So before buying stocks of a company, it is essential to judge the fundamentals of its business. In the case of Nestle versus Jet Airways, the interpretation was obvious. But in most cases, identifying a weak company just by looking at its name is almost impossible.
How to do it? By understanding a company better by analyzing its business. The process of doing so is called fundamental analysis. Here the main focus is on the company’s financial health’.
The above flow chart is a symbolic representation of how a company does its business. It all starts with the capital. The company has to source its capital from either shareholders/partners or lenders.
The company then uses its capital to produce goods and services for its customers. This activity, in turn, generates revenue and profits.
From the company’s profit, lenders earn a fixed return in the form of interest payments. The shareholder’s investment can also yield a non-fixed return. The return will be in the form of dividends and share price appreciation.
The risk profiles of shareholders and lenders are different from each other. Lenders will earn a fixed return no matter if the company makes a profit or loss. But shareholders may not be rewarded, with dividend or share price appreciation, in case of a loss.
Profit & Profitability – Which is More Important?
There is a company that needs capital to establish and run its operations. It will also need money for its CAPEX (for expansion and modernization of its facilities). The company is doing business to generate profits. The profits will yield returns to its investors (shareholders and lenders).
So people might think that it is the profits which is the most important thing for the investors. But something else is more important. It is profitability and growth rate.
In addition to profitability, investors would like to buy stocks of a growing company. Sales and profit growth is the first thing that pro investors see in a company. But more importantly, they would like EPS growth rate and enhancement in the company’s profitability.
Lenders and shareholders are both considered ‘investors’ by the company. But there is a difference in how a company treats both of them.
Shareholders are more like “family.” They are entitled to a proportional share of the company profits (if any). But shareholders would also need to take a burnt if the company makes a loss. It is one reason why shareholders are proportional owners of the company.
Lenders are more like a “family friend.” They are also a part of the ups and downs of the company. But they get preferential treatment. The company borrows the lender’s money with a promise to pay back the principal within due time, with interest.
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Investors give lots of weightage to a company that handles its PAT wisely. A company can do the following with its profits:
- Pay Interest: Payment of loan interest is an obligation of the company. So, a company must pay its lenders on time. What they have to pay? The due interest on the debt and maturing principal amounts. Payment of interest is done out of the current year’s profits. The principal amount is paid from the company’s liquid-cash reserves.
- Pay Dividends: Paying dividends to shareholders is a form of giving them immediate gratification. Companies that are very sure of their future cash flows pay handsome dividends to their shareholders. Other companies either pay less or no Dividends.
- Retain Earnings: A company may decide to pay or not-pay dividends to its shareholders. In both the case, no company will distribute all its net profits (PAT) as dividends. The portion of unpaid PAT becomes retained earnings.
Buying stocks of the company means one is buying proportional ownership in the company. Hence understanding a company before buying its stocks is essential.
Ownership in a company comes with its share of risk and reward. Hence we as an investor need to tune our expectations (from stocks) accordingly.
Stocks are not like Fixed Deposits of banks which will continue to yield a fixed return (though low), even if the world is in crisis. But this is also true that, when the world is earning only average returns, shareholders of quality companies make handsome money.
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