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One of most common question people ask me often is how to select stocks for a long term portfolio. Before we answer this, let's just reflect on what owning a stock means:
In summary, when you buy a particular stock, you are basically buying a share in the profitability of the company
Let me elaborate a bit so as to make things more clear. Let's assume a company named xyz issues 100 shares and you get to buy 10 shares out of it. So you basically own 10% of xyz stocks which in turn means you are entitled to receive 10% of the profit the company makes till you hold the shares. Generally speaking, you get your share of profit through the dividends the companies pay (or the price appreciation if they don't pay dividends). Hope you got the essence of it and without going into details further, lets return to the original question, which is how to identify nice to have stocks. With an innate desire to be a partner in profit of good companies, I will be focusing on three commonsense parameters to judge the company:
- How much company sells i.e. the market share of the company (indicated by revenue)
- How much revenue turns to net profit (indicated by net profit margin)
- How expensive or cheap the company shares have been historically (indicated by PE ratio)
Let me be clear that these three parameters in no way guarantee return on investment, however they will surely help in identifying stocks which you should avoid for your long term portfolio. As the expectations are set now, let's move ahead with the analysis. We all agree that buying shares is equivalent to getting a part of profit, hence companies with up trending profitability history naturally qualify for the next level of scrutiny. Now, how to find out stocks having long term profitability history? To answer this, we will have to start with the fundamental source of profits, which is revenue or sales of a company and then map it with the net profit figures. Here are two charts that depict the latest yearly revenue and net profit distribution of listed companies - winners on the right and losers on the left.
Oopssss..the data is overwhelming. But before I tell you how to narrow down your analysis, here is a fun fact. Just look at the revenue distribution of the companies in the table below. Roughly speaking 95% of the companies have revenue in the range of 0 to 5000 Crores and approximately 50% have revenue less that 100 Crores.
Also look at the total revenue figure. It's pretty interesting to note that:
Top few companies (last two row of table) roughly generate more revenue then 95% of the companies combined (top 2 rows of the table)
I will leave it to you to study the net profit data above, but roughly speaking the inference seems to be the same as that of revenue distribution. What is the implication of this observation? This clearly signifies that these top 5% companies position in the market is so dominant that “there is a de facto entry barrier for new entrants in their respective sectors". It is very difficult to compete with companies which have the highest market share for their products or services. Just spend some time on the data in the table above to appreciate how shallow or deep Indian Financial Market is in terms of revenue and profit generation in different pockets.
Now to zoom in on the Revenue and profit plots above and shrink your analysis basket, you can use the following buttons to plot revenues/net profit of the companies in above ranges. This is the right time to eyeball top revenue and net profit grosser of different sectors and jot down some names for second level analysis. Why I am saying so? Hear this:
The only sure shot way a company continues to grow its profit is by increasing its revenues and market share
We are basically hunting for dominant players both in terms of revenue and profit. Remember the old saying - Grasses do not grow under big trees. In ruthlessly competitive world, big players will do their every bit to ward off smaller players and new entrants.
Annual Revenue and Net Profit Data of Companies
Having identified the revenue and profit leaders, it's right time to add an additional dimension to our analysis. Hope you have already guessed it by now that I want to search for industry or sectoral leaders on revenue and profit front. Revenue or for that matter net profit as a standalone figure does not offer much in terms of decision making. So we need something to compare it with and for that let's plot sectoral revenue and profit figures of your choice (use the drop down below to choose sector or industry) and check who has the biggest revenue and profit share in that particular sector or industry.
Sector or Industry wise Revenue & Net Profit
So far so good, as now we have initial list of companies who have the largest market share in their respective industries. However, we still need to analyse how much of this revenue turns to actual profit as that is what will trickle down to our bank accounts in the form of dividends. Net profit is what remains after subtracting companies total expenses from total revenue and to get a hang of how much revenue the company is able to turn to actual profit, we will have to look at the net profit margin of the company.
The net profit margin is net profit divided by total revenue, expressed as a percentage.
Net profit margin is one of the most closely watched numbers as it clearly differentiates the companies who are achieving far more impressive results with the assets and resources they possess. Analysts and investors look at the net profit margin closely as it directly correlates to the stock price. Stocks with increasing or consistent net profit margin numbers YoY enjoys premium over their peers. Conversely, if a company is not generating healthy net profits, or if there is a lot of variation in net profit margin, the same will be reflected in decreasing share price over time.
Investors should always look for increasing or consistent net profit margin YoY, while choosing companies for long term investment.
This is pure common sense and following this one rule only will help you avoid most of your stock market losses. If you are still reading, then you must be hungry for more. So here is the option to plot the revenue, operating profit, net profit and net profit margin figure of the company who you think should be a part of your portfolio.
Company Revenue, Operating Profit, Net Profit and Net Profit Margin Chart
Time to buy the stock for your portfolio as you found some worthy names? Hold on for a bit as I don't want you to pay unnecessarily high price for your choice. Before you hit the buy button, an understanding of how cheap or expensive the particular scrip is would definitely help in building a long term portfolio with same return potential at relatively cheaper cost. No prizes for guessing that I want you to have a look at PE ratio of the company on standalone basis and relative to its peers.
Where to go from here?
Disclaimer* - The data on this page comes from what we have in our database and is not complete plus there might be inaccuracy in the numbers shown in the tables and charts above. So use this data for analysis purpose only and do not treat it as any recommendation to invest. Also do a second level check for data accuracy from direct sources like company annual and quarterly results before acting on the data.