Decoding basic financial data for stock investments

 

“At 11:58 hrs XXX has formed a bullish bar reversal chart pattern today. A Bullish Bar Reversal occurs when today’s low is lower than its previous day low and the current price / today’s close is higher than its previous day close!”

If statements such as these make you suspect that reading stock financials is something akin to sorcery and witchcraft, you are not alone! In fact, some statements that emanate from “industry experts” on this topic are so obtuse, that you may well be forgiven for rushing off to collect one eyed newt eggs to figure out what on earth these people are talking about! Well, I’m not about to pretend that its all gobbledegook and does not matter. Yes, the information is useful and has its time and place. But there’s really no point in stressing about how to run, even before you figure out how to walk. It’s as simple as that. And yes, do remember that every industry evolves its own complex jargon, so that an aura of indeterminate knowledge surrounds its experts. In an age when knowledge is everything,  it helps to make consumers think that there is valuable knowledge out there, which is not available to them. But when you decode the jargon, the theory sometimes turns out to be intuitively simple and often obvious! 🙂

So there’s hope, and since I belong to the group of people who still cant make sense of the statement we began with, let me try and share how I read basic financial data for shares I am interested in. Please note that this is just my pattern. There is no “right set” of data to follow. Different people follow a slightly different mix of factors. But they tend to be broadly in the same 4 zones. Business fundamentals, revenue, valuation ratios and future prospects.

To begin with, lets stress on the importance of going through this exercise of basic financial analysis. The quickest way to lose money in the stock market, is to blindly follow the “hot tip” that Joy achayans cousin who works in Bombay heard from the sub broker whose chacha works as a dealer in BSE. Period! Please remember that hot tips are almost always circulated by traders who want to move the stock in a certain direction for a short period of time and get out, while the bakras are left holding the can. You DO NOT want to be the bakra!

So the first Question I ask myself under business fundamentals is, do I understand this industry and do I have a sense of who is doing well in this business? Or can I at least learn up on this industry by going through reports, web data etc that exists freely today? Do I know someone in said company or industry who I can speak to and get some ground knowledge? Can I get a sense of where is this industry heading overall? If the answer to most of these questions is “No”, I simply drop it even if my banker is telling me that his research desk “strongly reccommends” this stock. Let me try an illustrate with some examples. As someone who had to warm airline seats as part of his job description for most of his life, one could sense quite early that Kingfisher was going down the tube, while Spicejet and Indigo seemed to be getting their act together. You could just get a feel for this, without anyone feeding you financial data or any kind of reports! So why would you not use your first hand, genuine street knowledge in assessing where you want to invest in? You would certainly need to build on it, but its not a bad starting point at all!

Now lets look at an e.g. where you may have no direct experience. Assume you get a recommendation to buy shares in a firm making Tractors, because the analyst believes that rising farm incomes and non availability of manual labor is going to drive demand for mechanization. Sounds perfectly logical, right? But if you speak to someone from the industry, they may tell you that two huge negatives are staring at the industry in the short term. The failure of monsoons means that many farmers are going to experience a severe cash crisis, and may not even bother ploughing their fields in absence of good rainfall. Moreover in the current economic climate, banks have severely curtailed lending. Which means loans to buy tractors are simply not available. Anyone should be now able to decipher that it may be smart to wait for 3 to 6 months. Shares of the same companies are likely to fall significantly below today’s levels, and that may be the right point at which to buy and wait for the fundamentals to kick in, for the long run. Remember, its not an exact science, but the value of understanding a business and thinking like a businessman, just cannot be understated.

Now armed with basic market intelligence, lets take a look at specific financial data that is published for public companies on almost every equity trading website. I use www.moneycontrol.com and http://economictimes.indiatimes.com/ but there are dozens of other sites out there, providing similar information. To begin, you will need to build some degree of familiarity with the terms and acronyms of the equity trade, and its also good to acquire basic knowledge of how to read a balance sheet etc. One recommended site which explains finance for beginners in very simple terms is uncle Sam’s SEC website, which you may want to go through in your spare time.   http://www.sec.gov/investor/pubs/begfinstmtguide.htm

A good place to begin specific analysis, is with revenue. After all, nothing works better in business than the phrase, “show me the money!”. As long as the cash is coming in at regular intervals, and in large enough chunks, even the most mismanaged of companies has hope of turning around. So its good to look at how much revenue has the company earned in the latest results, how does this compare with revenue earned by competitors, and against the overall market capitalization of the company, and what has been the year on year (or q on q) growth in revenue for this company?  Again, please remember that no data can be deciphered in absolute terms. For e.g. if you were to ignore overall economic indices, you would find that even the best of companies is showing a drop in revenue today. That means very little, unless examined in the context of overall industrial performance. However, if you see that a company has been posting poor revenues compared to its peers for many years, and if you see that for many quarters in a row, their revenues have been dropping, then its reason enough to worry. Is the company being mismanaged? Is it in a declining industry space etc.?  Bear in mind that its quite possible to see a strange drop in revenue in one given period. But often that is because the company is following healthy accounting practices and making provisions for either upcoming expenses or regulatory changes etc. Which is actually a good sign and not a bad one. So its quite easy to misread such data, if not observed in a detailed and historical manner 🙂

The ratio or factor that is commonly used to measure revenue performance is EPS, or “Earnings Per Share”. Put in simple terms, this is the net current revenue declared by the company, divided by the number of shares issued by the company. This is a useful ratio, because it helps us understand the overall profitability of the business. EPS is the revenue that would need to be paid out to the holder of each share, if it was to be divided proportionally. Does the entire revenue actually get paid out? Not really. The company would retain part of its profits every year for investing into the future. The remaining amount is shared, and this is what is paid out as “dividends”. Some companies historically pay high dividends, while others hold larger chunks as company reserves.

What this means is that different types of investors are attracted to different types of companies. Those that want a steady income from their shares, tend to invest into high dividend paying companies. While those who aren’t bothered about dividends, but would rather support high investments into making the company grow (and hence they would make money through share price appreciation), prefer the latter. You also get characters called “dividend strippers” (no, there are no shiny poles involved here) 🙂 who buy a share just before dividend is to be announced, collect the dividends and then sell the share. But its not as simple as it sounds. Based on the expectation of dividend going to be paid, the share price tends to rise as the date approaches for payout. And sometimes the payout is lesser than even how much the share has climbed up. As soon as the payout has been made, the share price tends to slip down again. So dividend stripping is much trickier than you might think and you can literally be caught with your pants down! 😉

I am guessing that by now your head is starting to feel a little heavy and the eyes grow weary. The danger of getting into too many concepts at once, is that we stop absorbing inputs. So lets summarize and stop for now. In the next part (as and when I can get out of lethargy and type 😉 we can discuss important financial ratios and how to analyze / compare them. In the meantime, lets get our teeth into the important concepts we covered today, and mull over :

Step 1. Understanding the importance of overall business analysis

Step 2. Analyzing the concept of revenue flow and EPS

step 3. Figuring out dividends and how to behave around them

Happy investing! And remember, if you fall off  a bike, you don’t stop riding! You pick yourself up, get back on the bike and keep going till you learn how to bloody ride! 🙂

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