Learn · The long-term investor's guide
How to assess a stock and a mutual fund
Everything we check before owning a business or a fund for the long run, in one place: what to look at, where to find it, what good looks like, and the red flags that deserve a second look.
The numbers below are common rules of thumb, not laws. Use them to decide what to read more carefully, never as a buy or sell signal on their own.
Part 1
Assessing a stock
A share is a small piece of a business. So the questions are the ones you would ask before buying a whole business: what does it do, does it earn good returns, does the profit turn into cash, can it survive bad years, and can you trust the people running it? Price comes last.
1Understand the business
- What does it sell, and who pays? If you can't explain it in two sentences, you can't judge whether it is doing well.
- Why do customers choose it? A brand, lower costs, a licence, a network, or customers who find it hard to switch. This is the "moat" that protects profits from competition.
- What could hurt it? Regulation, technology, a few large customers, raw material prices, or government contracts.
- Is the industry growing, or is the company fighting for share in a shrinking market?
Where to look: the annual report's business overview and management discussion, investor presentations and earnings-call transcripts on the company's website.
2Check growth over 5 to 10 years
Look at revenue, operating profit and net profit over at least five years, not one quarter. Ask whether growth came from selling more, charging more, or buying other companies. Steady growth that roughly keeps pace with or beats the economy is better than one spectacular year.
3Measure the quality of profits
- Operating margin: operating profit as a share of revenue. Stable or rising margins suggest pricing power.
- ROCE (return on capital employed): operating profit divided by equity plus debt. It shows how well the business uses all the money tied up in it. Sustained ROCE above 15% is a sign of a real advantage.
- ROE (return on equity): net profit divided by shareholders' money. Read it beside ROCE: if ROE is far higher than ROCE, debt is doing the work.
4Follow the cash
- Cash conversion: cash from operations divided by net profit. Over five years it should be close to 100%. Profits that never turn into cash are the most common early warning.
- Free cash flow: operating cash minus capital spending. A business that always needs more money than it makes depends on lenders or new shareholders.
- Working capital: watch receivable days (how long customers take to pay) and inventory days. If either rises much faster than sales, ask why.
Read our guide to annual reports for a worked example of profits rising while cash falls.
5Test the balance sheet
- Debt to equity: borrowings divided by shareholders' money. Below 0.5 is comfortable for most non-financial companies. Debt is the usual reason good businesses fail in bad years.
- Interest coverage: operating profit divided by interest cost. Below 2× leaves little room if profits dip.
- Contingent liabilities: disputed taxes, guarantees and legal claims sit in the notes, not on the balance sheet. Compare them with the company's net worth.
- Equity dilution: a share count that keeps rising means your slice keeps shrinking.
6Judge the people: promoters and governance
- Promoter holding and its trend: found in the quarterly shareholding pattern on BSE and NSE. Steady selling without explanation deserves a question.
- Promoter pledge: the share of the promoters' stake given as security for loans, also in the shareholding pattern. If prices fall, lenders can sell pledged shares, which can force prices down further. Any pledge needs a reason; a large or rising pledge is a serious warning.
- Related-party transactions: loans, sales or purchases with firms owned by the promoters, listed in the notes to accounts. Large or unexplained ones can quietly move value away from minority shareholders.
- Auditor: an unmodified opinion is normal. Qualifications, repeated "emphasis of matter", or an auditor resigning mid-term all need explaining.
- Capital allocation: what management did with past profits. Sensible reinvestment, debt repayment and dividends are good signs; expensive acquisitions outside the core business are not.
- Honesty over time: read three to five years of chairman's letters. Do they own their mistakes? Did they deliver what they promised?
7Only then, look at price
- P/E: price divided by earnings per share. Compare it with the company's own history and its peers, not with the whole market.
- P/B: most useful for banks and asset-heavy businesses.
- Earnings yield: earnings divided by price (the inverse of P/E). Compare it with the 10-year government bond yield; shares should offer more over time to justify their risk.
- Margin of safety: the gap between your estimate of value and the price. Use our calculators and test a pessimistic case.
- Watch for cycles: a low P/E in a cyclical business at peak profits can be a trap, not a bargain.
8Write down your reason
In three lines, write why you own it and what would make you sell, such as falling ROCE, rising debt, or a governance problem. Not "the price fell". Review it once a year against the annual report.
What good looks like at a glance
| What to check | Comfortable | Look closer | Red flag |
|---|---|---|---|
| Revenue growth, 5 years | Steady, around 10% a year or more | Lumpy, or 5–10% a year | Shrinking, or one boom year |
| Operating margin | Stable or rising | Swings with input costs | Falling year after year |
| ROCE | 15% or more, most years | 10–15% | Below 10%, or below its cost of borrowing |
| ROE | 15% or more with low debt | High only because of debt | Below 10% |
| Cash conversion (cash from operations ÷ net profit, 5 years) | 80% or more | 60–80% | Below 60% |
| Debt to equity (non-financial companies) | Below 0.5 | 0.5–1 | Above 1, or rising fast |
| Interest coverage (operating profit ÷ interest) | More than 5× | 2–5× | Below 2× |
| Receivable days | Stable | Rising slowly | Rising much faster than sales |
| Promoter holding | Stable or rising | Small sales, explained | Steady selling, no reason given |
| Promoter pledge (share of promoter stake pledged) | None | Up to about 10%, with a clear reason | Above 20%, or rising |
| Related-party transactions | Small and explained | Material but disclosed | Large loans to promoter firms |
| Auditor’s opinion | Unmodified | Emphasis of matter | Qualified, or auditor resigned mid-term |
| P/E against its own 10-year history | Near or below its usual range | Somewhat above | Far above while growth slows |
Banks and NBFCs are different: debt is their raw material. For them, look at asset quality (gross and net NPAs), net interest margin, the share of low-cost deposits (CASA), capital adequacy and return on assets (above about 1% is healthy).
Where to find most of these numbers: the company's annual reports and quarterly results, exchange filings on BSE and NSE (shareholding pattern, pledges, announcements) and credit rating reports. Free screening websites summarise them, but check anything important against the annual report.
Part 2
Assessing a mutual fund
With a fund, you are hiring a manager and a set of rules. The questions are: does this fund do the job you need, what does it cost, has it done that job consistently, and is it still doing what it says on the label?
1Start with your goal, not the fund
Decide when you need the money and how much fall you can sit through. Money needed within three years generally doesn't belong in equity funds. Then decide your mix of equity, debt and gold. The fund comes after.
2Choose the category
SEBI defines each category so names mean the same thing across fund houses. The main equity ones:
| Category | Rule (minimum share of assets) | Good for |
|---|---|---|
| Large cap | 80% in the 100 largest companies | A steady core; often matched by low-cost index funds |
| Flexi cap | 65% in equity, any company size | One fund that spreads across sizes |
| Multi cap | 25% each in large, mid and small companies | Fixed exposure to all three sizes |
| Large and mid cap | 35% each in large and mid companies | Core plus some growth |
| Mid cap | 65% in companies ranked 101–250 | Long horizons and patience with swings |
| Small cap | 65% in companies ranked 251 and below | Small portions of a long-term portfolio |
| ELSS | 80% in equity, 3-year lock-in | Tax-saving under the old tax regime |
| Index fund or ETF | Copies an index | Low-cost core holdings |
| Sectoral or thematic | 80% in one sector or theme | Rarely needed; easy to buy at the wrong time |
Rules as set in SEBI's categorisation framework. Check the latest SEBI circular and the scheme information document for exact limits.
3Decide: index or active?
In large caps, most active funds have trailed their benchmark over long periods after costs, so a low-cost index fund is a sensible default. In mid and small caps, and in flexi cap, a good manager has more room to add value, and more room to get it wrong.
4Check every cost
- Direct plan, always: the regular plan pays commission from your returns every year. Our cost calculator shows what that adds up to.
- Expense ratio: on the fund's factsheet. It changes, so check it yearly.
- Exit load: a fee for selling within a set period, usually one year.
- Taxes: gains are taxed differently by fund type and holding period. Check the current rules before you sell.
5Judge performance the fair way
- Use rolling returns, such as every 5-year window over 10 years, against the benchmark and the category. A single "5-year return" depends heavily on its start date.
- Look at the bad years: how far did the fund fall in 2020, and how fast did it recover? That is the experience you will have to sit through.
- Prefer consistency over a star year: a fund that is near the top most years usually beats one that tops the chart once.
- Risk measures on factsheets, such as standard deviation and Sharpe ratio, help compare funds within the same category.
6Look inside the portfolio
- Number of holdings and top-10 weight: how concentrated is it?
- Sector weights: is it quietly a bet on one or two sectors?
- Market-cap mix: for flexi-cap funds, how much is really in mid and small companies?
- Portfolio P/E and turnover: a hint of the manager's style and trading costs.
- Overlap: compare holdings with your other funds. Three funds owning the same companies is one fund paid for three times.
7Check the manager and the fund house
Who runs the money, for how long, and with what process? A great record built by a manager who has just left belongs to someone else. Very large small-cap funds can also find it harder to buy and sell without moving prices.
8For debt funds, ask different questions
- Credit quality: how much is in government securities and AAA-rated paper?
- Duration: funds with longer duration swing more when interest rates move. Match it to when you need the money.
- Yield to maturity: an unusually high yield usually means more credit risk, not free money.
What good looks like at a glance
| What to check | Comfortable | Look closer | Red flag |
|---|---|---|---|
| Expense ratio, direct plan | Active equity below 1%; index fund below 0.3% | 1–1.5% | Above 1.5%, or you hold the regular plan by default |
| 5-year rolling returns vs benchmark | Ahead in most periods | Ahead about half the time | Behind in most periods |
| Behaviour in falls | Falls less than its benchmark | Falls about the same | Falls clearly more |
| Fund manager | Same manager and process for 5+ years | 2–5 years | Recent change, or frequent changes |
| Portfolio turnover | Below about 50% a year | 50–100% | Well above 100%: heavy trading |
| Overlap with your other funds | Below 30% | 30–50% | Above 50%: you own the same thing twice |
| Style consistency | Holds what its category and documents say | Some drift | Holdings no longer match the label |
How many funds do you need? For most people, three to five equity funds is plenty. More usually adds overlap, not safety. Where to find the numbers: the fund's monthly factsheet and scheme documents, AMFI's website, and the fund house's portfolio disclosures.
Part 3
Habits that matter more than any number
- Decide your asset allocation before a fall, not during one. See how every past fall played out.
- Keep an emergency fund so you are never forced to sell at a bad time.
- Review once a year, with the annual report or factsheet, not with the daily news.
- Sell for a reason you wrote down, such as a business that has changed or a fund that no longer does its job, not because the price moved.
- Keep costs low and keep it simple. Fewer, better holdings are easier to understand and to stick with.
Understand what you own. Pay little to own it. Then give it time.
Next steps: get the free 20-minute annual report checklist, look up any term in the glossary, or join our four-week course to practise all of this with real annual reports.
For educational purposes only. This guide explains general methods and common rules of thumb. It is not investment advice, research, or a recommendation to buy, sell or hold any security or fund. Thresholds vary by industry and situation. Investments in securities are subject to market risks; read all related documents carefully. Zeneqt is not registered with SEBI as a Research Analyst or Investment Adviser.