[Building Blocks]: 4 principles of a fundamentally sound company

Hi all, as promised I would like to share with you some of the criteria I have before I decide that the company is fundamentally sound and worth investing. These 4 simple principles can be applied irregardless of what style of investing you pursue. (Growth, value, income etc) Investing in a fundamentally sound company reduces your exposure to the risk that the company may fail. These principles also act as red flags when a company with good track records flouted any of these principles. Adhering in these 4 basic principles should put you in good stead when investing directly on the stock market.

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Without further ado, here are 4 principles I always apply when evaluating a company.

1) Earnings Record

A fundamentally sound company should have a stable or growing earnings record. If the company can show stable or growing earnings over the past few years, it is likely that the company’s product or service are well sought after and there is some form of economic moat around them.

The 2 most important components to determine the strength of their earnings are:

  1. Revenue
  2. Net Profit

** Revenue – (Cost of Sales + Expenses incurred) = Net Profit

Revenue reflects the amount of sales that the company have done for the products/services it provides. It is often referred to as the company’s top line. On the other hand, net profit shows the earnings after subtracting the costs involved in manufacturing the products or providing the service and the various expenses incurred. Net profit is often referred to as the company’s bottom line. Hence, when someone say a company has achieved top line growth, it is referring to increase in revenue and likewise for net profit.

aem 3q result.png

Companies with stable or growing revenue shows that their sales are increasing. Improving net profit also shows that the company have been able to manage their costs and preventing it from exceeding its revenue. Thus, these are good sign of a company that will be stable compared to a company with fluctuating revenues and net profit.

2) Low Debt

This goes without saying. Company that takes on huge debt are often at higher risk of failing. Imagine being chased by debtors for payment while trying to do business. Earnings will definitely be affected as earnings may have to be used to pay off debt. These are definitely not a good sign for a company. A classic example would be Noble Group which I shared before in [My Story] component.

Of course low debts are healthy as they aid a company to grow its business. So what’s a healthy amount of debt? I have 2 ways to evaluate if a company have over-leverage.

  1. Cash and Cash Equivalents > ST Debt + LT Debt
  2. Current Ratio > 1.5

This works in such a way that if both rules 1 & 2 don’t hold, you are probably looking at an over-leveraged company. The best case scenario would be that rule 1 holds which most of the time means rule 2 will hold.

3) Positive Cash Flow from Operations

Cash flow is important for a good company as some companies can have very strong earnings but those earnings may not be recognised in cash. If a company consistently register a negative cash flow from operations, it should set off some red flags. This is because most of the company’s debt and expenses are paid for in cash, if their earnings do not bring in cash this might be a problem in the future.

Take the case of Yuuzoo Corporation.

yuuzoo

Strong growth in revenue and net profit recorded. Indeed very impressive.

yuuzoo3

However, look at net cash from operating activities. It has been negative for 2 years. It is okay if the company at times record negative cash flow from operations as they may have use the money to pursue expansion etc. But if it has been happening for a few years, it is definitely not a good sign of things to come.

4) Insider Ownership

Insider ownership is often a good sign to tell whether the company’s management believes in the company. This will show whether the company’s management put their money where their mouth is. A good level of insider ownership should give you the confidence that the company is good because the interests of the management is at stake as well.

Hence events like management buying or selling their own company’s shares could be a pre-indicator of their outlook on the company.

shareholder-info-for-dutech

This is extracted from the annual report of Dutech Holdings. Dr Johnny Liu Jia Yan who is the Chairman and CEO owns about 42.76% of the shares. Hence this should reassure shareholders that he will act in the interest of the shareholders.

Bonus

If you can find a company that satisfies most of the above, at least 3 out of 4 and you realise that the company are buying back their own shares (share buyback) or the management have been buying more shares of the company. (Insider ownership) This could mean that something big is brewing within the company and it is likely an excellent opportunity to invest in the company.

Some of you may ask how should I go about finding these information regarding the company I am investing. Firstly you should always check out the investor relations segment in their website which should contain information regarding the company. Alternatively, you can head to SGX website to find them. You can find out about every companies announcement with regards to their financials, insider transactions, annual reports etc here.

In conclusion,

these are 4 principles that I look for in a fundamentally sound company. It may not be fool-proof as many factors can affect a company. But these principles should allow you to sieve out the better companies in the entire stock market which should provide a relatively safe and lower risk investment should you decide to enter the stock market directly.

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4 thoughts on “[Building Blocks]: 4 principles of a fundamentally sound company

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