SynopsisThese profit powerhouses have traversed a remarkable journey to reach at the top, but you should not invest in a company just because it has been generating huge profits.
Did you know that just 18 companies earned more than 50% of the total profits of listed companies in FY21 in India? That is right, the largest listed companies command a lion’s share of the profits’ pie of India Inc. How much does profitability of a company matter when it comes to picking a stock, especially as a long term investment?
“Undoubtedly, net profit is one of the most important factors to be studied while investing in any stock. Higher net profits lead to higher capital investment and act as a catalyst for business growth,” explained Nitin Shahi, Executive Director of Findoc, a financial services group.
So, are these the companies you should be investing in? Should you avoid the rest? Read on to find out.
Why net profit matters
Signal about efficient use of resource: No matter how good the business strategy is or how big the revenue generated is, at the end of the day what matters most to shareholders is the bottom-line a company generates. “By and large, net profit or net profit margin is the first and foremost crucial financial metric used by investors and analysts to evaluate the financial strength to generate income (profit) from its operations during a specific period of time. It shows how well a company utilises its assets, inputs and labour to provide value to shareholders,” said Rajiv Kapoor, vice president, Trustline Securities.
Indicator of consistency in performance: A company does not get into biggest profit generating club just because of sheer luck; it is due to a consistent, long-term track record of high growth. “Companies with the highest profit today are important because these companies generally enjoy market dominance in their sectors and also have sustainability and high quality management,” said Nitin Raheja, Executive Director, Head – Discretionary Equities, Julius Baer, a wealth management firm.
Better equipped to manage a difficult period, future challenges: Companies which have maximum share in the overall corporate profit also get an edge when it comes to managing uncertainties. “Due to the pandemic as well as other structural changes in the past 3-5 years such as demonetisation, GST, etc, there is a strong unorganised to organised play that is in display. Many of these big players post covid have consolidated their positions and have started garnering aggressive market share from smaller players,” said Tarun Birani, Founder & Director, TBNG Capital Advisors.
The large companies not only thrive in good times but also provide comfort in difficult times as they do better than the small companies who perish when the difficult times prolong, said Narendra Solanki, Head Fundamental Research- Anand Rathi Investment Services. “The large companies are able to reinvest in the business and can grow inorganically. They also have advantage of scale and geographic reach which is absent in small companies,” he added.
Past performance hints at future delivery: While these profit figures may not give an accurate estimation of future performance, however, one could use it for guidance. “Covid-19 has enabled larger players to grab more market share or even acquire other companies at great valuation amid other small and mid-cap companies are struggling with liquidity and operational issues on an ongoing basis,” said Kapoor.
So, can a company that generates consistent net profit deliver stellar equity returns?
Why historical net profit should not be the only factor
These profit powerhouses have traversed a remarkable journey to reach at the top, but you should not invest in a company just because it has been generating huge profits. Unless a stock has equally good or better future potential, it will not give the return which an equity investor would expect.
Here is why you should not solely depend on the net profit figure, and what the other numbers you should look at are.
Net profit number may be misleading: When you are refining your search among the big profit-making companies you need to be watchful of occasional spurts in profit. “Companies in cyclical industries, like commodities, could show a sudden spurt in profitability due to rise in commodity prices and hence investments in such companies should not be made based on net profits. Other factors like Return on Equity and leverage should be actively considered,” said Nimish Shah, CIO – Listed Investments, Waterfield Advisors.
Besides this, you have to also guard against any smart work with the numbers. “Managements achieve their varied objectives using various techniques to manipulate financial statements and conceal its inefficiencies and wrongdoing in income statement. On account of flaws in the income statement, investors started focusing on analysing cash flow statements to see whether the profits are being converted into net cash flow from operations to substantiate validity of earnings,” informed Kapoor.
Assessing quality of profit is critical: Other than net profit there are other profit metrics that tell us about the quality of the profit earned by the company. “It is equally important to consider the company’s gross profit and operating profit as they will help you know about the other core activities and expenses of the company,” said Hingar. Many experts also suggest scrutinising the cashflow of the company as well. “Cash flow/Ebitda is in our viewpoint a more important indicator which we use to evaluate a stock,” said Raheja.
“Apart from profit, management commentary and future prospects, year-on-year results, capital investment, government policies are some of the aspects which help in analysing the stock.”
— Nitin Shahi, Findoc
Why future potential matters the most: While profit numbers tell us about the company’s performance so far it is equally important to look into its future prospects. “The current value of the company is already priced into a stock. Apart from profit, management commentary and future prospects, year-on-year results, capital investment, government policies are some of the aspects which help in analysing the stock,” said Shahi.
There could be a scenario where the company may not be able to live up to the investors’ expectation and which can be evaluated only through greater scrutiny of its overall performance. “If the market has already priced in the net profit and the future growth in the present valuations, then the long-term performance of the stock might or might not sustain depending on deviations in future actual growth from the expected growth,” said Birani. “More than the net profit, the growth in that net profit is what contributes to long-term performance of a stock. So, yes, market always rewards a company with sustainable growth in net profit or earnings growth as it is called over the longer term,” he added.
How to ascertain the future potential: “Future potential can be gauged by factors such as the ability of the company and its management to keep its competitive edge by constantly innovating their products and processes. This ability builds the proverbial ‘Moat’ around the business that would keep competition at bay. Equally and increasingly important is a company’s commitment towards Environment, Social and Governance (ESG) factors and the vision that the management has to adhere to and improve compliance to these parameters,” explained Shah.
Going for deeper analysis of the financial statement could also throw some light on the long term financial health of the company. “You can also do an in-depth analysis of the company’s Financial Statements and Financial Ratios like P&L Account, Cash Flow Statement, Earnings Per Share (EPS), Price To Earnings (P/E) Ratio, Return On Equity (ROE), Price To Book (P/B) Ratio, Net Profit Margin and Debt-To-Equity Ratio,” suggested Hingar.
What should you do?
“Both large and small companies have their own advantages and disadvantages. So, a mix of both should be there in the portfolio depending upon risk return requirements,” said Solanki.
Large-cap stocks are known to be relatively safe investments and they are also known to deliver high return in the long term. The Sensex, which is a collection of 30 large-cap stocks, has delivered a CAGR of 16.2% in the last 20 years since November 13, 2001. So, when you are selecting large-cap stocks for your portfolio, this universe will give you more confidence about your stock selection.
“Some of these companies should be a part of the core portfolio of investors as they provide stability to the portfolio and guard it against volatility normally seen in mid-cap stocks,” said Raheja.
(Originally published on Nov 17, 2021, 09:30 AM IST)
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