Equity means ownership

You have come a long way. We?ve already been through issues such as the need to invest. You also know when you are ready to invest. Now it is time to understand what we exactly buy when we buy equity.

So what we now need to figure out is how to evaluate which company to buy. I?m afraid this is where all those fancy sounding valuation tools come in? PE, RONW, ROCE, EVA, etc. Hey, hang on, it?s not as bad as it sounds. Stick around and we?ll demystify all the above in a jiffy.

But before you get into the complexities of the various valuations tools you can use and how you calculate them, we must table a fundamental principle:

?Investing in equities is akin to owning a business.?

Let?s now explore the full ramifications of this principle.

When you put your money in a bank deposit, you take a risk (albeit small, depending on which bank). In return, you get paid a small interest.

The bank takes on a higher degree of risk and lends that money at a higher interest rate to some businessman, or to a credit card holder who wants to buy a diamond ring for his wife. The bank pays your interest out of the money he earns from the businessman. Or the doting husband.

Whereas, when you buy shares in a company, you are not lending money to the company. By providing capital for the company, which is represented by an equity share, you are participating in the ownership of the company. Clearly, your risk is much greater in this case. Because, in this case, you are entrusting the company with the job of managing risk for you.

Relatively, the risk in lending to a bank is limited. For one, most of our neighbourhood banks are nationalised. So bank deposits are perceived to be backed by the government. There is little soul searching to be done as to which bank to choose. Even in doing so, the highest priority is accorded to a Nationalised Bank purely on the safety parameter. Obviously, when you invest in equities, even this notional sense of security, of a government standing guard over your money, isn?t available to you.

What kind of business would you like to enter?
Let?s look at this another way now. Let?s assume you want to invest your money into a business. How will you decide what kind of business to enter?

For starters, it should display the potential to earn you a return in excess of what the prevailing rate of bank interest is, right? Now you need to ask yourself what would be the essential factors in determining this return. And apart from the return angle, what qualitative factors should you be looking for?

In the long term, we all look for security. Business, being an entity, is also entitled to aspire for the same. The ideal business would thus have to have horizons where profits can be sustained. Like we mentioned above, there are external factors that determine the direction and growth of the activity. All this would need to be factored into a business plan that would have to sustain itself and grow over a period of years. Of course, on an ongoing basis, we would definitely have to get a feedback on the success of the business. Operations would have to be evaluated from market feedback, while the financial statements would give a view of the profitability of the concern.

The same concepts apply to stocks
Now, here?s the punch line. Everything we discussed above doesn?t apply only to running a business. The same concepts apply, even if you just own shares in the company.

We all know of a document called an annual report. This document is the most basic source for information available on the company?s operations. In the annual reports, the directors dwell, at times in length, explaining the nature of operations and the external environment surrounding the business and how it affected the company during the year.

If you take the additional effort of finding out the positioning of the company?s products in the marketplace, it would give a fair idea of the company?s reputation in the field it operates. All this with the objective of figuring out how stable the company?s operation is.

The company?s progress can be tracked periodically over close intervals of 3 months. This is through quarterly financial statements, the publication of which has been made mandatory by the regulatory authorities.

Next comes the question of management issues. The common question that pops up in this context is: ?How do I externally control the business if I do not have a say in the management??.

Ok, let?s assume that you are now running the business you chose. Can you, a single individual, handle all functions of the company? For a while, maybe. But once growth sets in, it would be humanly impossible to manage all the functions of an economic activity, viz. marketing, finance, procurement, etc. That?s when your business will need to morph from outfit to organisation status. Wherein the various functions are distributed across individuals, and finally the same is translated into a unified activity.

Similarly, as a shareholder, you end up delegating authority to others to run the organisation you have a stake in. Imagine Mr Narayana Murthy (Infosys), Mr Dadiseth (HLL) and Mr Anji Reddy (Dr Reddy?s) reporting to you. That?s exactly how the cookie crumbles.

The company whose equity base you have participated in is answerable. To you, as well as other shareholders of the company. Thus, while you as a joint owner have delegated the operations of the company to the professional managers and the employees, the management in turn is responsible to its shareholders. The management communicates through the balance sheet and the AGM, where shareholders voice their opinion on the performance of the company.

Infact, shareholders can actually participate in constructive criticism of the operation of the company.

What we brought you today was the first step in how to investigate and understand the qualitative issues in a business. We will be taking up the statistical part of our adventure into evaluating stocks in Valuing Equities.