Ask 'why' before you buy: understanding businesses

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So, say you’ve performed a thorough analysis of the industries you’re interested in. You’ve examined the reports and statistics, analysed the demand and supply and studied the life cycle of the industry you wish to invest in. Turns out that it was a good choice. 

What’s next, then? How do you continue with your stock market research or share market research? How do you perform company stock analysis to know which company to invest in? For this, you need to understand the business of the companies in that industry. And you need to ask yourself “why” before you buy the stocks of a company. In other words, a little bit of company analysis is needed, so you can find a good company to put your money on. 

Why is it important to understand a business before investing in it?

The answer to this question is pretty simple. It’s because you’re investing your hard-earned money in a company. And also because you cannot hope to create wealth in the long-term without understanding a business. After all, you wouldn’t want to invest your money in a company that does not give a satisfactory return on investment now, would you? 

So, to figure out if a company is the right investment choice for you, you’ll have to first understand its business. And what better way to do that than to do a comprehensive company analysis?     

What are the steps involved in understanding a business?

Let’s delve a little deeper into how you can carry on with your stock market research to analyse a company and understand its business better.

Start by identifying the company

Just like with industry analysis, you’ll first need to start off by identifying the company and the industry that it operates in. Once you’ve chosen a company, you’ll need to get to know it better to perform a company stock analysis

For instance, let’s say that you wish to invest in Hindustan Unilever Limited (HUL). You know that the company manufactures fast-moving consumer goods (FMCG) and that it operates in the household and personal products industry. Apart from this, say you know nothing else about Hindustan Unilever. 

So, how else do you go about getting more information about the company? One of the easiest and most reliable ways to do this is to visit the ‘About’ section of the company’s own website and read about its history and its profile. This way, you not only get a glimpse of the company’s history, operations and its present situation, but also a brief peek into the FMCG industry itself.  

Find out about the products and/or services on offer 

Once you’re acquainted with the company, the next step is to identify the products and/or services that it offers. Again, you can find more details about what the company offers on its own website. 

Take the same example we discussed earlier. In addition to getting to know the products that Hindustan Unilever sells, you can also get a host of information about the various sub-brands that it owns. Here’s a fun fact for you. Hindustan Unilever manufactures almost all the products in the FMCG space and owns major brands such as Vaseline, AXE, Lakme, Elle 18 and more.    

And while you’re at it, it’s a good idea to also analyse the nature of the products being offered, their supply and demand dynamics and the brand awareness and value that they carry. This would help give you some much-needed perspective on where the company stands with respect to other FMCG manufacturers.   

Figure out the risks associated with the company 

Irrespective of how big a company is and how much of a market share it commands, it always carries a certain degree of risk. These risks are capable of impacting the way the company performs. They also have the potential to bring down the company’s profits. Understanding these risks can help you stay ahead of the curve in the case of a negative eventuality.

Let’s take up Hindustan Unilever once again. The risk of losing out its consumer base is arguably the one of the major risks associated with the company. The possibility of its competitors offering either better or more affordable alternatives is another risk that HUL faces. As an investor, you need to factor in risks like these before investing in a company.  

Review the financial statements of the company

This is possibly the most important step when it comes to understanding a business. The financial statements give you a much better idea of the company’s profitability, its various streams of revenue and the different expenses incurred by a company. 

In fact, financial statements are so useful that you can get a very clear perspective of a company’s performance by simply comparing its financials with those of the other players in the industry. We’ll take a closer look and learn more about financial statements in the upcoming lessons in this module. 

The two ways to analyse a company

So, you now know the basic steps involved in understanding a business. It’s time to look at the two distinct approaches that you can take for analysing a company - the top-down approach and the bottom-up approach.

Top-down approach

In this approach, you start from the macroeconomic factors such as the prevailing economic and governmental policies, inflation, the state of the economy and global conditions. Once you’re done analysing these factors, you slowly work your way down to the individual company. This approach puts more emphasis on the market factors than the factors closer to the company. 

Bottom-up approach 

The bottom up approach focuses more on the individual company and microeconomic factors such as the entity’s financial statements and product portfolio. Once you carry out an in-depth analysis of the company, you then move up to the macroeconomic factors as mentioned in the previous point. Here, the focus is more on the company than the market.    

Wrapping up

With business analysis done, your next stop on the journey of company stock analysis and share market research involves the analysis of financial statements and reports. Companies regularly file reports and documents with regulatory bodies like SEBI and the Ministry of Corporate Affairs. In addition to this, stockbrokers and other third-party experts also prepare their own reports that help with your analysis. We’re going to get into all of these details in the coming chapters.

A quick recap

  • Company analysis begins by identifying the company and the industry that it operates in.
  • The next step is to identify the products and/or services that the company offers.
  • Understanding the risks that a company faces can help you stay ahead of the curve in the case of a negative eventuality.
  • Reviewing the financial statements of the company is possibly the most important step when it comes to understanding a business. 
  • There are two ways to analyse a company: the top-down approach and the bottom-up approach.
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