Where to start?
Suppose your friend advised you to invest in ABC Limited or an equity expert is recommending a particular stock. Before investing, you are eager to judge some basic parameters. However, you are confused. Starting from balance sheet ratios to valuation ratios, there are hundreds of such parameters. Which one to consider first? What should be the priority order? Many investors start with profit growth numbers. You will commit a big mistake if you begin with profit growth and put too much focus on it. Any company can easily manipulate profit numbers. Further big profit doesn't ensure real cash flow. A company may report one crore profit with negative cash flow in books. Moreover, anyone can report a big profit by utilizing huge external debt. In short profit growth doesn't ensure the quality of any business. The next thing that many investors follow is the sales number. Here is another problem. Sales growth can't ensure shareholders value creation. You are not sure how much sale is really translating into cash, whether those sales are adding margin or not. Most importantly. numbers can also inflate. Suppose you own a restaurant business and every day you are getting huge customers that translate into massive sales. However at the end of the day how much cash you retain matter the most. It is possible that your competitor is earning much more money with lower sales by focusing on cost optimization. It is very easy to understand proprietary business where there is a single owner, the only source of income and fixed types of expenses. But the companies that are listed on the stock market have complex revenue and expense structure. There are many sources of revenues, expenses on various heads and above all they have many subsidiaries. It results in the complex financial statement. As they can report various incomes and expenditures from different sources, so it is easy to inflate or deflate numbers. Moreover big accounting firms prepare their balance sheet. This is why it is much harder to interpret numbers of those companies. In case of a small business with the single owner and only source of income, it is much easier to conclude financial health of that business. However, it is entirely different for stocks that are listed in the stock market.
Due to the above-mentioned reason, investors should not put priority on profit and sales numbers. More or less many big companies alter profit numbers as they know amateur investors will first focus on profit growth. After releasing the financial result, you will find profit and sales growth numbers are highlighted the most) So, it is obvious that companies will do their best to keep those profit and sales growth at a best possible level to avoid any unnecessary volatility on the stock price. Steady stock price helps promoters for fundraising. So, promoters never wan sudden fluctuation in profit and sales numbers.
Now, here is the big question. If we should put the least priority on profit and sales growth numbers then what will be our priority? The answer is Return on Equity. As a shareholder, you need to follow how promoters are utilizing your invested amount. Are they creating value for their shareholder or for themselves? Let's have a look at the details of Return on Equity in our next Blog.