How to evaluate a company

Let's discuss the most curious topic that every investor wants to know. How to evaluate a company? To create long-term wealth by investing in stocks. For long-term wealth creation, you will require an understanding of the company you want to invest in. The process of the refined look of any company is known as Fundamental Analysis. The best way to understand this is to analyze with the help of different methods of company analysis.
Reason for analysis of Company
The major reason for performing an analysis of certain companies is to get a clear idea of the company. The annual reports and financial statements will help a lot in evaluating a company’s performance. This will in turn indicate whether or not you should add this stock to your portfolio.
Company analysis is a process to evaluate a company’s value by in detail analysis of fundamentals to get a fair view. There are many steps in company analysis those steps are mentioned in this article for better understanding.
Important factors you need to consider while evaluating a company
Examine the return of assets: You need to examine the company’s return on assets. Three different measurements will help you determine what the company is trying to accomplish with its earnings. The companies that are worthy of investments have strong returns. To know the returns you can calculate:
Return on equity
Return on Capital
Return on Assets
Examine the Company’s Liquidity: Before investing in any company you need to know the liquidity position of the company. The three financial statements that are very crucial to analyze and examine are:
Income Statement
Cash Flow
Balance Sheet
The best way to start the evaluation is by checking the liquidity position and cash balance. You are checking this to know if the company would be able to cover all the expenses. You should also know if the company’s short-term debts will cause any exhaustion of cash before the year-end. If you want to know the liquidity position from the balance sheet, you need to calculate the current ratio.
Check the Income Statement: As you have known the liquidity position of the company, now you should go on to the next factor of checking the income statement. In this, you need to check the growth of net income and growth of earnings.
Check the Operating Cash Flow: The final factor that is very important is that you should examine the operating cash flow. Additionally, it will help you to discover the generation of real cash. Now, have a look at the operating cash flow, subtract the money used for the purchase of equipment which is known as capital expenses, from the OCF (Operating Cash Flow).
Steps to follow for company evaluation
Identification of EIC characteristics: The very first thing we need to know in which industry the company operates in. We need to know the company and find other information that might be useful for decision-making. EIC Characteristics means Economic, Industry, and Company characteristics. There are various approaches like Top-down or bottom-up, accordingly you need to analyze the aspects. These factors will help you get an idea about the company’s value chain and its closest competitors.
Know the products and services of the company: After getting an overview of the company, now you need to know more about its product and services that are offered to the customers. You can check what type of quality of products they provide and if the price is suitable according to the quality. Take a look at the uniqueness of the product, nature, demand and supply dynamics, and brand awareness in the specified geographical area. In this manner, you will get the proper idea of a company’s products and services.
Understanding the risks: Every industry and business has its own set of risks and points to be concerned about. These risks and concerns might impact the profitability and performance of the company. Additionally, you need to have an idea about the risks and the cases of any eventualities that might occur. So, check and analyze thoroughly to find such risks and how the company will overcome them.
Analyzing the financial statements: The most crucial step of the whole process is analyzing a company. The financial statements provide us with the genuine quantitative picture of a company which is an integral part.
When an income statement is evaluated, margins, top-line, and bottom-line need to be evaluated. From the balance sheet, you get to know how strong a company is financially. On the other hand, cash flow statements show a picture of cash balances that are generated from activities like operating, investing, and financing. This will help to know the firm’s liquidity position.
Methods of company analysis
Primary company analysis is categorized into two methods:
Top-Down Approach: In the top-down approach, the investors analyze the company by looking at the macroeconomic factors first. Macroeconomic factors like inflation, monetary policy, broader events, and economic growth will help to do an in-detail analysis of an individual stock. Investors look for factors and events that take place in the market in order to understand the opportunities available for them.
Bottom-Up Approach: Another approach we have is a Bottom-up approach. It starts with analyzing the company first and then building a portfolio on the basis of specific attributes. The investors tend to focus on micro factors in the Bottom-up approach.
Conclusion
To sum it up, For long-term wealth creation, you will require an understanding of the company you want to invest in. The process of the refined look of any company is known as Fundamental Analysis. The best way to understand this is to analyze with the help of different methods of company analysis. The major reason for performing an analysis of certain companies is to get a clear idea of the company. The annual reports and financial statements will help a lot in evaluating a company’s performance. This will in turn indicate whether or not you should add this stock to your portfolio.