The Desi Investor's Guide to Analysing Stocks.

Chad Investor
 Copyright © 2021 Chad Investor

All rights reserved.

No part of this book may be reproduced, or stored in a retrieval system, or transmitted in any form or by any means, electronic,
mechanical, photocopying, recording, or otherwise, without express written permission of the author.

ISBN-13: 9781234567890
ISBN-10: 1477123456

Cover design by: Art Painter

Library of Congress Control Number: 2018675309
Printed in the United States of America
to the market - the best teacher i ever had.
 Contents
Title Page
Copyright
Dedication
Disclaimer
Preface – Please Read This
The Investing Philosophy
Sources of Information for Investors
Understanding the Annual Reports
Understanding the Financials
Statement of Profit and Loss Analysis / Income Statement Analysis
Analysing the Balance Sheet
Statement of Cash Flow Analysis
Other Sources of Information
Management Analysis
Valuation of Companies
How to Detect Accounting Fraud?
Comprehensive Checklist
Petronet LNG Stock Analysis
 Disclaimer
The information available through the book “The Desi Investor’s Guide to Analysing Stocks” (hereinafter
referred to as “book”) is provided solely for informational purposes on an “as is” basis at the user’s sole
risk. The information is not meant to be, and should not be construed as advice or used for investment
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specific investor.

You are responsible for your own investment decisions. We urge our readers to seek professional
advice before acting on the basis of any information contained therein has been prepared on the basis
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Disclosure:

The author is not a SEBI-registered investment analyst.

The author has not invested in any of the stocks mentioned in the book except Bajaj Consumer Care
Ltd.
 Preface – Please Read This
Dear Reader,
Thank you for choosing this book. The fact that you chose this book over thousands of other books
is incredibly rewarding in itself. More than the money, a writer values the fact that his ideas are being
read and appreciated by someone else.
As a 14-year-old kid, I was intrigued by the markets. I read every investment book I could lay my
hands on. While there were multiple books on stock analysis, none of them offered practical advice from
an Indian perspective. There was a huge gap between what western investors wrote and what I saw in
the Indian markets.
For instance, in western countries, managements use fraudulent accounting to show higher profits
and to push the stock prices higher. Indian promoters, on the other hand, used fraudulent accounting to
show lower profits and siphon off actual the earnings. The incentive structure is entirely different for
Indian managements. In the end, it is the shareholder who ends up paying the price for the
management’s indulgences.
These factors made it necessary to write a book that is dedicated solely to Desi investors. This book
is meant to be a practical guide. If you are a beginner, you can start analyzing stocks as soon as you
complete the book. If you are someone with experience, you can learn a few new things and brush up
the old concepts. I have consciously avoided getting into any arcane topics which do not have much
practical importance.
What do I expect from you?

A very basic understanding of what Stock Markets and Stocks are.

A basic understanding of arithmetic – addition, subtraction, division, multiplication, and
percentages.

This book’s main focus is on analysing the company’s finances and its management. This, in my
humble opinion, is the most fundamental part of investing I have not included methods such as
identifying competitive advantages, five forces analysis, and other abstract qualitative methods. The
reasons are three-fold:

My writings won’t do justice to these topics.

There are many well-written books on these topics by investors like Warren Buffet, Charlie
Munger, Pat Dorsey, etc.
Most of us do not have the skill required to analyse these aspects and should stick to numbers.

Once you understand and apply the concepts presented in this book, you will be able to distinguish
between good and bad companies easily. As you gain experience, you will develop your own set of
methods to analyze stocks.
I truly hope that this book adds value to your investing journey.
Yours Truly,
Chad Investor.
 The Investing Philosophy
If you see stocks as blips on the screen that move up and down randomly, this chapter is for you.
Stocks are not blips on the screen. Stocks represent ownership in the business. Now, some of you might
be thinking - “Yeah Chad, we all know that. Tell us something new.” But, if you truly understood what
being a business-owner meant, you wouldn’t be checking your Zerodha account every few minutes.
Neither would you be tempted to sell your stock, every time the prices rose by 2%. And you certainly
wouldn’t watch business news channels that hype up useless information.
If you owned a piece of land, would you call up the real estate agent every 15 minutes to check the
land rates?
If the land rates went up by 2% would you sell off the land?
Most probably, your answer to both of these questions would be “no”. However, when it comes to
stocks, this is precisely what most investors do. They see stocks through the emotions of greed and
fear. Even if you’re the smartest financial analyst, but you’re ruled by emotions, you’re doomed.
Today, thanks to quantitative easing, markets are at an all-time high. In this environment, every noob
is making money in the markets. There seems to be an incredible urgency among the crowds to make
quick money from the markets. People with no knowledge of finance have started putting in a major
chunk of their salary into the stock market, with the expectation of turning into millionaires overnight. An
Indian comedian is hosting trading classes. Meme pages are offering trading advice. While these people
might even make money for a while, over the longer term they are likely to lose their shirts. If you play
Russian roulette enough times, you’re bound to end up dead.
If you’re planning to learn to invest, you must change your mindset about stocks and view them as a
certificate of ownership. This is the only “philosophy” that you need as an investor. Approaching
investing with this philosophy makes your investing journey much easier. Let’s admit it, being
compulsively glued to your trading account screen is quite stressful and affects your daily productivity.
Rather than caring about useless news reports, you should only be concerned about the quarterly and
annual financial reports. A good night’s sleep is worth more than being constantly worried about what
the technical analyst on the business news channels said.
In conclusion, no amount of investing knowledge can help you if you’re driven by emotions. You must
learn to look at the bigger picture. As investors, we should be concerned about the business
performance and not the stock price. If you’ve bought good businesses with honest management the
stock prices will be taken care of by the markets.
 Sources of Information for Investors
As retail investors, most of us do not have direct access to the company's management or inside
information. For us to make a good investment decision, it is crucial to have the relevant information.
The most important sources of information:

1. Annual Reports: By far, the most important document on your investing journey. It contains all
the details about the finances, the management, company goals, accounting policies, etc.
Companies must publish an Annual Report at the end of each Financial Year. A
Financial Year (FY), is an arbitrarily decided period of 12 months. The phrase “Sales for FY 20”
refers to the Sales for the Financial Year 2020. Similarly, the phrase, “Sales for the year ended
March 2020”, refers to the Sales for the period starting from 31st March 2019 to 31st March
2020. Reading the annual reports of the
past 4-5 years will give you a good idea of the trajectory of the company's finances, the
effectiveness of strategies, business environment, management quality, etc.

2. Updates on BSE and NSE sites: The Company must inform the stock exchanges about any
significant developments related to the company. These developments might refer to the loss
of a large customer, financial results, changes in the management, sale of properties, sale of
subsidiaries, etc. Always check the BSE and NSE sites for such updates.

3. Conference Calls: These are telephonic meetings between the management and the investors
at the end of every quarter. The management might also hold these calls during a crisis to
provide clarifications. The managements often offer detailed answers to the questions posed
by investors, thereby offering insider insights to investors.

4. Red Herring Prospectus: This is a goldmine of information. However, this document can only
be found on the internet if the company has been listed within the last 15 years. Companies
must release this document before being listed on the stock exchanges (before the IPO). It
delves deep into the business risks faced by the company and underlines the weaknesses of
the company. It also contains in-depth details about its business model, promoters,
subsidiaries, financials, and company history. The RHP is a must-read for serious investors,
but be prepared to spend long hours reading this document in detail. To find this report, search
on the internet for "(Insert Company Name) red herring prospectus pdf."

5. Credit Rating Report: The credit rating agencies compile these reports. Credit Rating
agencies help provide a third-party opinion to banks, lending firms, and public investors. The
report details the capital requirements of the company and the risks involved in the business.
These agencies have access to the company's internal documents; hence, their reports can be
quite helpful in identifying any red flags that might be hidden from investors. To find this report,
search on the internet for "(Insert Company Name) credit rating report pdf."

6. The Internet: The internet is an excellent source of information. A single Internet search can
make or break your investment decision. The internet comes in handy when evaluating
management quality. We shall discuss this in detail later.
 Understanding the Annual Reports
An annual report provides two kinds of information to investors – Non-Financial and Financial.

Non-financial Information:

1) Notice of Annual General Meeting (AGM):

It contains information about the subjects that would be put up for a vote in the upcoming AGM.
Sometimes companies also take permission from shareholders for taking up extra debt, raising money
through the sale of shares, increasing the management’s salary etc. So, investors need to read through
this section carefully.

2) Management’s Letters to Shareholders:

The annual report contains a Letter to Shareholders from the Chairman/CEO/Managing Director. The
letter talks about the new expansions, achievements, changes in the business environment etc. The
letter is (in my opinion) usually biased towards the positive developments.

Some Promoters, however, write extremely honest and valuable letters. Brahm Vasudeva, the late
Chairman of Hawkins Cookers wrote some of the best letters to shareholders that I’ve read. Mr.
Vasudeva’s letters were absolutely honest, well-written, and engaging. He not only talked about the
business but also about the philosophy behind the business. The letters did not have any of the the
pretension and self-aggrandizing tendencies that many promoters have. He ran the company well,
which showed in the stock’s performance. He never took a huge salary and made his money through
dividends i.e. he rewarded himself along with the shareholders. Gems like Mr. Vasudeva are rare.

3) Directors’ Report:

In this section, the directors describe the company’s financial performance, significant changes in the
company’s financials, their causes, etc.

4) Management Discussion & Analysis Report:

Management Discussion and Analysis is one of the most important sections of the Annual Report.
The management informs the shareholders about the business environment being faced by the
company, the general economy, industry outlook, company outlook, opportunities, challenges, risks, key
changes in the business environment, human resources issues, etc.

5) Details about the Top Management and Directors:

The annual report provides details about the qualifications, experience, and remuneration of the key
management people responsible for decisions of the company. The remuneration being drawn by
Promoters/Management/Directors is mentioned here. Using this information, we can analyze whether
the remuneration is in line with the profits and profit growth the management brings in.

The section on Corporate Governance contains the details about the directors. The section contains
the details about the composition of the board of directors, various committees of the board, the
attendance record of the directors in a different meeting, plant locations, details of annual general
meetings, details of extraordinary general meetings, etc.

B) Financial Information:

1) The Independent Auditor’s Report:

The report of an independent auditor in which an independent entity provides its views about the
financial information is presented in the annual report. Auditor’s report comments on the key items like
lapses in accounting, payment defaults, issues with the financial control system, any frauds by a
company or its employees, etc.

Auditor’s report is supposed to give a stamp of legitimacy to the financial information in the annual
report. However, in cases like Vakrangee, Manpasand Beverages, etc., we find that even the best of
Independent and Statutory Auditors didn’t do their jobs correctly and might have approved questionable
financials.

2)Financial Statements:

The Financials Statements in an Annual Report are divided into three parts:

Balance Sheet
Statement of Profit & Loss / Income Statement.
Cash Flow Statement.

The Balance Sheet:

This section provides details of all the assets and liabilities of a company on the last date of the
financial year. Liabilities are the funds which the company uses to buy the assets it owns. These assets
then generate revenues for the company.
For instance, a company takes a loan of Rs. 100 Crores from a bank and buys machinery worth Rs.
100 Crores. Thus, the liability (the loan) funds the asset (the machinery). These machines then convert
the raw materials into finished goods and help the company to generate revenues. Let’s study an
example from Bajaj Consumer Care Ltd:
 The Total Equity and Liability of Rs. 621 Crores financed the Assets of Rs. 621 Crores. Assets and
Liabilities always have to be equal. If they aren’t, there is something wrong with the report. There are
two columns in the statements. The one on the left shows data from the current FY while the column on
the right shows data from the previous FY.

The Income Statement:

This section of financials provides details of total sales that a company has achieved in the past year
and all the expenses the company has incurred to achieve these sales. The amount remaining after
deducting expenses and taxes from revenues is the net profit for the shareholders. Let’s study another
example from Bajaj Consumer Care Ltd:
 For the year ended on 31st March 2019, The Total Revenue of Rs. 926 Crores is generated by
incurring a Total Expense of Rs. 638 Crores. The difference between the Revenue and Expenses is the
Profit before Tax (PBT) of Rs. 288 Crores. The taxes are deducted which finally leaves us with a net
profit of Rs. 226 Crores.

The Cash Flow Statement:

This section provides details of the cash that the company:

generated from operations (cash flow from operating activities)

used in making investments or received from selling investments (cash-flow from investing
activities)
Raised from banks as borrowings or repaid to them during the last year (cash-flow from
financing activities).
 What is “Standalone”?
If you have observed closely, the word “Standalone” is mentioned in the titles. Standalone
Statements do not include the financial performance of the subsidiary companies. Subsidiary
Companies are the companies in which the listed company has invested money. The Title “Standalone
Statement of Cash Flow” indicates that the Statements do not include the cash flow of subsidiaries. On
the other hand, the word “Consolidated Statement of Cash Flow” indicates that the financials of the
subsidiaries have been included in the Financial Statements. An annual report contains both – the
Consolidated and the Standalone Statements.

Standalone – Excluding Subsidiaries.

Consolidated – Including Subsidiaries.

For example,
Suppose Company A buys another company called Company B. Company B has become a
subsidiary of Company A. Suppose Company A has revenue of Rs. 100 Crores while Company B has
revenue of Rs. 50 Crores.
In the Standalone statements of Company A, the revenues of Company B will not reflect anywhere.
Thus the revenue will be shown as 100 Crores. On the other hand, in the Consolidated Statements for
Company A the revenues will be shown as 150 Crores (sum of Company A and B). Everything else
such as Costs, Assets, and Liabilities will follow the same pattern.

Company A’s Standalone Revenue – 100 Crores.

Company A’s Consolidated Revenues – 150 Crores.

Using Consolidated Statements to analyse a company is preferable as it gives a larger picture of the
company’s finances.
3) Notes to Financial Statements:
 This part lists down the Accounting Policies followed by the companies, breaks down the finances
further, provides loan details etc. The devil lies in the details. This section happens to be THE MOST
IMPORTANT part of the annual report, especially if you are trying to detect frauds by the promoters.
Accounting red flags are usually hidden here. It can be incredibly boring at times to read through this
part, just keep at it. You’re bound to get some good insights into the business model and the promoters’
integrity through this section. Practice and constant learning is the only way to understand this section
and make sense of it.
4) Related Party Disclosures:

Every company is required to disclose all the transactions it enters into, with its promoters and the
promoter’s private companies. Transactions like interest-free loans to Promoters, buying assets/raw
material from the promoters at prices higher than market value, investing in the promoters’ ventures are
some of the red flags which can help us detect dishonesty by managements.
 Understanding the Financials
Investing is a prediction game. Neither Rakesh Jhunjhunwala, nor Radhakishan Damani can be sure
about the future and certainly not us. But don’t lose hope, the investing world might be a dark place, but
Financial Statements offer a ray of hope.
Companies disclose their financial performance every quarter and produce a yearly Annual Report.
This is mandatory as per SEBI Guidelines. Investors can use this data to understand the company’s
past and extrapolate it to predict the future. Usually, barring sudden permanent changes in the business
environment, most businesses follow rather predictable patterns when it comes to Sales, Expenditure,
Profit Margins, etc.
For example, the steel business usually follows a cyclical pattern. When steel prices rise,
manufacturers produce more steel to take advantage of the high prices. Due to this increase in
production, the steel market gets oversupplied and steel rates collapse. After the price collapse, many
production facilities are unable to survive and are forced to stop production. Therefore, the oversupply of
steel reduces; resulting in higher prices and the cycle begins again. On the other hand, the FMCG (Fast
Moving Consumer Goods) companies follow a relatively stable pattern in terms of Sales and Growth. An
investor, who studies long-term financial data, develops an intuitive sense of these patterns. Hence,
understanding financials is an extremely important part of investing.
Some people might argue that extrapolating past data can be dangerous. For instance, Kodak could
never recover after the rise of digital cameras, despite being, one of the most profitable companies in
the world at that time. If an investor had simply extrapolated its excellent financial performance in the
past and invested based on the results, he’d have lost money.
Yes, extrapolating past data can prove to be quite dangerous. This is precisely why we diversify our
investments. If you had invested 30% of your portfolio in Kodak, you were being overly optimistic (and
foolish). On the other hand, if you had been wiser and put only 5% of your portfolio in Kodak, you
would’ve lost money but not too much. Always diversify, no matter how confident you are about the
company’s prospects. As investors, we bet that in most scenarios, the future will be similar to the past.
However, once in a while we’ll lose money. It’s a part of the game, so just suck it up.
 Statement of Profit and Loss Analysis / Income Statement
Analysis

Standalone Income Statement from Bajaj Consumer Care Ltd.’s 2019 Annual Report.

Please keep referring to this Income Statement as you read the chapter,.

Figures in brackets imply negative numbers.

i) Sales/Revenue Growth:

The first parameter to check is the rate of sales growth of the company. Sales/Revenue is the money the
company earns by selling its goods and services. Companies with a high demand product or service,
usually show high rate of growth in sales.

Bajaj Consumer Care Ltd has grown its sales from ₹468 cr in FY2011 to ₹962 cr in FY2020, resulting in
a compounded annual growth rate (CAGR) of 8% year on year.

You should check whether the company has grown at a rate greater than or equal to the rate of
inflation in past. At the same time, very high growth rates (>35%) are usually not sustainable for long.

ii) Profitability:
Profitability can be measured by two prominent measures operating profit margin (OPM) and net profit
margin (NPM). One should view these parameters over time, rather than focusing on a single year.
Profitability Analysis can help us understand whether a company has the pricing power to maintain
profits despite various issues.

OPM measures the portion of sales income that is remaining after deducting costs of producing these
sales e.g. raw material costs, employee costs, sales & marketing costs, power & fuel costs, etc.
Operating profit does not factor in expenses like depreciation of fixed assets, interest, and tax expenses.

OPM = Operating Profits / Revenue from Operations

Operating Profits = Revenue from Operation – Cost of Goods Sold (COGS) – Employee
Benefits Expense – Other Operating Expenses.

COGS is the sum of:

Cost of Materials Consumed

Purchase of Stock-in-Trade and
Changes in Inventories.

These three items can be found in the Statement of Profit and Loss under Expenses.

NPM reflects the net profit that remains after a company has paid its interest, tax and factored in the
depreciation. Net profit is the money that remains with the company after meeting all expenses.

NPM = Net Profit / Sales.

Companies with higher profit margins can face tough times comfortably.

Given below Profitability Analysis of Bajaj Consumer Care Ltd.:

The OPM has been stable at around 25-30% every year for the last 9 years. This is a sign that the
company can pass on increases in costs to its customers. Few companies have sustainable pricing
power for so long. Most companies compete on the basis of price, so they have to sacrifice margins to
garner more sales. This strategy is detrimental over the long term.

Similarly, the NPM has been stable in the 22-27% range. It indicates that the company can pay for all
its costs and still maintain the margins, a very positive sign.
 Always select companies with stable margins. Companies with fluctuating or declining margins (no
pricing power) might not survive in difficult times.
iii) Interest Coverage Analysis:

The Interest Coverage ratio reflects whether the operating profits generated by the company are
sufficient to pay interest on the loans the company has availed. Interest costs are listed as Finance
Costs on the Statement of Profit and Loss. The Interest Coverage ratio is calculated by dividing the
operating profits by the interest expense.

Interest Coverage Ratio = Operating Profit / Interest Expense

You should prefer companies that have an interest coverage ratio of 3:1 or higher. It implies that for
every ₹3 rupees of operating profit, their interest expense is ₹1. A higher interest coverage ratio
provides a cushion during tough times. A company with a higher ratio will still generate enough profits to
cover Interest expenses, while weaker companies might collapse under the interest burden.

Bajaj Consumer is a very low debt company with negligible interest expenses. Therefore, the interest
coverage ratio has been very high for all years. This is another positive sign.

However, there is a caveat. Accounting laws allow companies to not show a part of their Interest
Expenses on the Balance Sheet. Companies can “capitalise their interest” i.e. show their interest as an
asset. Getting into the technical details of why this is done is not too important at this stage.
Capitalization of interest is usually an issue when you are researching infrastructure companies or
companies which are investing heavily into expansion. These companies have large interest expenses
which they capitalise, so the interest expense figures from the Income Statement might mislead the
investor.
So, in such a case, how does one find the true interest expenses?
The Cash Flow Statement is our saviour. Under the heading “Cash flow from Financing”, we can find
the real Interest Expenses listed out. Using this figure will give you a more realistic idea of the
company’s interest expense.
Note: Some of you might be interested in why interest expenses are capitalised i.e. interest
recorded as assets. This happens when companies take loans for expansion. When a company
constructs a new building, all the costs related to it such as labour costs, installation costs, raw material
costs, land costs, etc. are added to the asset’s value. Similarly, any interest payments paid during the
construction period are also capitalised i.e. added to the asset’s value. This is done because these
expenses were not incurred while making sales for the current year. These expenses will benefit the
company for many years to come; hence they will be depreciated over the years. For details on
depreciation, refer to the end of this chapter.
iii) Taxation Rates:

Companies with honest promoters pay their taxes honestly. India’s corporate tax rate is currently 25%
for Indian companies, which was around 30% until last year. Extremely low tax payments are usually red
flags. Though sometimes, companies pay lower taxes due to various Tax Incentive Schemes that the
government launches to encourage business activities. You should read through Conference Calls and
Annual Reports to understand whether a company is the beneficiary of such schemes or is evading
taxes.

Bajaj Consumer’s Tax Rate:

As we can see, the company has paid only 20-22% taxes in the 2012-2020 period, whereas the
corporate tax rate was around 30% for this period. This is a red flag that should be investigated further.
So, we look at Bajaj Consumer’s Conference Call with Investors (the company changed its name
recently):

As we can see, the corporate tax rates are low because of Minimum Alternate Tax. This was a tax
scheme introduced by the Government. Similarly, the company had also received tax breaks for its
Guwahati factory. All of these factors have resulted in lower tax outgo for the company.

A legitimate lower tax pay-out is usually because of the following reasons:

Availing tax incentive schemes by the government.

The company has invested extra cash in Tax-Free bonds, tax-efficient mutual funds, etc.

If the company doesn’t have either, it probably is being dishonest.

Note:
What is Depreciation?
Most of the terms in the Income Statement are straightforward. However, depreciation and
amortization can be confusing for people who have not studied finance before. So we shall discuss
these terms in detail.
When a company buys an asset like a machine, building, or vehicle, it expects the asset to benefit it
for more than one year. A new machine with an expected life of 5 years, will not only contribute to the
sales for the current year but will continue contributing to the sales 5 years later. Therefore, it does not
make sense to deduct the entire cost of the machine in the current year itself. Hence, the cost of the
machine is divided by 5 and the result is subtracted each year. This amount is known as depreciation.
For instance, a company buys a machine for 10 Crores and expects the machine to work for 10
years. Therefore, the company will deduct 1 Crore per year as depreciation in the Income Statement.
Amortisation refers to the depreciation of intangible assets. Intangible assets refer to the assets
which do not have a physical existence – software, brands, exclusive licenses, mining rights, etc. These
assets cannot be touched or felt. These assets also contribute to sales over many years. Therefore,
they are amortized over their lifespan.
For instance, a company buys a software license for 100 Crores and the company is licensed to use
the software for 10 years. In this case, the company will deduct 10 Crores each year as amortization in
the Income Statement.
 Analysing the Balance Sheet

Standalone Balance Sheet from Bajaj Consumer Care Ltd.’s 2019 Annual Report.

Please keep referring to this Balance Sheet as you read this chapter, to get a better
understanding of what is being said.

i) Debt to Equity ratio (D/E, Leverage):

Debt to Equity is the ratio of the company’s borrowings (debt) to the money the company’s
shareholders put in (equity).

Debt to Equity Ratio = Borrowings/Shareholder’s Equity.

Where, Shareholder’s Equity = Equity Share Capital + Other Equity (also known as Reserves).

D/E ratio shows how much of the company’s total funds came from shareholders and how much was
borrowed as a loan. The debt and the equity provide the funds which the company uses to buy the
assets. These assets are then used to produce goods and services which the company sells.

For example, let’s say that you wish to buy a van (the asset) for your new delivery business. The van
cost 2 lakhs; you have 1 Lakh in your savings and borrow the rest from the bank. The debt to equity
ratio for your business is 1:[Link] means that 50% of your funding came from loans and the remaining
50% from your own pocket (equity).

In the Balance Sheet shown above, debt to equity for 2019 is the Borrowings divided by (Equity Share
Capital + Other Equity). That is 25 Crores/485 Crores = 0.05. For 2018 it is 0.02. This is a very low debt
company, which is a positive sign.
 Zero debt or a low debt to equity ratio (<0.5) is preferable. High debt to equity ratio implies that the
company owes a large debt to its lenders. If the company defaults, the lenders have the first right over
the assets, which means that the shareholders would practically get nothing if all the assets are sold to
pay the debts. Almost all bankruptcies in India yielded nothing for shareholders. Unless it’s a sector like
power generation, where revenues are virtually guaranteed through long-term contracts, you’re better off
staying away from high debt-to-equity ratios.

ii) Current Ratio (CR):

Current Ratio = Current Assets / Current Liabilities

Current assets (CA) are the assets that are used within the year. Current Assets include:

inventory that will be used in the same year

cash & similar investments kept by the company to meet day to day requirements
money due from customers (account receivables or debtors)
loans given to different parties that are expected to be received back within a year.

Current liabilities (CL) include the money which the company needs to pay its vendors, creditors,
employees etc. within the next one year.

The current ratio of >1 means that the company has CA which exceed CL. The company would be able
to pay off its short term liabilities with the money it receives from its current assets.

iii) Trade Receivables Analysis:

Trade receivables refer to the money that is owed by customers to the company. If the company gives
credit to its customers, the amount is recorded under the Trade Receivables. A company must be able
to collect this money or else it will be unable to produce cash to meet its other expenses. There are
multiple ways to calculate the efficiency with which a company collects the money from its customers:

a) The easiest way is to check for collection efficiency is to check the Receivables Turnover Ratio
or Debtor Ratio. It is the ratio of Total Sales to Total Trade Receivables. Below is the Debtor
Days ratio for Bajaj Consumer that I pulled off [Link].

As we can see, the debtor ratio has been decreasing. This is a red flag. We have investigated
the reason for this decrease in the final chapter.

b) The rate at which trade receivables grow year on year should be lower than or equal to the
revenue growth of the company. If receivables increase at a higher rate, it means that the
efficiency of collections is reducing, despite growing sales. It can also imply that the company
is giving credit to customers who do not have the ability to pay back.

iv) Fixed Capital Analysis:

Fixed assets refer to assets like machinery, plants, furniture, software, brands, vehicles, land, etc.
Manufacturing firms generally require huge expenditure on fixed assets.
Net Fixed Asset Turnover = Total Yearly Sales/Fixed Assets.
(Fixed Assets = Property, Plant and Equipment + Capital Work Under Progress + Intangible
Assets)
 One way to measure the capital intensity of an industry or company is to find the ratio of Sales to the
Fixed Assets for that year, also known as Net Fixed Asset Turnover.
Companies operating in asset-heavy industries such as cement, steel, and electricity generation
companies have a ratio of 2.5 or less. This means that for every Re 1 invested in fixed assets, the
company produces a sale of Rs 2.5. Contrast this to IT firms whose Fixed Assets are limited to
hardware, software, and office real estate. These firms can have a ratio of 15 or even more. Thus for
every Re. 1 invested in fixed assets, the company makes a sale of Rs. 15.
This has important implications for investors. Companies with a low NFAT need to constantly keep
investing in fixed assets to increase sales. Such companies pile up debt which can be dangerous in
tough economic conditions. A company with NFAT of 2, needs to invest an additional Rs. 100 Crores in
fixed assets to increase sales by Rs. 200 Crores. A company with NFAT of 5, an additional 100 Crore
investment in fixed assets would yield a Rs. 500 Crores increase in sales. With everything else being
equal, always go for companies with a NFAT higher than 3.5.
For Bajaj Consumer:
The NFAT has remained around 12-15 over the past years. This implies that the company produces
a Sale of Rs. 15 for every 1 Rupee invested in Fixed Assets. This is a very positive sign. The reason for
such a high ratio is that the company takes factories on lease rather than building new factories. This
results in a lower investment in fixed assets.
v) Trade Payables Analysis:
Trade Payables refers to the money the business owes its suppliers. Trade Payables Analysis along
with trade Receivables analysis helps us understand the terms of trade. If a company has a high
receivable turnover and low payables turnover, it has good terms of trade. The company is able to hold
on to the money it owes its suppliers while collecting cash quickly from its customers. Generally, if a
company has good terms of trade, it usually has a product that is in high demand. For instance, most
FMCG companies sell their goods to distributors on a cash basis while having long credit periods from
suppliers. They have good terms of trade and FMCG stocks have been among the best performers in
the Indian market.

The best way to calculate whether the company’s payment terms with suppliers are improving or
deteriorating is to find the Trade Payables Turnover:

Trade Payables Turnover = Cost of Goods Sold (COGS)/Trade Payables

COGS is the sum of

Cost of Materials Consumed

Purchase of Stock-in-Trade and
Changes in Inventories.

These three items can be found in the Statement of Profit and Loss under Expenses.

v) Inventory Analysis:
 Inventory refers to the goods, raw material, etc. that the company has. Inventory Analysis is done
using the Inventory Turnover Ratio. The ratio helps us analyse the pace at which the company can turn
its inventory into sales.

Inventory Turnover = COGS / Inventory (at the end of the Year)

COGS is the Cost of Goods Sold (Refer to the Previous Example)

The trend of the ratio should be constant or increase over time. If this ratio decreases over time it
implies that the company is unable to convert inventory to sales at a fast pace. Therefore, the company
might be losing its efficiency and its ability to convert inventories to sales (cold hard cash).

In the case of Bajaj Consumer:

We can see that the inventory turnover has tripled over the last 9 years. Therefore, the company has
improved the rate at which it converts its inventory into cash. It is a very positive sign indicating high
operating efficiency.
 Statement of Cash Flow Analysis
The Statement of Cash flow can be divided into 3 sections:

Cash Flow from Operations (CFO) - This includes details of the cash that the company
generated through its operations.

Cash Flow from Investing Activities (CFI) - This section also includes details of cash used in
making investments or received from selling investments.

Cash Flow from Financing Activities (CFF) - This section details the loans that were taken
from or repaid to banks during the last year.

Cash flow statements talk about the cold hard cash movements of the company. In contrast,
managements usually have a lot of freedom when preparing Profit and Loss Statements, thanks to
flexible accounting rules. The Cash Flow Statement cannot be manipulated as easily as the Statement
of Profit and Loss. Therefore, the cash flow statement offers a much better idea of the company’s
finances than the Profit and Loss Statement.

Free Cash Flow Analysis:

Our main objective in this analysis is to understand whether the company can generate enough cash
through its operations to fund its expansions and its payback its loans. If a company can do this
sustainably over long periods, it means that the company is a potentially great investment.

Let’s have a look at Bajaj Consumer Care’s performance:

As we can see from the figure above, the company has continually generated cash from operations. The
total cash generated from operations for the past 9 years (Rs. 1722 Crores) is almost 7 times the cash
spent in investing activities (Rs. 251 Crores) for the same period. Therefore, the company has produced
lots of excess cash that it does not need.

The difference between CFO and (CFI + Interest Expenses) is called Free Cash Flow. The company
has produced Rs. 1471 Crores is free cash flow. Free cash flow entirely belongs to the company. It can
be distributed to shareholders through dividends, invested in new projects, invested in mutual funds, etc.

Free Cash Flow = CFO – CFI – Interest Expenses.

This huge Free Cash Flow is the reason for the company being liberal with its dividend payments.
Almost the entire free cash flow is paid out as dividends to shareholders. This company has rewarded
its shareholders very well.

Over the long term, the cumulative CFO should be greater than the cumulative CFI.

Finding Cap-Ex from the Statement of Cash Flow:

Cap-Ex means Capital Expenditure. It refers to the money the Company has put into buying new
fixed assets, making new acquisitions, maintenance of fixed assets, etc.
The easiest way to check for Capital Expenditure is through the Cash Flow Statement.

I have taken the extract below from Bajaj Consumer’s Annual Report 2019. As we can see clearly,
the company has spent 6 Crores on acquiring new fixed assets i.e. Property, Plant, and Equipment.
Similarly, if a company has spent on new acquisitions, it will be listed under the CFI Section.

If Cap-ex is disproportionately large, even when the company not expanding, it is a red flag. The
company management might be categorizing operational costs as capital expenditure to lower
expenses in the Income Statement and boost the net profits. Therefore, investors should keep a tab on
the yearly Cap-ex.

Working Capital Efficiency Analysis:

Working Capital Management involves handling the short-term money movements, such as, buying
inventory, paying employees, paying vendors, collecting money from buyers, etc.
We must always pay attention to the working capital cycle of a company. If a company is unable to
collect money from customers, it will enter a crash crunch and will be unable to pay its vendors,
employees, etc. The company might have to pile on debt to pay its stakeholders. Over time continuous
cash crunches might even overburden the company with debt.
How to know if a Company is managing its Working Capital Cycle Effectively?

The above Cash flow Statement has been taken from Force Motors’ Annual Report for FY 16-17.

1. In the Consolidated Cash Flow statement, find these two items - “Operating Profit Before
Working Capital Adjustments” (OPBWCA) and “Cash Generated from Operations” /(CGO).
2. Next, find the cumulative OPBWCA and cumulative Cash Generated from Operations for the
last 5 years or more and compare both.
3. If the ratio of cumulative CGO to cumulative OPBWCA, is greater than 0.9, the company is
efficiently managing the Working Capital, if it is less than 0.5, it is doing a terrible job and is
quite likely to face a cash crunch. If the ratio is somewhere between 0.5-0.9, one must be a
little cautious.
 Let’s understand this with the example of Force Motors (Figures in Lakhs). I have pulled these
figures from the Annual Reports for each year:
2010 2011 2012 2013 2014 2015 2016 2017 2018
OPBWCA 9785 15048 14299 6706 14330 19363 32113 32987 31894
CGO 6210 8735 6986 9666 11843 25874 29361 12077 28431

Here the ratio of cumulative CGO to cumulative OPBWCA is around 0.83. Therefore, the company is
doing a fair job of managing its working capital. However, the investor must keep tracking the working
capital efficiency.
A Credit Rating report by CARE, CRISIL, ICRA, Moody’s, or Fitch would also include a lot of
information about working capital management. An investor should always check a Credit Rating Report
before investing.
Before ending this section, I have a few words of advice:

Do not follow hard and fast rules of analyzing companies.

Keep your mind open to other ways of analysing companies. For instance, I have invested in
companies with declining margins, simply because I believed that the economic cycle would
turn and it did.
These rules will only guide you.
As you read more annual reports, you will grow as an investor and develop your techniques of
analysis.
 Other Sources of Information
Red Herring Prospectus:
This is a document that a company must release before its (IPO Initial Public Offering). This report
contains a comprehensive and detailed report about the company, the management, promoters,
financials, risks the company faces, its history, details about manufacturing plants/offices, opportunities,
details of the business model, sources of revenues, largest costs, etc.
The sections in this report are the most important:

1. Risk Factors - The report has a section that analyses all the risks the company faces. It gives
you an idea about which internal and external factors can affect the company’s performance.
You should keep a tab on these factors to understand when the situation might turn
unfavourable for the company.

2. About our Company – This section details the sources of income, the entire business model,
and the opportunities the company has to do well. It also has details about where the company
started from and the strategy ahead.

3. Financial Information – Needless to say, understanding financials is critical to an investor’s

success.

Conference Calls:
These are meetings held between investors and the management every quarter to discuss quarterly
reports and the company’s progress. Conference Calls provide a huge opportunity for investors to speak
to the management and get some clarity and accountability on business-related issues. The companies
release the Conference Call Transcripts after every call. These transcripts can offer deep insights into
the company. You can understand the thought process of the management and whether they are
delivering on their promises or just taking investors for a ride. I highly recommend reading through
conference call transcripts.
An example of the importance of reading through conference calls can be seen through the following
example - I was a huge fan of a company’s business model, the company shall go unnamed. In one of
the Con-calls, the management said that despite having a huge cash balance, the company would not
pay out dividends. The reason for not doing so was that paying out dividends would lower the interest
income the company earned on that money; therefore, the management wouldn’t be able to “show
higher profits”. This meant that the management was prioritizing its career over the shareholders. The
management was not aligned with the shareholders’ interests, So, I decided to sell my stock.
Credit Reports:
Credit Rating Agencies assign credit ratings to companies. These agencies are given access to
internal company records for their research. The reports are brief but contain information that a retail
investor does not have any access to.
Rather than just looking at the ratings, one should look at the trend of the ratings. If the ratings are
declining with each report, you can be sure that something is wrong. If a Credit Rating Agency
withdraws ratings, it may have negative connotations. Usually, rating withdrawals happen because
companies do not have any more debt or they do not need more debt, hence they voluntarily ask the
credit rating agency to stop rating them. On the other hand, sometimes companies stop cooperating
with rating agencies, and the agencies are forced to withdraw ratings. This usually happens when there
is some internal problem and is a huge red flag for investors.
Credit Ratings can also help affirm your analysis or push you to look for the red flags you might have
missed. Hence, reading credit reports is extremely important for investors.
 Management Analysis
In this chapter, we shall use two terms:

Promoter: They are the controlling/largest shareholders of the company.

Management: These are the people who look after the day-to-day operations. In India, most of
the promoters are also a part of the management team. Therefore these two terms will be used
interchangeably in this chapter.

The usual priority list of stock research is:

1. Study the financials.

2. Study the management.

But in India, management analysis comes first, and business analysis comes second. Though many
Indian businesses have strong business models and healthy financials, the managements lack integrity
and honesty. Indian promoters have often used company funds to fund their personal (extravagant)
expenses or have siphoned off the company's assets.
Most unethical managements in the West try to boost the earnings using fraudulent accounting. They
do this to inflate the stock price and draw larger bonuses. The average Indian management does the
opposite. They underreport revenues and inflate costs, resulting in meager profits. The actual earnings
are siphoned off through various shell companies owned by the management. Two birds killed with a
single stone - Low profits imply lower taxes, and the management gets to pocket most of the earnings.
An old technique used by Indian promoters is selling their personal properties like plots, factories,
flats, etc., to the listed company at inflated prices. It is an easy way to siphon off cash without resorting
to blatantly illegal measures. The Boards of Directors, which is supposed to guard the shareholders'
interests, are usually hand-in-glove with the promoters. Promoters ensure that the Board Members are
close associates or relatives who will not object to such activities.
In other cases, the promoter forces the listed company to buy raw material from his private company.
These transactions are supposed to be at arms-length-basis (i.e. no partiality towards either party), but
who's to check. These transactions take place at inflated prices, filling up the promoter's pocket.
Rather than enforcing not-so-useful rules for the market, lawmakers should focus on making
managements and directors accountable to shareholders. Many of the rules are superficial at best and
detrimental to actual market development at worst.
Red Flags to look out for:

1. Large numbers of Associate Companies or Subsidiaries: If a firm has more than 10

subsidiaries with no revenues or a clear purpose, an investor should become cautious. If
subsidiaries are spread worldwide, and most of them don't have substantial revenues, they're
probably being used to launder money and evade taxes. For instance, Sintex Ltd. had multiple
subsidiaries all over the world. Barring one or two subsidiaries, none of the subsidiaries had
any operations or revenues. As of June 2021, the company has been accused of fraud by
banks and declared a defaulter.

2. A large number of related party transactions: The related party transactions show the
company's dealings with the promoters and their private companies. These transactions come
in various shapes and sizes - payments for "raw materials", payments for "Consultancy Fees",
donations to the promoters' charities, or money lent to promoters.

The pictures below are from the annual reports of Force Motors. As you can see, the Force's
main supplier is Jaya Hind Industries – the holding company itself. The company is buying goods
from its promoter. The investor should examine these transactions closely.
 The next picture shows that the company has donated (Corporate Social Responsibility
contribution) to a hospital that the promoters are building. If this is a for-profit hospital, it could be a
potential red flag that investors should look at. However, on investigating, we find that this is a
charitable hospital. Therefore, the promoters have not misused the CSR funds.

3. Basic Internet Search: Type the promoter or the company's name and add - "fraud," "scam,"
"murder," "arrested," or other no-so-honourable words. While researching a company called
Pincon Spirits Ltd., I found the following search result. The promoter himself was arrested for

fraud.

4. Avoid High Profile Promoters: If the company's promoter appears too frequently on Page 3,
showbiz news, or seems to spend a lot of time in high-profile events, it is best to avoid him/her.
While this may sound like a bit of biased and anecdotal advice, most business people who
appear regularly on Page 3 or keep trying to build a mainstream media presence are usually
more interested in glamour and playing status games rather than creating wealth. Example –
Vijay Mallya, Anil Ambani, Subrata Roy, Nirav Modi, etc. Low-profile promoters are usually
quite focused on handling their business rather than obsessing over their public image. There
always are exceptions.

5. Management Remuneration: This can be found in the annual reports easily. The
management's remuneration is limited to 5% of the net profits of the company by law. If the
remuneration is higher than this limit, either the management has received special permission
 from shareholders or is simply flouting the rules. Some promoters also install family members
in various fake positions. These family members take home large salaries without doing any
actual work. Another red flag is when the management's remuneration keeps increasing
despite a decline in net profits. Ideally, management remuneration should grow/de-grow with
the profits. Such a remuneration structure incentivises the management to perform better.

6. Management Holding & Commitment: More often than not, a company is a good investment
if the management is aggressively buying the company's stock from the open market. No one
knows the company better than management. If the management is buying aggressively, then
they certainly foresee a better future. Similarly, suppose the
management has a significant stake in the firm but does not have substantial stakes in other
companies. In that case, you can expect them to be committed to this business. You can check
if they have other professional commitments in the annual reports or by searching for their
name on [Link].

7. Past Management Decisions: The future usually rhymes with the past. If the management
has consistently made terrible decisions that destroyed shareholder wealth, it probably will
continue to do so into the future. For instance, Jain Irrigation, a Jalgaon-based agriculture
equipment manufacturer, got into IT services, Merchant Banking, Granite Mining, Advertising,
etc. These were needless diversifications that only caused Jain Irrigation to pile up on debt.
The late Mr. Bhavarlal Jain wrote an apology to the shareholder in the Economic Times.
Despite these mistakes, they again diversified into lending. Jain Irrigation is a loan defaulter as
of June 2021. No matter what the management said, it ended up diversifying into unrelated
areas. Diversifying into unrelated areas is the perfect recipe to destroy shareholder wealth. Go
through past annual reports to understand past business decisions and how they worked out. A
string of bad management decisions is something to avoid.
 Valuation of Companies
Let’s say you are offered a stock by a broker. If you buy the stock, the company will pay you Rs. 20
at the end of each year, for 5 years.
Assuming zero inflation, would it make sense to buy the stock for Rs. 150? No, because you will
spend Rs. 150 to buy the stock and then receive Rs. 100 (20 x 5) in return.
On the other hand, if the broker offers the stock at a price Rs. 50, you should certainly buy the stock.
You are investing Rs. 50 and receiving Rs. 100 in return.
Here, the real value of the stock is Rs. 100. This is also known as the intrinsic value. No matter what
rate the market offers the stock at, our sole focus should be on buying it at less than the real value.
If the stock sells at a price higher than the real value, it is overvalued and must be avoided. On the
other hand, if the stock is selling at a lower price than the real value, it is undervalued and should be
bought.
How does one calculate the real value of a stock?
In reality, you do not need to calculate the stock’s actual value
You just need to get an indication whether the stock is overvalued or undervalued. Let’s understand
this with an example – You can make out whether a person is fat or skinny by just looking at their
shadow. You don’t need their waist size or weight details. Similarly, most valuation techniques give you
a rough idea of the valuation. You do not need a precise stock value to make a decision. Trying to
calculate the precise value of a stock is a futile endeavour as it involves too many variables. It is better
to be roughly right than precisely wrong.
There are multiple ways to calculate the value of a stock. However, before we begin, we should
revise an old concept – GIGO. GIGO means Garbage In-Garbage Out. Unless you select your data
correctly and understand the concept behind the valuation method you’re using, you’re bound to get
incorrect results.
There are multiple ways to Value a Company:
Price to Earnings Ratio:
The most basic and the most abused metric. The PE ratio compares the stock price to the earnings
per share (EPS). Earning per Share (EPS) is the Net Profit divided by the number of Shares
Outstanding.
Price to Earnings = Stock Price/EPS.
EPS = Net Profit / Number of Outstanding Shares
One way of viewing this ratio is that, if a stock has a PE of 10, it means that you are paying Rs. 10
for every 1 Rupee of the company’s earnings. Another way of viewing the PE ratio of 10 is that, if the
earnings stay constant, you will recoup your invested money after 10 years.
If the PE ratio is low compared to the company’s peers’ PE, or the company’s past PE, the stock
might be undervalued and might have the potential to rise. Usually, most investors prefer stocks with a
PE below 20.
There are multiple problems with this approach. Some companies might pay their employees with
company shares. These payments are known as stock options. If the company pays its employees with
stock options, the number of shares outstanding goes up, resulting in lower EPS. The EPS calculated
after taking into account these stock options is known as Diluted EPS. Some people might not consider
these stock options while calculating the PE ratio, resulting in a lower EPS and a falsely comforting
lower PE ratio. On similar lines, we have already seen how easy it is to manipulate the profit figures. If
the profit figures are manipulated, we cannot trust the EPS. Hence, despite the simplicity, the PE ratio
must be used carefully.

PEG Ratio:
The PE ratio does not take into account the growth prospects of the company. Here is where PEG
comes in. PEG is derived by dividing the PE ratio by the yearly sales growth rate. This ratio should
ideally be less than 1 and the revenue growth rate should continue into the foreseeable future. If the
growth rate drops, the PEG ratio will go up.

PEG = PE Ratio/ Yearly Sales Growth

 Example:
Company A has a PE ratio of 30 and has consistently grown at 10% per year for the last 9 years.
The PEG ratio for Company A is 3 (30/10).
Therefore, the growth rate does not justify the valuation. Unless there is some trigger that could
boost growth rates, the company might be overvalued.

Price to Cash:
Price to Cash Ratio = Stock Price / Cash Earnings per Share

Cash EPS = Cash from Operations / Total Number of outstanding Shares.

This is the same as the PE ratio, except the fact that we use Cash EPS instead of plain EPS. Cash
EPS is calculated by dividing the Cash Flow from Operations by the number of shares outstanding. This
can also be calculated using Free Cash Flow.

EV/EBIDTA Ratio:
Enterprise Value (EV) is the amount of money that an investor buying the entire company must shell
out. He must buy all the shares of the company from the stock market (the entire market capitalization)
and take responsibility for the company debt. However, the company’s cash and Current Investments
can be used for any purpose. Current investments are usually investments in bonds, liquid mutual
funds, short-term funds etc. These can be liquidated very easily and therefore are considered equivalent
to cash.

Therefore, EV = Market Capitalization + Debt – (Cash+ Current Investments).

EBIDTA is Earnings before Interest, Depreciation, Taxes, and Amortization. EBIDTA is the same as
Operating Profit. EBIDTA can also be replaced with Cash Flow from Operations to get a clearer picture.
EV/EBIDTA gives you a good idea of the company’s overall valuation. Most investors prefer a ratio
lower than 15.

Implicit Growth Calculation:

Stock Markets expect companies to grow at a certain rate. This expected rate of growth is implied in
the stock price. The expected rate of growth changes as various new data points come up each day.
This expected rate of growth is known as the implicit growth rate.

Implicit Growth = Expected Returns – [(Free Cash Flow/Enterprise Value)*100]

Here,
Expected Returns is the rate of return you want from the investment. Keep it at 15% to be on the
safer side. The Free Cash Flow number should be adjusted to account for any cyclical changes or one-
time profits.
Once you have the implicit growth number, you can compare it with your expectations of growth and
understand whether the market is expecting too much from the company or underestimating it.
Let’s try this Analysis for Hindustan Unilever Limited (year ended Mar 2021):
Market Cap - Rs. 554,268 Crores
Cash & Current Investments- Rs. 7004 Crores
Debt - Rs. 0
Enterprise Value = 554268 – 7004 = 5,47,264. Crores
FCF - 7000 Crores.
Expected Returns - 15%
By substituting these numbers into the formula provided above, we derive an Implicit Growth of 13%
per year. Therefore, the markets are predicting that HUL will grow at 13% per year.
However, in the past 5 years, HUL’s growth rate has come down to 9% per annum. Given its huge
size and already widely spread network, it is unlikely to grow at 13% per year. Most companies of this
size in the FMCG business usually grow at the GDP growth rates. Therefore, the markets might
expecting too much from HUL.
NOTE: Experienced readers might put forward the objection that the formula calculates the expected
growth rate of FCF and not of the sales. I have simplified the idea to not confuse the beginners.
Conclusion:
 A valuation metric must not be trusted in isolation. Valuation requires both working with the numbers
and trying to predict the future. Simply relying exclusively on only past data or exclusively trying to
predict the future will not work.
For instance, assume Company A’s stocks sell at Rs. 100, while Company B’s stock sells at Rs. 500.
If both have the same EPS of Rs. 10, then:
Company A PE = 100/10 = 10.
Company B PE = 500/10 = 50.
For every 1 Re of earnings, you’re paying Rs. 10 for company A and Rs. 50 for company B. At first
glance, Company A seems to be the best choice as an investment. However, there might be multiple
other factors at play. Company A might have declining earnings and company B might be growing at
30% every year. Company A might have dishonest promoters, while company B has clean promoters.
Company A might be facing labour unrest, while Company B has strong relations with its labour force.
Company A might be a large oil company, while Company B might be a fast-growing Electric Vehicle
manufacturer. You get the idea. There are multiple factors apart from a valuation that must be
considered. Do not buy or sell solely based on the PE or any other valuation metric. Valuation metrics,
when wrongly used, can lull you into a false sense of security
There are no valuation rules set in stone. There are multiple ways to modify each valuation metric
and adjust it to suit different situations. Understanding the metric and its limitations is more important
than just feeding numbers into formulas.
 How to Detect Accounting Fraud?
Fraud has been a part and parcel of business since times immemorial. Today, despite having multiple
regulatory bodies and multiple securities regulations, fraud still occurs. In this chapter we shall discuss
the various ways in which one can detect dishonesty by promoters.

In recent years, managements of Manpasand Beverages, Vakrangee, Fortis Healthcare among

others have been rumored to have committed frauds. The matters are subjudice; however, multiple
major Fund Managers have lost money on these companies. If large fund managers can lose money,
how does a retail investor survive?

More often than not, fund managers do not detect fraud because they are so focused on the larger
picture and are so enamored by the management’s charisma, that they overlook the murky details. The
“growth stories” and superficial numbers end up influencing their decisions. This is especially an issue
with growth investors who focus exclusively on the business’s future, growth prospects and
managements rather than focusing on cold hard numbers.

Walter Schloss, a close friend of Warren Buffet, refused to meet managements so that he was not
influenced by the management’s charisma or the lack of it. His style of money management was to
simply focus on the numbers and buy low P/E, P/B, P/C stocks. It worked incredibly well; he delivered
returns of 15.5%, while S&P 500 delivered 10% over a 40 year period.

Given below are a few ways to detect financial fraud. These have been discussed earlier in the
Financial Analysis section too:

1) Compare Cumulative Cash Generated by Operations (CGO) to Cumulative Profit After Tax
(PAT):

Like we discussed in in the chapter for Statement of Cash Flow analysis, it is quite difficult to
manipulate the Statement of Cash Flow Statement compared to the Statement of Profit and Loss.
Therefore, we must compare the cumulative CGO over the past 10 years to the cumulative PAT for the
same period.

If the cumulative PAT is much greater than cumulative CGO, it is a huge red flag. It means that the Profit
after Tax figure does not give an accurate picture of the company’s earnings. The company might be
using fraudulent methods to boost its profits and its stock price.

A case in point is Pincon Spirits Ltd., a West Bengal based manufacturer of country liquor. The company
had a negative cash flow from operations for several years. The company’s debt kept rising each year.
However, even then, the Net Profits kept rising every year. This was a huge red flag. The stock price
kept increasing. The bubble soon burst when the Promoter was arrested for fraud and cheating. The
stock collapsed and never recovered.

2) Disproportionate Value of Assets/ Income/ Expenses:

This is a topic which requires common sense. If any item of Income, Assets or Expenses is either too
high or too low by industry standards, chances are that it is a red flag. For instance one of the first red
flags raised by Vakrangee Ltd.’s critics was that the company had recorded Computer Hardware worth
200 Crores on its annual report. Assuming that it managed to buy the computers at an average cost of
around Rs. 20,000 each, this implied that it had around one lakh computers. The question arises - what
does a company do with one lakh computers, unless, it’s an IT sweatshop? Though Vakrangee did take
up some small government contracts which required it to set up small centers, however, the scale wasn’t
so huge that it would require one lakh computers. As an investor, you should go through all sources of
information carefully. If something doesn’t make logical sense despite having thought of most feasible
explanations, usually it is a fraud.
3) Decreasing Inventory Turnover:

A decreasing inventory turnover implies that the company is unable to convert its inventories into
sales. The company has obsolete inventory on its records, which is still being recorded as useful
inventory. Once this inventory is actually recorded as obsolete, the company must write it off i.e. show it
as a loss on the Statement of Profit and Loss, resulting in lower profits. Many companies keep deferring
these write-offs so that the losses do not affect the stock price.

4) Decreasing Receivables Turnover:

If receivables turnover declines, it means that the company is unable to collect payments from its
customers. Quite a few companies in the past have recorded fake sales to their boost earnings.
However, since the sales are fraudulent, there is no way the company can actually collect any
payments. Therefore, receivables keep rising and receivables turnover keeps declining over time. The
receivables growing at a higher rate than sales, is another red flag.

5) Check for Positive Free Cash Flow:

Like we discussed in the Income Statement Analysis chapter, a company is allowed to capitalize
certain expenses. Capitalization means that the company shows an expense as an asset and does not
include it under the expenses section of the Statement of Profit and Loss. However, not all expenses
can or should be capitalized. Some companies capitalize normal day to day expenses resulting in
fraudulently generated higher profits. However, the expenses which are capitalized show up in the Cash
Flow from Investing Activities. Therefore an investor should subtract Cash Flow from Investing Activities
from the Cash Generated from Operations. You might remember that this is the formula for Free Cash
Flow (FCF). If FCF is negative or zero while the Income Statement shows high profits, you should check
whether the company is expanding. If it isn’t expanding, negative FCF along with large accounting
Profits is a huge red flag.

6) Performance that is too Good/Consistent to be True:

Great companies are incredibly rare. These companies consistently perform extremely well for years
and their stock price skyrockets. However, many mediocre companies resort to fudging data, in order to
meet or exceed the market’s expectations. Even if their competitors are doing badly, these companies
keep doing well. Extremely consistent results raise several red flags. Why are the results so consistent?
Does the company have any advantage that its competitors don’t? How does the company meet analyst
expectations every time? Asking questions like these can save you from making a wrong decision.

7) Changes in Accounting Policies/Disclosures:

Companies might change accounting policies to modify financials according to their needs. They might
change Revenue Recognition Policies, Depreciation Policies, and Pension Fund Policies etc. This
misguides investors and paints a falsely rosy picture of the company’s finances. Companies might also
stop disclosing certain metrics or certain disclosures which is a red flag. Unless some information is
proprietary and grants the company a competitive edge, it does not make sense to hide that information
from investors.
 Comprehensive Checklist
Statement of Profit and Loss:
Item Criteria Notes
Sales Growth (10 >Inflation
year CAGR) Rate
Operating Profit Stable or
Margins Increasing
Stable or
Net Profit Margins
Increasing
Interest Coverage >3
This rate can be lower if the company avails tax
Tax Rate 25-30%
benefits/incentives.

Balance Sheet:
Item Criteria Notes
Debt to Equity <0.5
Inventory Turnover Increasing or Stable
Receivables Turnover Increasing or Stable
Payables Turnover Decreasing or Stable
Current ratio >1.5
NFAT Ratio (Sales to Fixed Assets Ratio) >3

Cash Flow Statement:

Item Criteria Notes
Ratio of Cumulative Cash Flow from Operations
(before Tax) to the Cumulative Operating Profit before >0.8
Working Capital Adjustments
Positive FCF is a Sign of
Preferably Healthy Financials. Cause of
FCF
FCF>0 negative FCF should be
investigated.

Valuation:
Item Criteria Notes
PE Ratio <20
PEG Ratio <1
Price to Cash <15
EV/EBIDTA or EV/CFO <15
Implied Growth Rate <Expected Growth Rate
 Petronet LNG Stock Analysis
Petronet is a PSU specializing in operating LNG terminals in India. It buys LNG from Qatar, stores
the LNG in its terminals, re-gasifies it and resells it to GAIL, ONGC, IOCL, etc.
Financial Analysis:

Unfortunately, [Link] does not have a 10-year report for Petronet. However, we can still make
out the most relevant strengths and weaknesses of Petronet from its 5 years of financial data. As we
can see from the data above, Petronet’s sales have been very volatile in the past few years. In 2015,
Petronet had a capacity of 10 MTPA. By 2021, this has increased to 21 MTPA. Yet, today revenues are
nowhere near their 2015 peak.

Last 5 Years’ Gas Prices Graph

Petronet’s Revenue Graph (Figures in Crores).

 The first graph shows the movement of natural gas prices in international markets over the last 5
years. The second graph shows the movement of Petronet’s Sales over the last 5 years.
Both the graphs are similarly shaped, indicating that Petronet’s Revenues are extremely dependent
on the International Gas Market rates. Since 2015, the gas prices have mostly remained subdued
resulting in lower sales for Petronet. The gas market has been oversupplied with cheap and abundant
American shale gas since 2014, resulting in extremely low prices.
Margins:

As we can see from the data above, margins have varied widely from 4% to 18%.​This is a classic
characteristic of businesses that lack pricing power. They do not get to decide the margins their product
will sell at. They are forced to sell at prices they have no control over.
Why does this happen?
There is no way for a gas company to differentiate its gas from the other company’s gas. Gas is gas,
no matter if it is Indane Gas, Bharat Gas, or HP Gas. On the other hand, a company like Nestle, has the
option to advertise its product and make people believe that its Instant Noodle is better than the other
Noodle brands out there. It has built a strong brand value around its product which guarantees its stable
margins. However, there is no way a gas company can create a brand around its product. Therefore,
these companies’ margins are unstable and vary with the price of gas.
Pricing power can also come from having a monopoly or duopoly. Since, competition is limited/non-
existent; companies can keep increasing the product prices. However in the case of gas firms, there are
tens of thousands of gas producers, therefore there is extreme competition, resulting in producers
lowering their prices to sell off the inventory.
Interest Coverage Ratio:

The company has been lowering its debt every year, resulting in a higher interest coverage ratio.
This is a positive sign of prudent financial management.

Taxes:

Taxes have been quite lower than 30% for multiple years. This is a huge red flag.
However, on investigating further, we find that low tax for all of the years is the result of MAT credit.
This deduction is allowed under a tax scheme of the government. For instance, on checking the annual
report for FY 2015, we find that the company has received MAT Credit. Therefore, it has paid out lesser
taxes. Extract from the Annual Report:

Trade Receivables Turnover:

Receivables Turnover has fallen from 29 to 22. This means that the company is not able to collect its
receivables as quickly as it did in the past. This should be investigated further. However, on reading
CRISIL’s report dated December 30, 2019, we find that the company has secured its credit by take-or-
pay contracts. Such contracts mandate that if the buyer doesn’t buy a specified amount of gas, he must
pay a penalty. This prevents any revenue loss risks. At the same time, Petronet’s customers are GAIL,
IOCL, HPCL, etc. these companies have strong financial conditions. Therefore, the risk of receivables
default is low. Given below is the extract from the CRISIL report:
 Inventory Turnover:

Inventory Turnover is quite high every year, even exceeding 100 for FY 2016. This is because the
entire capacity is tied-up through take-or-pay contracts. These contracts incentivize customers to keep
buying gas from Petronet all year round. Therefore, Petronet can convert its inventory into sales at a
very fast rate.

Net Fixed Assets Turnover:

NFAT has been declining over the years. The main reason for this decline is the company’s LNG
terminal at Kochi. This terminal has been running at 20% of its total capacity for the last few years.
Petronet has been unable to secure buyers for the remaining 80% of the terminal’s capacity. Despite
having assets, the company is unable to generate revenue. This results in a low NFAT.
However, a new gas pipeline connecting Kochi to Mangalore has been built. Petronet expects
Mangalore Refinery and Petrochemicals Ltd. to become a new customer.

Debt-to-Equity Ratio:

Debt to Equity has been decreasing continuously every year. The company has been paying back
its debts. At the same time, the company has been expanding by using its cash, thanks to strong cash
flows. This is illustrated in FY 20’s Annual Report’s Director’s Report:

Working Capital Efficiency:

2015 2016 2017 2018 2019 2020 Total
OPBWCA 1483 1639 2772 3397 3406 4217 16914
CFO before Taxes 1038 3573 2445 3692 2954 3820 17522

The ratio of cumulative Cash Flow from Operations before Taxes (CFO before tax) and cumulative
Operating Profit before Working Capital Changes (OPBWCA) and is 1.03. Therefore the company has
been extremely efficient in managing its working capital.

Free Cash Flow:

As we can see, the company has consistently generated Free Cash Flow. The CFO is 3X the CFI.
The company has used the remaining cash to pay dividends to investors and reduce the debts.
Therefore, the company has a very healthy cash flow profile and has rewarded its shareholders with
dividends.
While reading the Annual Report, we find that the business is facing competition from new LNG
terminals that are being set up.
 Petronet’s has two terminals – in Dahej and in Kochi. Both are situated on the west coast. Newer
terminals such as Swan Energy’s terminal in Jafrabad are situated further west to Dahej, making the
journey cheaper and quicker for tankers from the Gulf.
ONGC, IOCL, and GAIL - Petronet’s customers (and promoters) have booked almost 60-70% (3.5
MMTPA) of Swan Energy’s terminal capacity. Therefore, once this new terminal starts operating,
Petronet will lose out on customers and almost 20% of its volumes. Petronet’s competitive edge might
dwindle, with new terminals coming up. These terminals might end up in a price fight, resulting in losses.
Apart from new terminals, Petronet also faces competition from alternate fuels like petrol, diesel,
LNG, etc. If these fuels become cheaper, then consumers will be inclined to use them. Therefore,
Petronet will have to lower its gas prices to compete with these fuels.
Management Analysis:
A preliminary internet search for “Petronet LNG fraud” yields the following result:

An investor should investigate in-depth the allegations and the actions taken.
In terms of Remunerations, the management is paid around 0.15-0.2% of the Net Profits of the
company which is reasonable. In terms of salary hikes, the management has received hikes in line with
the profit growth, which a good sign. If managements receive salary hikes higher than the profit growth
rate, it is a red flag.
Related party transactions have only taken place with the Promoters – Gas Authority of India Ltd
(GAIL), Oil and Natural Gas Corporation Ltd (ONGC), and Bharat Petroleum Corporation Ltd.(BPCL)
These promoters are also the largest customers of BPCL therefore they figure in the related party
transactions list. Since both Petronet and its Promoters are owned by the government and run by
professional management, the transactions are quite certainly conducted on an arms-length basis.

Valuation (As of March 2020):

Market Capitalisation = Rs. 34970 Crores.
Debt = Rs. 64 Crores.
Cash & Current = Rs. 4615 Crores.
 Therefore, Enterprise Value = 34970 + 64- 4615 = Rs. 30,419 Crores.
Cash Flow from Operations = Rs. 2863 Crores.
Free Cash Flow = 2200 Crores (Approximate Avg. of last 5 years)
EBIDTA = Rs. 3989 Crores
Expected Returns = 15%
Stock Valuations:-

1. P/E = 11.
2. EV/EBIDTA = 7.6
3. EV/CFO = 10.6
4. EV/FCF=13.8
5. Implicit Growth: On calculation, we get an implicit growth of 8%. Therefore the market
expects the company to grow at 8% per annum consistently.

While valuing the firm, the investor should keep in mind, the volatile nature of the business and de-
growth in revenue in the past years. Plus, the new terminals that are coming up in the region will give
Petronet stiff competition. Petronet’s largest customers have already booked capacities in its
competitor’s facilities, which could cause Petronet to lose around 20% of its current volumes. Though
the stock looks cheap, these factors should be taken into consideration.
In the end, it is up to the investor to analyze these facts and come up with a decision to buy, sell or
hold as per their conclusion.

Bajaj Consumer Care Ltd. Analysis

Financial Analysis:

Sales/Revenue Analysis:

Sales have grown at a CAGR of 10% in the last 9 years, have grown at a CAGR of only 6% over the
past 5 years. This slowdown in growth is probably because the hair oil market is already highly
penetrated, as per the management. High penetration means that hair oils are available in most retail
shops in India. Low penetration would mean that the product is present in a few retail shops. The same
slow growth trend can be seen in Marico which manufactures “Parachute” hair oil. The entire hair oil
industry is growing at a very slow pace.

The sudden boost in earnings in FY 2015 came from the marketing push of the newly acquired No-
Marks brand. We can see this from the revenue breakup given on Page 90 of FY 2015’s annual report
below:
 Apart from hair oil, all of the other products were launched under the No-Marks brand. From FY 2015
onwards, the No-Marks have been in constant decline and hence revenue for FY 16 and FY 17 are
lower.

Sales fell again in FY 2020 due to the complete lockdowns in March 2020, the last quarter of the year.
At the same time, the wholesale markets were already facing a cash crunch and FMCG companies
were facing a cash crunch. From Q2 FY2020’s Con Call –

Hence, the lockdowns created any other hurdle to increasing sales in an already tough year.

Margins:

The company commands operating margins of around 25-30%. This shows that the company has
strong pricing power. This indicates that the product is unique, has high demand and the customers are
ready to shell out money for it. The company has built a strong and valuable brand.

However, with the rise of bulk customers like Jio-0Mart, Amazon Grocery, Flipkart Grocery these
margins might go down. Since, these customers order in bulk and sell directly, they will ask for higher
discounts. These brands might also launch their own brands which receive higher visibility on the
platforms, resulting in more competition for Bajaj.

Tax Rates:

As we can see, the company has paid only 20-22% taxes in the 2012-2020 period, whereas the
corporate tax rate was around 30% for this period. This is a red flag that should be investigated further.

So, we look at Bajaj Consumer’s Conference Call with Investors (the company changed its name
recently):
 As we can see, the tax rates are low because of Minimum Alternate Tax Credits. This was a tax
scheme introduced by the Government. Similarly, the company had also received tax breaks for its new
factory in Guwahati. All of these factors have resulted in lower tax outgo for the company.

Debt-to-Equity Ratio:

Debt-to-Equity has remained extremely low over the years. Given the company’s strong financials, the
company doesn’t have to borrow to meet its monetary needs. This is a positive sign. Given the
negligible amount of debt the company has, the interest expenses are also very low.

Fixed Capital Intensity:

The company has managed to maintain a high but stable NFAT of around Rs. 15. An NFAT of 15
implies that the company is generating sales of Rs. 15 with every Rs. 1 invested in fixed assets.

Receivables Turnover:

The receivables Ratio is decreasing over the years. This is a red flag. It implies that the company is
not collecting payments as quickly as it did in the past.

In the past, most of the sales were made to distributors who bought the product from the company and
paid immediately in cash. Today, though distributors have the largest revenue share, bulk buyers like
Supermarkets and large retailers contribute to a significant part of the sales. These retailers enjoy higher
discounts and long credit periods. Due to these issues, the company has a decreasing receivables
turnover.

Inventory Turnover:
Though Inventory turnover is higher than an average manufacturing company, it has fluctuated quite a
lot. An investor should investigate the reason behind such fluctuations and ascertain whether there are
any negative implications.

Cash Generation:

The firm consistently has produced positive Free Cash Flow over the past 10 years. Out of its 9
manufacturing plants, it owns only 3. The other 6 plants have been taken on lease. Therefore, the
company did not have to invest in new plants. This resulted in lower Cash spent on Investing Activities.

Working Capital Intensity:

2012 2013 2014 2015 2016 2017 2018 2019 2020 Tota
OPBWCA 117 172 180 239 273 263 253 277 206 1980
CGO
89 114 165 252 246 270 239 237 179 1791
before Tax

The ratio of cumulative CGO before Tax to cumulative OPBWCA is 0.9. Therefore, the company can
efficiently manage its working capital.

Business and Product Analysis:

The company has just one main product, Bajaj Almond Drops Hair Oil (ADHO). It generates 95% of the
revenues of the company. The rest of the 5% consists of other small brands which could not make it big.
They also launched various products like amla oil, jasmine oil, dental products, skincare products,
soaps, creams, powders, and recently, hand sanitizers. However, none of these brands grew. It acquired
No-Marks a skincare brand in 2013 for 150 Crores, however, the acquisition did not work out too well.

This partly shows the difficulty of brand building in the FMCG industry, it is incredibly difficult to
create a consumer brand, especially for smaller firms. Brand creation requires financial firepower,
innovation, and distribution skills to create great brands in price-sensitive India. With this view, despite
what critics say, it is quite impressive that ITC has created multiple 500 Cr+ brands within 15-20 years.

The Almond Drops product has a very loyal consumer following since it has a distinctive smell. Unlike
traditional coconut hair oils (which the majority of Indians use), it doesn’t have a sticky feeling or has a
weird smell. Hair oils usually tend to be habitually used products; most users who use a particular type
of oil tend to stick to it unless skin problems or better products come up.

Promoters:

It is promoted by the Shishir Bajaj Group and is run by professional managers.

While reading through the Red Herring Prospectus, we notice that the promoters receive a royalty of 1%
of the revenues for allowing the company to use the “Bajaj” brand. Whether this is justified, is up to the
investor to decide. The extract from the Red Herring Prospectus:
 Apart from this, there aren’t any regular related party transactions. The promoters do not take any
salary, except Mr. Kushagra Bajaj (brother of Shishir Bajaj), who receives Rs. 1 lakh per annum as the
Director’s sitting fees.

In 2011, right after the IPO, the Bajaj Consumer bought its promoters’ stake in a company called
“Uptown Properties and Leasing Ltd.” by paying Rs.25 Crores and taking responsibility for liabilities
worth Rs. 50 Crores. This is a potential red flag. In the past, many promoters have used such tactics to
siphon off cash from the listed company. The investor should investigate whether the transaction took
place at the fair market rates or inflated rates. Extract from the News Report:

Another point to note, the promoters also run the largest sugar producer in India “Bajaj Hindustan”
which is a loss-making entity and is going through financial troubles. Many Indian promoters have used
money from healthy group companies to run their sick firms. Though this hasn’t been the case with Bajaj
Consumer, one must take this into cognizance before investing.

The company’s auditor appears to be a Surat-based sole proprietorship and holds annual meetings in
Udaipur. These can be potential red flags. Even with these issues, I believe that the company’s books
are genuine and honest because in the past the company has paid almost its entire free cash flows as
dividends since the past few years and has 450+Cr cash on books.

Dividends were also very high earlier but have come down now. This is because promoters used the
dividends to pay interest costs on pledged shares. Since no shares are pledged, there is a lack of
urgency in dividend payments.

Management:

Recently, Mr. Jaideep Nandi took over the management as CEO and MD. He formerly worked at Asian
Paints and is an IIM-B graduate. However, he was not the first choice to succeed the outgoing MD. In
2016 Sandeep Verma formerly President of HUL’s global brands was poised to take up the CEO and
MD mantle, however, he left Bajaj Consumer. Though reasons for this resignation have been kept
private, however, it should be kept in mind before investing. The KMP salaries are around 2.5-3% of
annual profits. The salary growth is in line with the profit growth.

Valuations:

M. Cap = Rs. 1800 Cr

Debt = Nil.

Profit after Tax = 184 Crores

Free Cash Flows = Rs .170 Cr

Cash on Books = Rs 450 Cr

Expected return = 15%

PE = 10
EV/EBIDTA = 7
EV/CFO = 8
EV/FCF = 9.7
 Implied Growth Rate - On Calculating, we find that the expected growth rate is around 3 % p.a
at the current valuation. However, the firm has managed to grow at 7- 10% until quite recently.
It is reasonable to assume that the firm can reach those levels of growth once again.

It is up to the investor to weigh all of these facts and come to a conclusion with these facts at hand.
Disclosure: I am invested in this company, and will continue to remain invested for the foreseeable
future.

It is up to the reader to interpret this analysis and take a call. This analysis was produced in June
2020 so some facts and figures might be outdated.