intrinsic value/book value of any stock. I appreciate if you could publish an article with a fully detailed example on how to calculate the book value/ fair value at any given time.

I mean how can anyone know whether a particular stock is over valued or under valued? What parameters need to be considered in order to find out the value? like the P/E , future earnings, past dividend % or any specific equation? Where to find the values of the parameters? If I look at the websites such as money control or rediff money, they may not have all the parameters values or all past years results. In that scenario, how would any one can judge whether a fundamentally good stock is currently undervalued and start accumulating it or not.

As most of the times, I get the recommendation from some site/blog about a stock being available at a good price, but if I want to judge myslef and do the research on own, I would like to see its fair value along with other parameters as its P/E, fundamentals, sector growth etc.

Appreciate your thoughtful advice.!

- Ronak

sumi said...

Hi Puneet nice informative article. I normally dont look at margins but will do some studying now keep the series going :)

Puneet said...

@ Ronak
There are a number of different though complementing ways to calculate the fair value of a company. Depends on what kind of business it is in. If it were a monolithic mature company like Infosys I could use DCF. For a diversified conglomerate like Reliance probably Sum of the Parts would work.
For specific parameters, I am writing this series. So watch out for more.
Info is available on the NSE/ BSE website in the company filings.

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This blog should not be construed as investment advice, either on behalf of particular stocks or in regard to overall investment strategies. It is a site aimed at understanding competitive advantages and valuing businesses. The information provided here comes from publicly accessible sources, but errors in these sources and in transcription may occur. Any investment decisions you make should be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs.