The Art Of Identifying Market Winners

When it comes to choosing the right stocks, Dr. Ruzbeh Bodhanwala and Dr. Shernaz Bodhanwala, faculty at FLAME University, Pune suggest that no single metric or ratio should be used to make an investment decision. There is no substitute for thorough fundamental analysis and one should understand the companies' risk profile before investing

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The Nifty is trading at a PE multiple of 22, which makes it reasonably valued considering the historical PE multiples at which it has traded earlier. Whenever the market is reasonably valued, it gives investors a good investment opportunity.

In this article, we discuss some of the characteristics of companies that have generated great wealth for shareholders as compared to other companies that have either been de-rated or not appreciated as much. We use the past 10 years of data to study the performances of the top 500 publicly listed companies.

For wealth creation, investors should look out for three metrics: return on capital, growth in sales and earnings, and reasonable valuation. The earning potential can be influenced by many factors such as changes in sales, changes in cost structure, tax efficiency, better capital allocation, etc. For an investor, the most important parameter which captures many business efficiency factors is the return on equity (ROE) or return on net worth (RONW), which is provided by many database providers. This is a standardised ratio that is calculated as net profit divided by the total shareholders' fund.

This ratio indicates the return generated by the company over the capital obtained from the shareholders and is one of the good indicators to quantify business performance. The shareholders' fund is defined as equity capital invested plus all reserves and surpluses of the company generated through its years of operations. The ROE can be used in comparing companies across various sectors. A change in ROE can be caused by a combination of any of the factors such as a change in the profit margins, capital turnover, financial cost ratio, financial structure ratio and change in tax structure.