August 08, 2011

Evaluating a company

In this post, I will share with you my approach in evaluating companies whose stocks are listed on the Malaysian stock exchange.

My method for evaluation is based on what I have read from a few books, mainly:

1. The Intelligent Investor - by Benjamin Graham
2. How to Make Money from Your Stock Investment Even in a Falling Market - by Ho Kok Mun
3. Secrets of Millionaire Investors - Adam Khoo and Conrad Alvin Lim

I invest in Malaysian stocks for the long term and for dividends. I do not use a trading approach.




To hold for the long term, it is important that the company has good financial strength and profitability.

I use the following  criteria to determine financial strength, which can be calculated based on the data from the latest quarterly report:

1. Current ratio > 1.5

where current ratio = Net current assets / net current liabilities

2. Working capital - LTD > 0

where Working capital = net current assets- net current liabilities
and LTD refers to long term debts or non-current liabilities

3.  DE ratio < 0.5

where debt-to-equity (DE) ratio = non-current liabilities / shareholder equity

4. LTD/PAT < 3

where LTD means long term debts or non-current liabilities
and PAT means profit after tax ( I use the net profit attributable to shareholders, rolling over the past 4 quarters )

5. cash/debt > 0.3

where cash is the "cash and cash equivalents" in the balance sheet and debt = total liabilities (current and non-current)

The more of these criteria are fulfilled the better it is.

For profitability, I would prefer the following:

1. No deficit in last 5 years i.e. the company did not have a loss in the past 5 years

2. Annualized earnings growth of over 15%.
I would look at the earnings for the past 5 years. If there is a year or two when the profits dipped (e.g. due to the global financial crisis), that is alright, as long as the overall trend is increasing profits. I tend to avoid companies with cyclical earnings.

3. Increasing operating cash flow


Next, I will also look at the companies average return-on-equity (ROE) and return-on-revenue (ROR) of the past 5 years. I prefer the company to have better ROE and ROR compared to its peers in the same industry. According to Benjamin Graham, it is advisable to have ROE of over 15%.

For dividends I prefer the company pays out dividends every year. I would keep a few stocks that have a track record of paying dividends higher than FD rate for every year in the past.

Finally, if I think the company is good to buy based on my evaluation, I will then check the annual reports of the company for the past few years. I will try to understand the company's business and products, it's business segments and markets, it's director's compensation and it's shareholders. This part is rather subjective and I am still learning.

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