Question

What are the qualitative factors you should consider as an analyst when evaluating a company's likely future financial performance? Why? What would be your decision for a company with very satisfactory financial performance but on the other hand not having well reputation in market? (I need 500 words and more details)

Answer 1

Qualitative Factors in Valuation are the different factors in the valuation of the business or the investment which are not possible to quantify directly but are equally important as the quantitative factors and includes the factors such as quality of management, competitive advantage, corporate governance, etc.

Valuations are done using quantitative data (like Income Statement, Balance sheet, Cash Flows, etc.) from the Annual Reports. Think about preparing a Financial Model of a company and applying valuation tools like DCF, Relative Valuation tools like PE ratio, EV/EBITDA, etc., to value the company. However, there are other “not-so-tangible” factors that also impact the valuation of the business.

Qualitative factors are the factors in business valuation that are almost impossible to quantify for business. Or we can say that these are the factors in business valuation that can’t be directly quantified. But they are equally, if not more important than quantitative factors in valuation. And at the same time, no company can ignore these less tangible factors because they really matter in valuing a company.

Numbers are not the only thing that matters when you think about evaluating a business. There are other factors as well that may skip your mind as an investor.

Here is the list of top 10 qualitative factors –

#1 – Company’s Core Business

As an investor, your first concern should be – “How a business makes money?” Yes, according to a recent definition of business, money-making may not be the sole ingredient of a good business. But as an investor, you should invest in a stock which will make you money. That’s why it is essential to peep through their revenue model and find out whether it will really work in the long run.

For example, if you look at the business model of KFC, we will see that they sell delicious chicken burgers, chicken roasts, many varieties of mouth-licking chicken and veg recipes, and their business model is straightforward to follow. As an investor, you know that this is how KFC makes money.

Similarly, before ever spending a penny on any stock, know the business model of a company. Do your own due diligence. Find out its history, revenue generation model, how it got started, how long they are in the market, what is the revenue and profit margin they have been maintaining as of now. And then go for business valuation.

As seen in the below Facebook business overview, it provides us information on how the revenue is generated. Facebook generates all of its revenue from selling advertisement placements to marketers.

#2 – Quality of Management

The second factor is the quality of management in the company. If the management is motivated enough to steer the company toward its summit, the company would be a gigantic force, and it would always find a way even amid the most significant economic turndowns.

So before you invest in a company, having a check on the management quality is of utmost importance. Having the most significant business model will not serve unless the management quality of the company is at par.

So what would you do?

Every company, nowadays, has a website where they mention their “teams.” Go through the page, find out who are the promoters of the company, filter out their background on different levels, and find out what experiences they have in a similar industry.

#3 – Customers and Geographic exposure

There are two basic things you need to check out if you want to penetrate the actual picture of the company.

First, you need to find out about the customers of the company. Does the company have a few big customers or many small customers? Does the company serve only businesses or end customers as well? Do their focus revolve around a niche market, or do they cover all segments of customers? To understand a company, getting answers to the above questions is essential. Because then you will understand where the company stands as per the customers’ mind-map.

Second, you need to find out the geographical exposure of the company. Does the company only operate in certain territories? If yes, why? Do the company cover only urban or rural areas? What is their sales-break-down as per each territory? Where they sell more, and why? Asking yourself these questions and searching for answers will help you know the company well and make wiser choices at the end of the day.

In its Form 10K, Facebook has provided us with Geographical information. We note that the United States is the major contributor to Facebook’s revenue. The rest of the world share is seeing a rapid rise and thereby diversifying geographical risk.

#4 – Competitive Advantage

Before you ever evaluate a company in quantitative terms and judge the company based on figures, you need to find out what’s the competitive advantage of the company. Competitive advantage is a term coined by Michael Porter. He says there are few factors that are important for a company to have, to be called a competitive advantage –

• The competitive advantage of a company is a unique ability that can’t be emulated by other companies easily.
• Competitive advantage helps the company to produce more profits, more revenue, efficient systems, and processes.
• Competitive advantage helps all the activities of the company get aligned with the organizational strategy.
• Competitive advantage helps a company receive benefits usually for five-to-ten years.

For example, if a company sells online, its logistics can be its competitive advantage, which can help them reach their customers super fast and deliver goods and products faster than their competitors.

As an investor, you need to think through the competitive advantage or lack of it before investing in it because competitive advantage or lack of it is their sole ingredient of producing astounding or mediocre results!

#5 – Corporate Governance

In simple terms, corporate governance is the holy grail of a sustainable business. If the corporate governance of a business is not in order, the whole business will crumble sooner or later. So, checking out the corporate governance of a company is of utmost importance as an investor.

You need to see three things –

• Are the rules of the company aligned with the company’s mission and vision?
• Are the company serving each and every stakeholder well?
• Are they legally compliant with the government’s policies?

If the answer to the above three questions is “yes,” usually, the company is pretty good at corporate governance.

#6 – Industry Growth Trends

Doing your own due diligence doesn’t end at the company level. You need to find out which sector the company is in and then see the industry under the researcher’s light. You should gather the data for the last ten years and then use different tools to see whether you seem to find any pattern or trend or not.

In this case, quantitative factors may help you get an idea about the qualitative factors. Look at different trends, analyses, experts’ forecasts, and suggestions. But make sure that you decide on the basis of your own thinking and your knowledge of the data. Don’t put the industry on a higher rung because an expert says so.

Once you know the trends, you will have definite ideas about predicting future trends of the company.

#7 – Competitive analysis

Many investors skip this.

But if you want to know the right value of a company, look at their competitors and do an analysis.

Look at their strengths and compare them with the company you want to invest in. Look at their weaknesses and see how the company you have targeted is doing in those areas.

Doing competitive analysis will not only help you the position of a company, but it will also help you discover similar companies to invest in in the near future.

The industrial analyses can’t be done by taking competition into account. The only comparison with similar companies can give you an overview of how a company is doing in the same industry.

Facebook is in competition with lots of players, including Google, Snapchat, etc.

#8 – Disruptive technologies

Technologies can shape or break a company.

Look for disruptive technologies that have shaped the industry altogether. And then see whether the company you are evaluating using those technologies or not.

In this age of continuous advancement of technologies, only disruptive ones make ruckus of the industry. And before you ever invest in any company, look for the technological state of the industry first.

One disruptive technology for Facebook is Oculus. Oculus virtual reality technology and content platform power products allow people to enter a completely immersive and interactive environment to play games, consume content, and connect with others.

#9 – Market share

The company doesn’t need to have a significant share in the market, especially when it has been in the market just for some time. But what we need to look at as investors are whether it has the potential to grow or not.

You can use BCG Matrix or any other strategic tool to find out where this company belongs to and then evaluate it on the basis of that.

As an investor, it is essential to know that the company can grow in the near future. If a company has reached its saturation point and there is limited or no growth (rather a downward slope along the way), investing in it wouldn’t be a great idea.

#10 – Regulations

No company can be free of regulations. And when you attempt to evaluate a business, you need to see the regulatory factors as well.

For example, in the pharmaceutical industries, the FDA (Food and Drug Administration) has direct regulations. According to FDA, before any drug comes into the market, it has to go through a series of clinical trials before they reach the end customers.

However, not all industries have the same regulatory constraints. So, as an evaluator, you need to see whether the company is following all the regulatory practices or not.