Undervalued stock: A valuable proposition for investors

by March 6, 2019 0 comments

Undervalued Stock

While quantitative factors help give a ratio analysis of a stock, a qualitative analysis helps an investor take an informed decision based on its quality

Picking undervalued stocks requires both quantitative and qualitative analysis. Quantitative factors use more of numbers and can be analysed through a ratio analysis or other valuation methods. On the other hand, qualitative factors are important to identify fundamentally strong companies and the quality of the stock, beyond numbers. Although these factors are very crucial for business valuation, they are very difficult to quantify. However, no company can ignore them as they are, sometimes, tangible. At the same time, they can be intangible, too, as they are the imperatives for valuation of a company. They provide a range of important information that factors both the financial statement analysis and valuation process. They also often identify important catalysts for the upward or downward movement  of stocks in the future.

Qualitative factors can be internal (company-related) or external (industry-related). There are different ways to make an analysis that has a significant bearing on the fundamental analysis: The business model, competitive advantage, customer base and management as well as corporate governance.

The core business model: It is important to understand what the company does and how it generates value for its customers. For some firms this is easy because they sell food or manufacture something simple. For example, if you look at the business model of KFC, one will notice that it sells delicious chicken burgers, chicken roasts, many varieties of mouth-licking chicken and veg recipes. Their business model is very easy to follow. An investor knows that this is how KFC makes money. Other times, it is more complicated. Therefore, it is imperative to first know the business model of a company and then conduct due diligence — find out its history, revenue generation model, how it got started, how long the company has been in the market, what is the revenue and profit margin maintained by them.

Customers and Geographic exposure: An investor must identify if the firm has a few large customers or a very fragmented customer base. It is also essential to know how the firm is viewed by the customers — as a value or premium brand? Is it consistent with the quality of its product? Does it deliver on time? And are the products fairly priced? Some companies serve only a handful of customers while others serve millions. In general, it’s a red flag (a negative) if a business relies on a small number of customers for a large portion of its sales because the loss of each customer could dramatically affect revenues. Further one must know the geographic sales breakdown — each economy has different growth rates and critical factors that may require additional research.

Competitive advantage: Before an investor evaluates a company in quantitative terms and judges it on the basis of figures, he/she needs to find out what’s the competitive advantage of the firm? This is important because without competitive advantage, competition increases and profit margins decrease or disappear. For example, if a company sells online, its logistics can be its competitive advantage, which can help it reach its customers superfast and deliver goods/products faster than its competitors. As an investor, one needs to think about the competitive advantage or lack of it before investing. Because competitive advantage is the sole ingredient of producing astounding or mediocre results. For example, while for Intel, Research & Development and size maybe advantageous, for Wal-Mart, it’s their industry leading logistics along with size that provide them leverage over suppliers.

Quality of management: One of the most important factors of any business is the quality of management in the company. If the management is motivated enough to steer the company toward its summit, it would be a gigantic force and it would always find a way even amid greatest economic turndowns. A good management team can make a big difference, especially when a business is in a challenging environment or still developing industry. Checking management comments in the financials can reveal if a team is hitting targets and has had successful strategy in the past. So before investing in a company, having a check on management quality is of utmost importance.

Corporate governance: In simple terms, corporate governance is the holy grail of a sustainable business. If corporate governance of a business is not in order, the entire business will crumble sooner or later. So, an investor should check out the corporate governance of a company and look out for three things: Are the rules of the company aligned with the firm’s mission and vision?; is the company serving each and every stakeholder well?; and is it legally compliant with the Government’s policies? If the answer to these questions is a ‘yes’, usually, the company is pretty good at corporate governance.

Externally, industry related factors that an investor should look out for are:

Industry growth trends: If an industry is expected to decline by five per cent, it is hard to forecast a company in it to grow at 10 per cent. Knowing the industry trends and cycle is critical factors in modelling company growth. Look at the historic data along with forecasts from competitors and trade groups.

Market share: A company can be the largest player in an industry, a small, up and coming firm or a niche player. Gaining or losing market share is a growth factor to consider, know what trends are driving the stocks gains or losses. Good market research help uncover these trends.

Competition: Identifying the closest competitor is very important. Often times, the competitive position determines pricing power and margins. Also, conduct market research to track competitors and search for actions that are disruptive such as a new product launch, discounting or strategic shift.

Regulatory authorities: External regulators are impactful for some firms. Knowing who plays key roles and issues critical legislation or rulings is critical.

Disruptive Technologies: Technologies can shape or break a company. Look for disruptive technologies that have shaped the industry altogether. And then see whether the company you are evaluating is using those technologies or not. In this age of continuous advancement of technologies, only disruptive ones make any progress.

These are the ten mantras that can help an investor look more than just numbers like profits and sales that can help them make an informed decision based on the quality of stock.

(The writer is Assistant Professor, Amity University)

Courtesy: Pioneer

Writer: Hima Bindu Kota

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