I earlier shared my views on how to look around us for great investment worthy companies.

Spotting a great company is just the first step. We also need to make sure that the company we are going to invest in is also fundamentally very strong. Before I delve into to this topic, let me share a very basic fact with all of you. How do we make profits when we invest in a company? 1. Price appreciation 2. Dividends Lets take the first and the primary reason why we can profit from investing in stocks. A stocks price can rise for two reasons: 1. Speculation in the short term 2. Company performs well We have no control over speculation. It is highly risky and a short term phenomenon, whereas in the long run, what matters is a companys Performance. Thus, if and only if a company performs well, will the markets pay a higher amount for it. This is where the fundamentals play a very important role. Only when a company is fundamentally strong, it will be able to perform and deliver good performance, resulting in price appreciation. Please Note: It is equally important to get such great companies at an attractively low price; else you have already missed the bus. Most of the people start investing in stocks when the markets are already overpriced or nearing that. Dont commit that mistake. In my next post Ill also talk about how to find out the right attractively low buy price and then eventually the right sell price!!! Wait for my next post. How to decide if a company is fundamentally strong or not? Well, when we want to judge a students performance, what do we do? We check the students Report Cards. 1. We check the marks obtained in important and relevant subjects. 2. We look for consistency it means that the student should perform well in not just one year [which may be due to chance or may be cheating ] but each and ever year! 3. Extracurricular activities Likewise, when we want to judge a companys performance we need to look at its past performance. A companys performance is reflected in the numbers in Balance sheets and Profit & Loss Accounts. But does that mean that we need to go through the entire boring and mundane balance sheets? Isnt it a big task and time consuming? Well, the answer to these questions is that it can be so, if you decide not to be wise! Okay, Ill come straight to the point. No beating around the bush. Note I said that to judge a students performance, we check the marks obtained in relevant subjects. Likewise, for a company, all you need to do is be selective and understand a few important numbers. Im listing the most important numbers below:

A Companys Report Card: 1. 2. 3. 4. Profits of the company EPS (earnings per share) Net Sales Book Value per share (BVPS) Return on Investment Capital Judgment Criteria Indicates (Based on Growth Rates) Very Somewhat Not Good Good Good 8%-12% <8%

S. Parameter No.

Earnings per share give us the profitability per share figure of the company. We look EPS > 12% for a company with consistently growing EPS. When will a company be profitable? A company can continue to be profitable only Net Sales when the sales are increasing. So the next > 12% important figure we want to check is the net sales figure. The book value per share figure is a measure of whether a company is expanding its current business or buying a new business. It BVPS > 12% helps us to understand whether the demand for the companys products is increasing or not To be able to expand its business, a company either borrows money from banks or it takes the money from us as the shareholders. Return on Invested Capital is a measure of the return generated by the ROIC > 12% company on the investments it has made in the business. It gives us a better picture of the returns because it includes return on investment made from all sources debt and equity.

8%-12%

<8%

8%-12%

<8%

8%-12%

<8%

Apart from these, its also important to look at Debt/Net Profit Ratio. This number tells us the debt position of a company. It tells us the number of years a company will take to repay the debt given the companys current levels of net profit. If this number is less than or equal to 3 years, good enough, else its a reason to investigate it further as to why the company has taken so much debt? Is it expanding its business, setting up a new factory or acquiring another company? If the loan is taken for any of these reasons which may prove fruitful for the current business, it can be seen as a positive. Yet, its important to find out the reason for a high debt! Why 12% growth rate?

A company worth owning forever must be able to grow at a good consistent rate. Hence while we check out each of the significant variables, we need to see if they have been growing consistently year on year. And what is this consistent growth rate? In the last ten years, Inflation has been growing at a CAGR of 6-7%. Hence, we put our lower limit as twice that at 12% as Good Consistent Growth. CONSISTENCY of a companys Performance: We should look for a company which has been performing well (means has had a growth rate of more than 12% y-o-y) over a long period of time with consistency. What is this long period? In case of Indian markets, it has been observed that usually a business cycle is of approximately 3-4 years. Thus, analyzing the performance over a time frame of 10 years is essential to understand how a company has fared during good as well as bad times. Wasnt it easy? No need to go through complex balance sheets. Just check the performance of the company over these 5 important numbers over a period of 10 years and see the growth rate! I know its easier said than done. But its just a matter of a few days before you familiarize yourself with this method and believe me its SIMPLE!!! I have been applying these Value Investing Rules since the time I started investing and doing pretty good. I feel proud of the fact that I learnt it at the beginning of my career, because the early you start the right way, the better it is! What you just learnt is the First Golden Rule of Sensible Investing. Investing on the basis of fundamentals rests on the principle that you buy a company which is fundamentally strong (which we just learnt how to judge) and buy it when it is available at an attractively low price (Ill explain this in my next post!). A very important cautionary note: Most of the companies balance sheets and profit & loss accounts are manipulated in many ways. One has to thus adjust these numbers to take care of such manipulations! Im listing down a few important adjustments that need to be made: 1. 2. 3. 4. Change in Financial Year Extraordinary items Bonus Issues Stock Splits

Sounds complicated? Yes it can be complicated and tedious too. Dont worry; Ill guide you through these as well. And theres more to judging whether a company is worth investing in or not. But Ill explain that in my next post. For the time being, just absorb this much J