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Thursday, December 17, 2009

How to distinguish between a good company and a great company

If you are going to become a better investor you will not only need to distinguish between a good company from the not so good, but more importantly, learn to distinguish the merely good from the truly great company.

After all, it is your hard earned money. Why squander it on the not so good or a merely good company when you can let your money work for a truly great company?

So, how do you go about finding the truly great companies? In a mini-series on how to find out the financial health of a company, I had explained why I prefer to check the financial health prior to checking the profitability.

One of the major reasons is that profit figures are 'doctored' in a large number of companies. Cutting costs instead of increasing sales, calculating depreciation by different methods, valuing inventory differently, making inadequate provisions for taxes or debt or R&D expenses, using 'other income' or a one-off adjustment are some of the ways by which companies show 'profits'. And these are 'legal' methods!

Checking out the cash flow from operations and the other financial health ratios separates the good company from the not so good. But the cash flow from operations or the net profit margin does not provide any information about how much money is being used in the operations of the company.

We have to find out how much real profit a company is able to generate from the money it invests in the business. Almost all companies - whether listed or otherwise - borrow money from others (banks, financiers, relatives, friends, shareholders) and use that money to run its operations and generate a profit.

So the true differentiator between the great company and the merely good is how efficiently it can generate a higher profit relative to the amount invested in the business (also referred to as the 'capital employed').

In another mini series of forthcoming posts, I will discuss about financial efficiency and profitability ratios.

Related Post

What does the Interest Coverage Ratio signify?


VJ said...

Some of the Great Companies in my opinion:
1. Blue Star Limited
2. Voltas
3. HDFC / HDFC Bank
4. Thermax
5. Page Industries
6. Hawkins
7. Voltamp Transformers
8. Nestle
9. Asian Paints
10. Shree Cement

Mitran said...

Nice series which can help all investors. If you give for each factors with example, it would be better understanding and never losting.

Ruy said...

I would like to add to what VJ said:
1. Bharat Bijlee
2. Divi's Laboratories
3. NIIT Technologies
4. Colgate Palmolive
5. Navneet Publications

Subhankar, if you can spare some on TA of Navneet and share it with us, it would be helpful..

The Visitor said...

Thermax is on my list too...

Subhankar, what's your take? Do you have any fundamental analysis on this scrip?

Subhankar said...

@VJ: That's a list of very good companies. Are they truly great? Let's find out after I discuss the profitability ratios.

@Mitran: I will try to provide practical examples of the ratios.

@Ruy: Another list of very good companies. We'll see if they cut it on the ratio analysis.

Don't track Navneet. I used to work with a publications group and am not greatly enamoured by the ability of the sector to scale up.

@TV: Used to track Thermax, but don't follow it any longer.

Will take a look at both Navneet and Thermax.