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The Best Questions To Ask When Investing: Part 7

Over the past 10 years, I have probably read about a hundred books or so on investing. However, I have found it hard to retain much of the content in most of the books.

That’s because after I had gone through 10 books on investing, I realised that most investing books seem to be repeating the same concepts and ideas.

However, there is one book that is embedded in my mind like how a sticky chewing gum gets stuck to the sole of a shoe. This book is one of the first I ever read and the best investment I’ve made so far. It is Common Stocks and Uncommon Profits by Philip A. Fisher.

One of the most valuable insights I got from the book are the 15 questions that Fisher himself asked when analyzing a company. Till this day, I continue to ask the same questions about every investment I’m making. So far, the 15 questions have been very profitable for me. That is why I want to share the questions, along with my thoughts on them, in a series.

I’ve reviewed the first 12 questions in here (the first three), here (the next three), here (the seventh), here (the eighth and ninth), here (the 10th and 11th), and here (the 12th).

It’s now time to explore the next question.

Question 13: In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from the anticipated growth?

Even though a company can be growing rapidly or have great growth potential, it may not necessarily be a great investment for investors. Whether it would be a winning investment would also depend on how the company plans to fund its growth.

If a company funds its growth projects largely with debt, investors need to be aware of the increased liquidity and solvency risks the company faces. The recent wave of bankruptcies concerning Singapore-listed service providers to the oil and gas industry is a sharp reminder that a company’s use of debt to expand can be extremely dangerous for its investors.

But, if a company chooses to use equity to fund its expansion, then investors need to make sure that the benefit of the growth outweighs the dilutive effects.

For example, let’s assume a company, Company ABC, is currently earning S$10million and is valued at 10 times its trailing earnings. This gives the company a market capitalisation of S$100 million. Let’s then assume Investor A owns 10% of Company ABC, making her investment worth S$10 million.

If Company ABC goes out and raises another S$100 million in equity from other investors, this effectively dilutes the ownership stakes of its current investors by 50%. Investor A would thus own just 5% of Company ABC after the fund raising.

Let’s imagine now that it is five years later and Company ABC has managed to grow its profit to S$15 million. With a price-to-earnings (P/E) ratio of 10, Company ABC would thus have a market capitalisation of S$150 million, which is 50% higher than the S$100 million seen five years ago.

But, Investor A, who now owns just 5% of Company ABC after the dilutive equity raise, would have an investment that’s worth just S$7.5 million. That’s a 25% decline.

Notice how Investor A lost money even when the overall size of Company ABC increased. This is why we have to be careful in thinking about how a company intends to fund its growth. Sometimes, it might even be better for a company to slowdown its growth in order to protect its current shareholders.

Foolish Summary

Fisher’s 15 questions are essentially a checklist for us to think about when analysing a company.

The first six questions focus on a company’s future potential and how well a company can generate profits for its shareholders. The seventh question reminds us of the important idea that a company will only thrive if great people are working in it. Meanwhile, the eighth and ninth questions touch on the importance of the need to learn how to assess a company’s management.

Coming to the 10th and 11th, they help us find out if a company has a unique competitive advantage. Often, companies with strong competitive advantages can earn outsized profits in relation to their peers, or in relation to the value chain of the industries that they are in.

As for the 12th question, it reminds us of the importance of finding companies that have a long-range outlook to profit-making. Just because a company is reporting growing profits every quarter does not mean it is a great company to invest in. Sometimes, management may be boosting short-term profits through unsustainable means. Looking at how a company maintains its relationships with its suppliers and customers can give us insight on the mindset that it has.

The question featured above prompts us to think carefully about how a company intends to fund its growth. A growing company may not always become a growing investment even if its valuation is low.

Stay tuned as I explore the rest of Fisher’s questions soon!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.