Second set of Questions
The below are very simple techniques, yet I find them powerful while practicing. Some of them tells you what you see may not be true always e.g.:
- high debt equity ratio with a good dividend track record, buy back may be a sign of moat.
- Or low current ratio with high earnings, buy back or dividend can be very good.
- high stock pile of inventory may indicate superior product profile and order book.
Explore for yourself and let me know.
Question: Whether Net Earnings for company showing a consistent upward trend? (last ten years).
Hint- remove share buy backs, other income to normalize earnings. Company with competitive advantage will have always higher earnings. Watch out for the ones above 20% consistently over a long period of time.
Caution- a very high net profit ratio may indicate company has accepted higher risk to make easier money. For example banks make good amount from arbitrage take at @6% and lend @7%. When a disaster looms like sub prime it can plunge to darkness.
Question- is the EPS (pre-tax) is consistently on rise for last ten years?
Hint- the company may not be going through expensive process of change management or even not spending mega bucks on selling, advertisement etc.
Question- does the company have a surplus cash consistently over ten years (cash and cash equivalent divided by total assets). Cross check with low debt as well to rule out loan has been not utilized.
Hint- rule out three scenarios for excess cash balance 1. Sale of asset 2. Temporary pile of asset before usage 3. Sale of shares or debentures
Question: inventory to sales is on rising trend over last ten years?
Hint- this may indicate company is finding profitable ways to increase sales, and this increase has called for increase in inventory, to ensure orders can be honored in time.
Question: does the company show a declining trend of lower percentage of net receivables to sales?
Hint- check this with number of big 5 customers (if available). If you see same customers are there and sales days are going down it would mean company is able to manage oligopoly status and demand lower credit terms from customer.
Question: Current ratio (current assets divided by current liabilities) is consistently less than 1.
Hint: these companies are so strong they easily overcome current liabilities. Check the dividend power or stock buy backs to confirm the earning power.
Question: low asset base (tangible asset).
Hint: check this with debt and earning. This means moat companies doesn’t spend much in replacing assets. Also consistent products, no transformation required in products to stay alive.
Question: does company buy bonds and shares of moat companies?
Hint: two genius thinks alike, this may tell us moat company is putting money in another moat company which will compound earnings better.
Question: check for moderate return on assets with high asset base.
Hint- the premise here is if a company having 40% ROA with 1 Cr asset base will be easily taken over. But some one with 25% ROA and 10K Cr asset base difficult to be bull dozed.
Question: check whether company is using secured loans to make payment for unsecured loans?
Hint- this means I am pledging my assets to pay off debt required for day to day assets. This is not a good sign. For moat company do the reverse.
Question: check whether long term debt is maximum 2-3 times of earnings.
Hint: moat companies don’t need a lot of debt, this is a way to check that.
Question: increasing debt- equity ratio over the years?
Hint: the logic behind this is moat companies spend a lot of money in buying back shares or pay dividend. That pulls down the equity base, check high debt equity ratio with share buy back or heavy dividend payment (30-40% pay out ratio).
Question: check whether retained earnings growing consistently.
Hint: this means that moat company has made a lot of earnings which are reinvested to business. Confidence of making more compounding, check this with high ROE. Rule out the high retained earnings because of acquisition.
Question: check whether capital expenditure (see cash flow) is less than 30% of net profit.
Hint: moat companies doesn’t pay much for replacing asset. Even if you get a super number like 30 ensure capex to net profit is going down.