Module 3   Fundamental AnalysisChapter 13

Equity Research (Part 1)

View chapters →

13.1 – What to expect?

Having set the context in the previous chapter, we will now develop a methodology for conducting a ‘limited resource’ equity research. The reason why I call it ‘limited resource’ is because you and I, as a retail investor, have access to just a few resources to conduct equity research. These resources are – internet, company annual report, and MS Excel. Whilst an Institution has access to human resource (analyst), access to company management, financial database (such as Bloomberg, Reuters, Factset etc.), industry reports etc. So my objective here is to demonstrate how one can better understand a company and its business with the limited resources at hand. Of course, we will do this exercise keeping the end objective in perspective, i.e., deciding whether to buy or not to buy a stock.

As mentioned in the previous chapter, we will structure the equity research process in 3 stages-

  1. Understanding the Business
  2. Application of the checklist
  3. Intrinsic Value estimation (Valuation) to understand the fair price of the stock

Each stage mentioned above has several steps within it. One must understand that there is no shortcut to this, and one must not compromise any of these steps.

13.2 – Stock Price vs Business Fundamentals

When we take up a company for research, the first step is to understand the business as much as possible. People often miss this crucial step and go directly into the stock price analysis. Well, just analyzing the stock price is great if you have a short term perspective. However, for long term investments, understanding the business is essential.

Why is it important you may wonder? Well, the reason is simple: the more you know the company, the higher is your conviction to stay put with the investment, especially during bad times (aka bear markets). Remember, during bear markets, the prices react and not the business fundamentals. Understanding the company and its business well gives you the required conviction to reason why it makes sense to stay invested in the stock even though the market may think otherwise. They say bear markets creates value, so if you have a high conviction on the company, you should consider buying into the stock during bear markets and not really selling the stock. Needless to say, this is highly counter-intuitive, and it takes years of investment practice to internalize this fact.

Anyway, moving ahead the best source to get information related to the business is the company’s website and its annual report. We need to study at least the last 5-year annual report to understand how it is evolving across business cycles.


13.3 – Understanding the Business

As a first step towards understanding the business, we need to make a list of questions we need to find answers to. Do note, the answers to all these questions can be found out by reading through the company’s annual report and website.

Here are a bunch of questions that I think helps us in our quest to understand the business. I have discussed the rationale behind each question.

Sl No Question The rationale behind the question
1 What does the company do? To get a basic understanding of the business
2 Who are its promoters? What are their backgrounds? To know the people behind the business. Sanity check to eliminate criminal background, intense political affiliation etc
3 What do they manufacture (in case it is a manufacturing company)? To know their products better, helps us get a sense of the product’s demand-supply dynamics
4 How many plants do they have and where are they located? To get a sense of their geographic presence. Also at times, their plants could be located in a  prime location, and  the value of such location could go off-balance sheet, making the company highly undervalued
5 Are they running the plant in full capacity? Gives us an idea on their operational abilities, demand for their products, and their positioning for future demand
6 What kind of raw material is required? Helps us understand the dependency of the company. For example, the raw material could be regulated by Govt (like Coal) or the raw material needs to be imported either of which needs further investigation
7 Who are the company’s clients or end-users? By knowing the client base, we can get a sense of the sales cycle and efforts required to sell the company’s products
8 Who are their competitors? Helps in knowing the competitors. Too many competing companies means margin pressure. In such a case, the company has to do something innovative. Margins are higher if the company operates in – monopoly, duopoly, or oligopoly market structure
9 Who are the major shareholders of the company? Besides the promoter and promoter group, it helps to know who else owns the company’s shares. If a highly successful investor holds the shares in the company, then it could be a good sign
10 Do they plan to launch any new products? Gives a sense of how ambitious and innovative the company is. While at the same time a company launching products outside their domain raises some red flags – is the company losing focus?
11 Do they plan to expand to different countries? Same rationale as above
12 What is the revenue mix? Which product sells the most? Helps us understand which segment (and therefore, the product) is contributing the most to revenue. This in turns helps us understand the drivers for future revenue growth
13 Do they operate under a heavy regulatory environment? This is both good and bad – Good because it acts a natural barrier from new competition to enter the market, bad because they are limited with choices when it comes to being innovative in the industry
14 Who are their bankers, auditors? Good to know, and to rule out the possibility of the companies associated with scandalous agencies
15 How many employees do they have? Does the company have labour issues? Gives us a sense of how labour-intensive the company’s operations are. Also, if the company requires a lot of people with a niche skillset, then this could be another red flag
16 What are the entry barriers for new participants to enter the industry? Helps us understand how easy or difficult it is for new companies to enter the market and eat away the margins
17 Is the company manufacturing products that can be easily replicated in a country with cheap labour? If yes, the company may be sitting on a time bomb – think about companies manufacturing computer hardware, mobile handsets, garments etc
18 Does the company have too many subsidiaries? If yes, you need to question why? Is it away for the company to siphon off funds?

These questions are thought starters for understanding any company. In finding answers, you will automatically start posting new questions for which you will have to find answers to. It does not matter which company you are looking at if you follow this Q&A framework. I’m very confident your understanding of the company would drastically increase. This is because the Q&A process requires you to read and dig out so much information about the company that you will start getting a greater understanding of the company.

Remember, this is the first step in the equity research process. If you find red flags (or something not right about the company) while discovering the answers, I would advise you to drop researching the company further irrespective of how attractive the business looks. In case of a red flag, there is no point proceeding to stage 2 of equity research.

From my experience, I can tell you that stage 1 of equity research, i.e. ‘Understanding the Company’ takes about 15 hours. After going through this process, I usually try to summarize my thoughts on a single sheet of paper which would encapsulate all the important things I have discovered about the company. This information sheet has to be crisp and to the point. If I’m unable to achieve this, then it is clear that I do not know enough about the company. After going through stage 1, I proceed to stage 2 of equity research, which is “Application of Checklist”. Please do bear in mind the equity research stages are sequential and should follow the same order.

We will now proceed to stage 2 of equity research. The best way to understand stage 2 is by actually implementing the checklist on a company.

We have worked with Amara Raja Batteries Limited (ARBL) throughout this module. Hence I guess it makes sense to go ahead and evaluate the checklist on the same company. Do remember, the company may differ, but the equity research framework remains the same.

As we proceed, a word of caution at this point – the discussion going forward will mainly revolve around ARBL as we will understand this company better. The idea here is not to showcase how good or bad ARBL is but instead illustrate a framework of what I perceive as a ‘fairly adequate’ equity research process.

13.4 – Application of checklist

Stage 1 of the equity research process helps us understand how, what, who, and why. It helps us develop a holistic view of the company. However, as they say – the proof of the pudding is in the eating; so no matter how attractive the business looks, the numbers of the company should also look attractive.

The objective of the 2nd stage of equity research’s objective is to help us comprehend the numbers and actually evaluate if both the nature of the business and the business’s financial performance complement each other. If they do not complement each other, then clearly the company will not qualify as an investible grade.

We looked at the checklist in the previous chapter; I’ll reproduce the same here for quick reference.

Sl No Variable Comment What does it signify
1 Net Profit Growth In line with the gross profit growth Revenue growth should be in line with the profit growth
2 EPS EPS should be consistent with the Net Profits If a company is diluting its equity, then it is not good for its shareholders
3 Gross Profit Margin (GPM) > 20% Higher the margin, higher is the evidence of a sustainable moat
4 Debt Level The company should not be highly leveraged High debt means the company is operating on high leverage. Plus the finance cost eats away the earnings
5 Inventory Applicable for manufacturing companies A growing inventory, along with a growing PAT margin is a good sign. Always check the inventory number of days
6 Sales vs Receivables Sales backed by receivables is not a great sign This signifies that the company is just pushing its products to show revenue growth
7 Cash flow from operations Has to be positive If the company is not generating cash from operations, then it indicates operating stress
8 Return on Equity >25% Higher the ROE, better it is for the investor, however, make sure you check the debt levels along with this

Let us go ahead and evaluate each of the checklist items on Amara Raja Batteries and see what the numbers are suggesting. First, we will look into the P&L items – Gross Profit, Net Profit, and EPS of the company.

Revenue & Pat Growth

The first sign of a company that may qualify as the investable grade is the rate at which it is growing. To evaluate the growth of the company, we need to check the revenue and PAT growth. We will evaluate growth from two perspectives –

  1. Year on Year growth – this will give us a sense of progress the company makes every year. Do note; industries do go through cyclical shifts. From that perspective, if a company has a flat growth, it is ok. However, just make sure you check the competition and ensure the growth is a flat industry-wide.
  2. Compounded Annual Growth Rate (CAGR) – The CAGR gives us a sense of how the company is evolving and growing across business cycles. A good, investable grade company is usually the first company to overcome the shifts in business cycles. This will eventually reflect in a healthy CAGR.

I prefer to invest in growing (Revenue and PAT) companies over and above 15% on a CAGR basis.

Let us see how ARBL fares here…

FY 09 -10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Revenue (INR Crs) 1481 1769 2392 3005 3482
Revenue Growth 19.4% 35.3% 25.6% 15.9%
PAT (INR Crs) 167 148 215 287 367
PAT Growth (11.3%) 45.2% 33.3% 27.8%

The 5-year CAGR revenue growth is 18.6%, and the 5-year CAGR PAT growth is 17.01%. These are an interesting set of numbers; they qualify as a healthy set of numbers. However, we still need to evaluate the other numbers on the checklist.

Earnings per Share (EPS)

The earnings per share represent the profitability on a per-share basis. The EPS and PAT growing at a similar rate indicate that the company does not dilute the earnings by issuing new shares, which is good for the existing shareholders. One can think of this as a reflection of the company’s management’s capabilities.

FV Rs.1 FY 09 -10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
EPS (In INR) 19.56 17.34 12.59 16.78 21.51
Share Cap(INR Crs) 17.08 17.08 17.08 17.08 17.08
EPS Growth   – -11.35%  – 27.39% 33.28% 28.18%

The 5 year EPS CAGR stands at 1.90% for the FY14.

Gross Profit margins

Gross profit margins, expressed as a percentage is calculated as a –

Gross Profits / Net Sales


Gross Profits = [Net Sales – Cost of Goods Sold]

Cost of goods sold is the cost involved in making the finished good; we had discussed this calculation while understanding the inventory turnover ratio. Let us proceed to check how ARBL’s Gross Profit margins have evolved over the years.

In INR Crs, unless indicated. FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Net Sales 1464 1757 2359 2944 3404
COGS 1014 1266 1682 2159 2450
Gross Profits 450 491 677 785 954
Gross Profit Margins 30.7% 27.9% 28.7% 26.7% 28.0%

Clearly, the Gross Profit Margins (GPM) looks very impressive. The checklist mandates a minimum GPM of 20%. ARBL has much more than the minimum GPM requirement. This implies a couple of things –

  1. ARBL enjoys a premium spot in the market structure. This may be because of the absence of competition in the sector, which enables a few companies to enjoy higher margins
  2. Good operational efficiency, which in turn is a reflection of management’s capabilities

Debt level – Balance Sheet check

The first three points in the checklist were mainly related to the company’s Profit & Loss statement. We will now look through a few Balance sheet items. One of the most important line items that we need to look at on the Balance Sheet is the Debt. An increasingly high level of debt indicates a high degree of financial leverage. Growth at the cost of financial leverage is quite dangerous. Also do remember, a large debt on balance sheets means a large financial cost charge. This eats into the retained earnings of the firm.

Here is how the debt stands for ARBL –

Debt( INR Crs) Evaluation –

FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Debt 91.19 95.04 84.07 87.17 84.28
EBIT 261 223 321 431 541
Debt/EBIT (%) 35% 42.61% 26.19% 20.22% 15.57%

The debt seems to have stabilized around 85Crs. In fact, it is encouraging to see that the debt has come down in comparison to FY 09-10. Besides checking for the interest coverage ratio (which we have discussed previously), I also like to check the debt as a per cent of ‘Earnings before interest and taxes’ (EBIT). This just gives a quick perspective on how the company is managing its finance. We can see that the Debt/EBIT ratio has consistently reduced.

I personally think ARBL has done a good job here by managing its debt level efficiently.

Inventory Check

Checking for the inventory data makes sense only if the company under consideration is a manufacturing company. Scrutinizing the inventory data helps us in multiple ways –

  1. Raising inventory with raising PAT indicates are signs of a growing company
  2. A stable inventory number of days indicates management’s operational efficiency to some extent

Let us see how ARBL fares on the inventory data –

FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Inventory (INR Crs) 217.6 284.7 266.6 292.9 335.0
Inventory Days 68 72 60 47 47
PAT (INR Crs) 167 148 215 287 367

The inventory number of days is more or less stable. In fact, it does show some sign of a slight decline. Do note; we have discussed the calculation of the inventory number of days in the previous chapter. Both the inventory and PAT are showing a similar growth sign which is again a good sign.

Sales vs Receivables

We now look at the sales number in conjunction with the receivables of the company. A sale backed by receivables is not an encouraging sign. It signifies credit sales, and therefore many questions arise out of it. For instance – are the company sales personal force selling products on credit? Is the company offering attractive (but not sustainable) credit to suppliers to push sales?

FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Net Sales(INR Crs) 1464 1758 2360 2944 3403
Receivables (INR Crs) 242.3 305.7 319.7 380.7 452.6
Receivables as a% of Net Sales 16.5% 17.4% 13.5% 12.9% 13.3%

The company has shown stability here. From the table above we can conclude a large part of their sales is not really backed back receivables, which is quite encouraging. In fact, just like the inventory number of days, the receivables as % of net sales has also shown signs of a decline, which is quite impressive.

Cash flow from Operations

In fact, this is one of the most important checks one needs to run before deciding to invest in a company. The company should generate cash flows from operations; this is, in fact, where the proof of the pudding lies. A company which is draining cash from operations raises some sort of red flag.

In INR Cr FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
Cash flow from Operations 214.2 86.1 298.4 335.4 278.7

The cash flow from operations through a bit volatile has remained positive throughout the last 5 years. This only means ARBL’s core business operations are generating cash and therefore, can be considered successful.

Return on Equity

We have discussed at length about Return on Equity in chapter 9 of this module. I will encourage you to go through it again if you wish to refresh. Return on Equity (ROE) measures in percentage the return generated by the company keeping the shareholder’s equity in perspective. In a sense, ROE measures how successful the company’s promoters are for having invested their own funds in the company.

Here is how ARBL’s ROE has fared for the last 5 years –

In INR Cars FY 09-10 FY 10-11 FY 11-12 FY 12 -13 FY 13 – 14
PAT 167 148 215 287 367
Shareholders’ Equity 543.6 645.7 823.5 1059.8 1362.7
ROE 30.7% 22.9% 26.1% 27.1% 27.0%

These numbers are awe-inspiring. I personally like to invest in companies that have an ROE of over 20%. Do remember, in case of ARBL, the debt is quite low. Hence the good set of return on equity numbers is not backed by excessive financial leverage, which is again highly desirable.


Remember, we are in stage 2 of equity research. I see ARBL qualifying quite well on almost all the required parameters in stage 2. As an equity research analyst, you have to view the output of stage 2 in conjunction with your finding from stage 1 (which deals with understanding the business). If you can develop a comfortable opinion (based on facts) after these 2 stages, the business surely appears to have investable grade attributes and therefore worth investing.

However, before you buy the stock, you need to ensure the price is right. This is exactly what we do in stage 3 of equity research.

Key takeaways from this chapter

  1. ‘Limited Resource’ Equity Research can be performed in 3 stages
    1. Understanding the Business
    2. Application of the checklist
    3. Valuations
  2. The objective of stage 1, i.e. understanding the business requires us to gather all business information. The best way to go about this is the Q&A way
  3. In the Q&A way, we begin with posting some simple and straightforward questions for which we find answers
  4. By the time we finish stage 1, we should be through with all the information related to the business
  5. Most of the answers required in stage 1 are present in the company’s annual report and website
  6. Do you remember while researching the company in stage 1, if there is something not very convincing about the company, it is often a good idea to stop researching further
  7. You need to get convinced (based on facts) about the company in stage 1. This is how you will develop a strong conviction to stay put during bear markets
  8. Stage 2 of Equity Research requires you to evaluate the performance of the company on various counts.
  9. You will proceed to stage 3 only after the company clears in stage 1 & 2.


View all comments →
  1. raman says:

    Very informative
    When is next chapter being uploaded ?

  2. Harshad Salvi says:

    In gross profit margin calculations, i think COGS figure seems to have been considered instead of Net Sales Figure while computing the GP Ratio. GP Ratio is much lesser (more than 10%) in all cases although above norm.

  3. Harshad Salvi says:

    Is it possible for you to explain on how to write research report/paper?

  4. Harshad Salvi says:

    Don’t know. But yeah.. It’s my dream to write a Professional Research Report/Paper on my own..
    Hope this is possible one day.
    Going by your credibility & forte in this financial world, need your help in accomplishing this objective

    • Karthik Rangappa says:

      It is just a matter of practice of identifying good will soon realize a report is just a formality 🙂

      • Harshad Salvi says:

        Yup.. But in today’s world a lot of emphasis is placed on the presentation. Hence, it is essential that identification of good opportunity being translated into proper presentation.
        I would love to make a career in this… Is it possible?

        • Karthik Rangappa says:

          Sure why not. There are many firms that require research analyst. Getting yourself a CFA certification is a good start.

  5. kumar sunil says:

    very informative and summrize tutorials.hats off for your honest efforts to aware peoples

View all comments →
Post a comment