The Study of Stock Market through Fundamental Analysis

Lesson -> The Equity Research Part 01

13.1 - What should you expect?

After establishing the context, we will now create a method for conducting limited resource equity research. It is called a 'limited resource' because retail investors have only limited resources for equity research. These resources include the internet, company annual reports, and MS Excel. Institutions have access to human resources (analyst), company management and financial databases (such as Bloomberg, Reuters or Factset). ), industry reports etc. My goal is to show how you can better understand a company's business using the resources available. We will keep the ultimate goal in mind, i.e. deciding whether or not to purchase a stock, as we do this exercise.

We will be dividing the equity research process into three stages, as we mentioned in the previous chapter.

  1. Understanding the Business
  2. The checklist should be used
  3. To understand the fair market price of a stock, use Intrinsic Value estimation (Valuation).

Each step in the above stages has many steps. It is important to understand that there are no shortcuts and that you must not compromise any of the steps.

13.2 - Stock price vs. Business fundamentals

The first step in researching a company is to get as much information as you can about it. This crucial step is often overlooked and people rush to the stock price analysis. If you only have a short-term perspective, it is fine to analyze the stock price. Understanding the business is crucial for long-term investments.

You must be thinking why it is so important. The reason is simple. If you are more familiar with the company, the greater your confidence in staying invested, even during bear markets. Bear in mind that bear markets are when the price reacts to the fundamentals of the business. Knowing the business and company will give you the conviction necessary to justify why it is a good idea to invest in the stock, even if the market thinks otherwise. Bear markets are good for creating value. If you believe in the company, then you should consider investing in the stock during bear market conditions and not selling it. This is counterintuitive and requires years of experience in investing to fully understand.

Moving on, the best place to find information about the company is its website and annual report. To understand how the business is changing across business cycles, we need to review at least five years of its annual reports.

13.3 - Understanding the Business

To begin understanding the business we must make a list. You can find the answers to these questions by looking through the annual report of the company and the website.

These are some questions I believe will help us understand the business. Each question has a rationale.

Sl NoQuestionThe rationale behind the question
01What does the company do?To get a basic understanding of the business
02Who are its promoters? What are their backgrounds?To know the people behind the business. Sanity check to eliminate criminal background, intense political affiliation etc
03What do they manufacture (in case it is a manufacturing company)?To know their products better, helps us get a sense of the product’s demand-supply dynamics
04How many plants do they have and where are they located?To get a sense of their geographic presence. Also at times, their plants could be located in a  prime location, and  the value of such location could go off-balance sheet, making the company highly undervalued
05Are they running the plant in full capacity?Gives us an idea on their operational abilities, demand for their products, and their positioning for future demand
06What kind of raw material is required?Helps us understand the dependency of the company. For example, the raw material could be regulated by Govt (like Coal) or the raw material needs to be imported either of which needs further investigation
07Who are the company's clients or end-users?By knowing the client base, we can get a sense of the sales cycle and efforts required to sell the company’s products

Who are their Competitors?

Helps in knowing the competitors. Too many competing companies means margin pressure. In such a case, the company has to do something innovative. Margins are higher if the company operates in – monopoly, duopoly, or oligopoly market structure
09Who are the major shareholders of the company?Besides the promoter and promoter group, it helps to know who else owns the company’s shares. If a highly successful investor holds the shares in the company, then it could be a good sign
10Do they plan to launch any new products?Gives a sense of how ambitious and innovative the company is. While at the same time a company launching products outside their domain raises some red flags – is the company losing focus?
11Do they plan to expand to other countries?Same rationale as above
12What is the revenue mix? Which product sells the most?Helps us understand which segment (and therefore, the product) is contributing the most to revenue. This in turns helps us understand the drivers for future revenue growth

Do they operate under a heavy regulatory environment?

This is both good and bad – Good because it acts a natural barrier from new competition to enter the market, bad because they are limited with choices when it comes to being innovative in the industry
14Who are their bankers and Auditors?Good to know, and to rule out the possibility of the companies associated with scandalous agencies
15How many employees do they have? Does the company have labour issues?Gives us a sense of how labour-intensive the company’s operations are. Also, if the company requires a lot of people with a niche skillset, then this could be another red flag
16What are the entry barriers for new participants to enter the industry?Helps us understand how easy or difficult it is for new companies to enter the market and eat away the margins
17Is the company manufacturing products that can be easily replicated in a country with cheap labour?If yes, the company may be sitting on a time bomb – think about companies manufacturing computer hardware, mobile handsets, garments etc
18/Does the company have too many subsidiaries?If yes, you need to question why? Is it away for the company to siphon off funds?

These questions can be used as a starting point for understanding any company. As you begin to search for answers, new questions will be posted that you will need to answer. This Q&A framework doesn't matter what company you're looking at. Your understanding of the company will increase dramatically, I am certain. Because the Q&A process requires that you read and find so many information about the company, you will begin to understand the company better.

This is only the first step of the equity research process. I recommend that you stop researching the company further if you discover red flags or other issues about the company. If you find red flags, it is not worth continuing to stage 2 equity research.

Based on my experience, stage 1 of equity research (i.e. It takes approximately 15 hours to complete 'Understanding The Company'. After going through the process, I try to sum up my thoughts on one sheet of paper. This would allow me to capture all the key information I have learned about the company. The information sheet must be concise and clear. This information sheet must be concise and to the point. If this is not possible, it means that I don't know enough about the company. Stage 1 is completed. I now move on to stage 2, which is the "Application of Checklist" stage of equity research. Keep in mind that the equity research stages should be performed in the same order.

Now we will move on to stage 2 in equity research. You can best understand stage 2 by actually implementing it on your company.

Throughout this module, we have been working with Amara Raja Batteries Limited. (ARBL). Therefore, it seems sensible to evaluate the checklist for the same company. Remember that the equity research framework is the same regardless of whether the company is different.

We will be discussing ARBL in detail as we get to know the company better. This is not intended to demonstrate how awful ARBL is but to provide a framework to what I consider to be a fair and adequate equity research process.

13.4 - Use of the checklist

The equity research process's Stage 1 helps us to understand the how, what, who and why. This helps us to get a complete picture of the company. But, they say that the proof of a pudding is in its eating. So, no matter how attractive a business may look, the numbers should be equally attractive.

The 2 nd stage in equity research's goal is to help us understand the numbers and evaluate whether the nature of the company and its financial performance are complementary. If they don't complement one another, the company won't be considered investable grade.

We have seen the checklist in the preceding chapter. I will reproduce it here for your quick reference.

Sl NoVariableCommentWhat does it signify
01Net Profit GrowthIn line with the gross profit growthRevenue growth should be in line with the profit growth
02EPSEPS should be consistent with the Net ProfitsIf a company is diluting its equity, then it is not good for its shareholders
03Gross Profit Margin (GPM)> 20%Higher the margin, higher is the evidence of a sustainable moat
04Debt LevelThe company should not be highly leveragedHigh debt means the company is operating on high leverage. Plus the finance cost eats away the earnings
05InventoryApplicable for manufacturing companiesA growing inventory, along with a growing PAT margin is a good sign. Always check the inventory number of days
06Sales vs ReceivablesSales backed by receivables is not a great signThis signifies that the company is just pushing its products to show revenue growth
07Cash flow from operationsHas to be positiveIf the company is not generating cash from operations, then it indicates operating stress
08Return on Equity>25%Higher the ROE, better it is for the investor, however, make sure you check the debt levels along with this

Let's take a look at each item on the Amara Raja Batteries checklist and analyze the results. We will first examine the P&L items: Gross Profit, Net Profit and EPS.

Revenue and Pat Growth

The rate at which a company is growing is the first indicator that it may be of an investment grade. We need to assess the company's growth by looking at its revenue and PAT growth. Growth will be evaluated from two perspectives.

  1. Year-on-year growth - This will show us how much progress the company makes each year. Industries can experience cyclical shifts. If a company experiences flat growth, that is acceptable. But, make sure to check the competition and make sure the industry is experiencing flat growth.
  2. Compounded Annual Growth Rate (CAGR - This gives us an idea of how the company evolves and grows across business cycles. An investment-grade company that is good and reliable will often be the first to weather the changes in business cycles. You will see a healthy CAGR.

I prefer to invest in companies that are growing (Revenue or PAT) at a rate of 15% CAGR.

Let's see how ARBL does here...

 FY 09 -10FY 10-11FY 11-12FY 12 -13FY 13 – 14
Revenue (INR Crs)14811769239230053482
Revenue Growth 19.4%35.3%25.6%15.9%
PAT (INR Crs)167148215287367
PAT Growth (11.3%)45.2%33.3%27.8%

CAGR revenue growth for the 5-year is 18.6% and CAGR PAT growth for the 5-year is 17.01%. These numbers are interesting and can be considered healthy. We still have to assess the remaining numbers on the checklist.

Earnings per share (EPS)

Earnings per share are the per-share profitability. The company's earnings per share and PAT growth at a similar pace indicate that it does not reduce its earnings by issuing more shares. This is good news for existing shareholders. This can be viewed as an indication of the management's abilities.

FV Rs.1FY 09 -10FY 10-11FY 11-12FY 12-13FY 13 – 14
EPS (In INR)19.5617.3412.5916.7821.51
Share Cap(INR Crs)17.0817.0817.0817.0817.08
EPS Growth -11.35% – 27.39%33.28%28.18%

For FY14, the 5 year EPS CAGR is 1.90%.

Margin of gross profit

As a percentage, gross profit margins are calculated as a.

Gross Profits/Net Sales


Gross Profit = [Net Sales - Price of Goods Sold]

The cost of making finished goods is called the cost of goods sold. We discussed this calculation as we were analyzing the inventory turnover ratio. Let's see how ARBL's Gross Profit margins changed over time.

In INR Crs, unless indicated.FY 09-10FY 10-11FY 11-12FY 12 -13FY 13 – 14
Net Sales14641757235929443404
Gross Profit450491677785954
Gross Profit Margins30.7%27.9%28.7%26.7%28.0%

The Gross Profit Margin (GPM), is clearly impressive. According to the checklist, a minimum GPM requirement of 20% is required. ARBL can do more than meet the GPM minimum. This means that ARBL has a few things to consider.

  1. ARBL occupies a top spot in the market structure. This could be due to the lack of competition in this sector which allows a few companies higher margins
  2. High operational efficiency is a reflection on the management's abilities.

Debt level - Balance Sheet check

The checklist's first three points were mostly related to the company’s Profit & Loss statements. Now we will look at a few items on the Balance Sheet. The Debt is one of the most important lines on the Balance Sheet. A high level of debt is indicative of high levels of financial leverage. Growing at the expense of financial leverage can be very dangerous. Remember that a high level of debt on the balance sheets can lead to a significant financial cost charge. This reduces the firm's retained earnings.

Here's how ARBL's debt looks.

Debt (INR Crs) Evaluation

 FY 09-10FY 10-11FY 11-12FY12-13FY 13-14

The debt seems to be stable around 85Crs. It is actually encouraging to see the debt have fallen in comparison to FY 2009-10. Apart from checking the interest coverage ratio, which we discussed earlier, I also check the debt percentage as a percent of 'Earnings after interest and taxes' (EBIT). This is a quick overview of how the company manages its finances. It is evident that the ratio of Debt to EBIT has been decreasing.

ARBL did a great job managing its debt levels efficiently, which I believe is a credit to them.

Inventory Check

If the company being considered is a manufacturer, it makes sense to check for inventory data. We can use the inventory data to help us in many ways.

  1. A growing company will raise inventory and increase PAT.
  2. An indefinite inventory of days is a sign that management is operating efficiently to some degree.

Let's see how ARBL does on the inventory data.

 FY 09-10FY 10-11FY 11-12FY 12-13FY 13-14
inventory (INR Crs)217.6284.7266.6292.9335.0
Inventory Days6872604747
PAT (INR Crs)167148215287367

The inventory number of days is more stable than it used to be. It does show signs of a slight decrease. We have already discussed how to calculate the inventory number of days. Both PAT and inventory are showing similar signs of growth, which is a positive sign.

Sales vs Receivables

Now we will examine the sales number together with the company's receivables. It is not a good sign to have a sale that is backed up by receivables. This is a sign of credit sales and raises many questions. Is the sales team selling products on credit? Are suppliers offered attractive, but not sustainable credit by the company to help them sell?

 FY 09-10FY 10-11FY 11-12FY 12-13FY 13 – 14
Net Sales(INR Crs)14641758236029443403
Receivables (INR Crs)242.3305.7319.7380.7452.6
Receivable at a% of Net sales16.5%17.4%



Here, the company has demonstrated stability. The table shows that a significant portion of their sales are not backed up receivables. This is very encouraging. The receivables percentage as a percentage of net sales has shown signs of decline just like inventory days. This is quite remarkable.

Cash flow from Operations

This is actually one of the most critical checks to make before investing in a company. Cash flows should be generated by the company. This is where the proof of the pudding. Any company that is stealing cash from operations is a red flag. 

In INR CrFY 09-10FY 10-11FY 11-12FY 12 -13FY 13 – 14
Cash flow from Operations214.286.1298.4335.4278.7

Although cash flow has been volatile, it has remained positive over the past 5 years. ARBL's core operations are able to generate cash, so they can be considered successful.

Return on Equity

In chapter 9, we have had a lengthy discussion about Return on Equity. If you need to review it again, I encourage you to do so. The company's return on equity (ROE), measures the percentage of the return it generates, keeping shareholders' equity in perspective. ROE is a measure of how successful company promoters have been in investing their own money in the company.

This is how ARBL's ROE performed over the past 5 years.

In INR CarsFY 09-10FY 10-11FY 11-12FY 12 -13FY 13 – 14
Shareholders’ Equity543.6645.7823.51059.81362.7

These numbers are amazing. Personally, I prefer to invest in companies with ROEs above 20%. Remember that ARBL has very low debt. The good return on equity is not supported by excessive financial leverage. This is another highly desirable feature.


Remember that we are currently in stage 2 equity research. ARBL is able to meet all of the requirements in stage 2 and I believe that they are very competitive. You must consider the outputs of stage 2 and your findings from stage 1 when you are an equity analyst. After these two stages, you will be able to form a reasonable opinion based on facts. The business is likely to have investment-worthy attributes.

But, before you purchase the stock, ensure that the price is correct. This is what we do in stage three of equity research.

To summarize

  1. Equity Research on 'Limited Resources' can be done in three stages
    1. Understanding the Business
    2. The checklist should be used
    3. Valuations
  2. Stage 1, which is the objective of this stage, i.e. Understanding the business is only possible if we have all of the necessary information. This is best done using the Q&A method
  3. We start the Q&A process by posting simple questions that we can answer.
  4. We should have all information about the business by the time that stage 1 is completed
  5. The company's annual reports and website contain most of the answers needed for stage 1.
  6. Remember that when you were researching the company in stage 1 it was important to note that if something is not convincing about the company, then it is often a good idea for you to stop further research
  7. Stage 1 requires you to be convinced (based on facts). This will help you to be strong and confident during bear markets.
  8. Stage 2 of Equity Research requires that you evaluate the performance and financial condition of the company in various ways.
  9. Only after your company has passed stage 1 and 2, you can move on to stage 3.