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In the stock market, you will find multiple stock recommendations from multiple sources. Before investing in any stock, you may want to judge the quality of the stock, however, you may get overwhelmed with the data and fiscal metrics. Starting from balance sheet ratios to valuation, there are hundreds of parameters. Which one to consider first? What should you prioritize? Many investors start with profit growth numbers as that is the most easily available and highlighted figure in the financial statement. You will make a big mistake if you begin with profit growth and put too much focus on it. Any company can easily manipulate profit numbers. Furthers a big profit does not ensure real cash flow. A company may report one million profit with negative cash flow in the books. Moreover, profitable growth might be fuelled by external debt. In short. Profit growth does not ensure the quality of any business. Take a look at the once famous, 100+ year old tour operator COX and Kings. Until 2018, the company reported good profit growth. IN fact, their consolidated profit growth rate stood at 153% in the financial year ending March 2018. However, the stock price crashed from 270 level in January 2018 to only August 2019, resulting in loss of 95%+. It was later proved that the profit figures were manipulated. There are hundred of examples of stock price crashing 70-90% within years, despite good profit growth.
The next thing that many investors follow is the sales number. There is another problem. Sales growth does not ensure shareholders’ profit. You cannot be sure how much of sales is translating into cash and where those sales are adding margin. Most importantly, sales number can also be manipulated. Suppose you own a restaurant and every day you are serving many customers, which would translate into massive sales. However, at the end of the day, how much cash your retain matters the most. It is possible that your competitor is earning much more money with lower sales but focusing o cost optimization. It is very easy to undemand proprietary small businesses where there is a single of income and fixed types expenses. But the companies that re 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 might have several subsidiaries. All of these results in a complex financial statement. Since businesses can report various incomes and expenditures from different sources, it is easy to inflate or deflate numbers. Moreover, big accounting firms prepare their balance sheet. Therefore, it is much harder to interpret numbers of those companies. Many large enterprises alter profit numbers as they know amateur investors will first focus on the profit growth. In most of the financial results, you will find profit and sales growth number are higher excusably. So, it is obvious that companies will do their best to keep those profits and sales growth at the best possible level to avoid any unnecessary volatility into the stock price. Steady stock price movement help promoters n seamless fundraising. So, promoters would never desire sudden fluctuating in profit and sales numbers which is why investors should not give priority to these metrics.
If we give the least priority on profit and sales growth numbers then what will be our priority? The answer is, return on equity (ROE). As a shareholder, you need to follow how prompters are unitizing shareholders’ money. Are they creating value for their shareholders or themselves?
