Monday, August 29, 2011

Four Point Scheme to identify profitable stocks

We have developed a ladder with nine points, which helps investors to identify stocks with a solid financial situation and which can continue to improve further. The profitability, leverage, liquidity and operational efficiency of companies are examined using their annual reports and basic financial items that are easy to find and apply. A stock must achieve a score of 4 out of 4 to pass the scrutiny and analysis of profitability.

We will give 4 points to profitability:
(1) one for a positive return on investment,
(2) one for a positive cash flow,
(3) one for an improved investment performance over the previous year,
(4) and if a cash flow provided by operating activities exceeded net income.
These simple tests are also easy to measure. Since the requirements are minimal, do not worry for the sector, the market or for comparisons related to the timing.

Return on investment (ROI) is calculated on the ‘income before extraordinary items’ related to the analysis of the fiscal year prior to analysis, divided by total assets at the beginning of the fiscal year. The ROI analyzes the performance generated by the assets of the company. A high output indicates that the activities are productive and well managed. We do not seek high levels, only positive data. Although the selection might not seem very restrictive, we have observed that more than 40% of the shares with low price / equity had recorded a loss in the two previous fiscal years. A positive income is a significant event for these companies.

One point if a company has a positive operating cash flow. The positive cash flow is shown in the statement of cash flow and measures the ability of a company to generate cash flow from day to day operations when providing goods and services to its customers. Consider factors such as liquidity coming from the from the collection of credit, the cash used to produce any goods and services, payments made ​​to suppliers, labor costs, taxes and interest payments. A positive cash flow from operations currents implies that a company has been able to generate sufficient cash flow from continuing operations without the need for additional funds.

Another variable taken into account by us is the ‘increasing profitability’. We will give one point if the return on investment for the current year is higher than the previous year.

Finally we will examine the relationship between profits and cash flow. A very strong point, if the current cash from operations exceeds net income before extraordinary items this is an exceptional case. This parameter seeks to avoid companies that do accounting maneuvers to increase profits in the short run, which could weaken the long-term profitability.

We will also add the latter criterion for stock selection. By what we have already done we have already screened the stocks from few thousands to few hundreds. What we mean to say is the these parameters are not sufficient and that further analysis.

ROA is an acronym for Return on Assets. Some stocks are perfectly analogous to the ROI, but consider banking and insurance companies, their ability to generate an income can be analyzed by using only ROA. Banking companies: ROA = Gross profit / Total assets. Insurance Company: ROA = Profit before extraordinary items / Total assets.
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