7 ways to shortlist the right stocks

Equity as an asset class outperforms all other asset classes in the long run. True. 

But, how do you pick the right company?

It’s always important to spend time in knowing a company, its business, financial health and prospects, market capitalization of these companies ranges from a few lakhs to over Rs 2 lakh crore and the prices of shares from less than a rupee to over Rs 12,000 per share.

So, how and where do you make a start? I will give you seven basic screening criteria, which will help you shortlist companies that are worth researching in the first place.

1. Is the company’s market cap more than Rs 250 crore (Rs 2.50 billion)? - Setting a minimum market cap floor really helps — it eliminates very small companies, or penny stocks. Generally, small companies have a small revenue base and they do not spend too much on investor relations. This makes tracking them difficult.
2. Are the company’s trading volumes high? - The company should have a reasonable trading volume — at least a few thousand shares per day. If you buy into a stock that has low volume, it can become difficult to get out when the markets fall. Both rise and fall is sharp in stocks with low volume. Also, the impact cost is high.
3. Does the company make quality disclosures? - The company should have good quality disclosures. This is an easy test. All you have to do is visit the company website and see press releases and results for the last few quarters. In the results part, you need not get into numbers in detail as of now, but do see how the developments of last quarter have been explained. For example, see if cost has increased, or margins have declined, and whether there is an explanation for it. Large companies, especially in the information technology sector, are generally good at this. Tata Consultancy Services, India’s largest IT company by revenue, has a transcript of analyst conference call on its website, which possibly answers all the questions that investors have. Availability of information makes tracking easy and decision-making becomes quicker while you are invested in the company. 
4. Does the company have operating profits? - Sometimes, companies raise money from the equity markets in their initial stages and hope to cover the costs by generating profits from operations later. Actually, they are in a stage when they spend money for, say, setting up plants, or research and development facilities. These businesses sound exciting, but can be risky. It is advisable to avoid such companies. New projects involve a lot of regulatory approvals and can get delayed, which can escalate cost. Also, stock prices of such companies are the first to fall during any broader market correction, as there are no earnings to support the prices. Therefore, it is always safer to be in companies that generate profits from their operations. 
5. Does the company generate constant cash flows? - At times, fast-growing companies may show profits without generating cash. These companies are in their expansion stage. They have to generate cash eventually and create value for the shareholders. Companies with a negative cash flow may have to seek additional capital, either through debt or equity. Debt will increase the risk while equity will dilute the earnings, which will get reflected in the share prices also. 
6. Is its return to equity (RTE) constantly above 10 per cent? - RTE is the profit a company generates with the shareholders’ money and is calculated by dividing net profits with shareholders’ equity. It indicates how well a company has deployed investors’ money. The RTE is generally low in case of manufacturing companies and is higher for services companies as the cost of setting infrastructure is low in services companies. Use 10 per cent as the minimum limit for companies to qualify. There are just about 400 companies listed on NSE with a market cap above Rs 250 crore that generated return on equity above 10 per cent in the financial year 2007-08. 
7. Is the earnings growth constant or cyclical? - Cyclical earnings implies that profits move up or down depending on the business cycle. Businesses generally move in cycles. This is commonly seen in commodity companies, where a shortage or sudden rise in demand helps prices to move up, resulting in super normal profits for a while. Once the cycle is reversed, it becomes difficult to get out. Commodity prices are interlinked globally, and any demand-supply mismatch in one corner of the world can disturb prices all over.

Companies in the Pharmaceuticals and FMCG space have stable growth in the long term as demand in these sectors depends on the business cycle and macroeconomic movements. The services sector also has stable earnings growth compared to commodity stocks.

If you carry out these seven checks, you will, by and large, be able to eliminate companies that are not worth investing. However, investors must note that these conditions are not fool-proof and there can always be exceptions.

 Important terms to check while purchasing a stock

• P/E:
  The P/E ratio (price-to-earnings ratio) of a stock (also called its “earnings multiple”, or simply “multiple”, “P/E”, or “PE”) is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share.A higher P/E ratio means that investors are paying more for each unit of income. It is a valuation ratio included in other financial ratios.The reciprocal of the P/E ratio is known as the earnings yield. Stock having a P/E less than 30 are said to be good investments
• EPS:
  EPS. Total earnings divided by the number of shares outstanding. Companies often use a weighted average of shares outstanding over the reporting term. EPS can be calculated for the previous year (”trailing EPS”), for the current year (”current EPS”), or for the coming year (”forward EPS”). Note that last year’s EPS would be actual, while current year and forward year EPS would be estimates.
• DVI (Dividend yield):The yield a company pays out to its shareholders in the form of dividends. It is calculated by taking the amount of dividends paid per share over the course of a year and dividing by the stock’s price. For example, if a stock pays out $2 in dividends over the course of a year and trades at $40, then it has a dividend yield of 5%. Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower ones, and most small growing companies don’t have a dividend yield at all because they don’t pay out dividends