Below are the 6 Important Steps to Explore Best
Stocks for Investment
Step-1: Find out how the company makes money
Step-2: Do a Sector Analysis of the Company
Step-3: Examine the recent & historical performance of
the Stock
Step-4: Perform competitive analysis of the firm with its
Competitors
Step-5: Read and evaluate company’s Financial statements
Step-6: Buy or Sell
Step-1: Find out how the company makes money
Before you decide to invest in a company’s stock, find out how
the company makes money. This is probably the easiest of all the steps. Read
company’s annual and quarterly reports, newspapers and business magazines to
understand the various revenue streams of the firm. Stock price reflects the
firm’s ability to generate consistent or above expectation profits/earnings
from its ongoing/core operations. Any income from unrelated activities should
not affect the stock price. Investors will pay for its earnings from its core
operations, which is its strength and stable operation, and not from unrelated
activities. Thus, you need to find out which operations of the firm are
generating revenues and profits. If you do not know that you are bound to get a
hit in future.
Warren Buffet once said that “if you do not understand how a
company makes money, do not buy its stock- you will always end up loosing
money”. He never invested even a single penny in technology stocks and yet made
billions and billions of dollars both during tech bubble and bust.
Step-2: Do a Sector Analysis of the Company
First is to figure out which sector the stock is in. Then,
figure out what all factors affect the performance of the sector. For example,
Infosys is in IT services sector, NTPC is in Power sector and DLF is in Real
Estate sector. Half of what a stock does is totally dependent on its sector.
Simple rule-Good factors help stocks while bad factors hurt stocks.
Let’s take an example of airlines industry. The factors that
affect it are fuel prices, growth in air traffic and competition. If fuel
prices are high, tickets would be expensive and hence fewer people will fly.
This will hurt the airlines sectors and firms equally. This would make the
sector less attractive because there would be less scope for growth of the
firms.
The idea is to find out the good and bad factors for the
sectors and figure out how much they will affect the stock and how. What we are
really looking at are reasons that will make stock price good or bad or a
company look more or less valuable, even though nothing about the company changes.
This will give you a broader view whether the stocks will do well or poorly in
the future.
Step-3: Examine the recent & historical
performance of the Stock
By performance we mean both operational and financial
performance of the company. Take out some time to find out how the company has
done in its business over the years. Were there issues with its operations such
as labor strike, frequent breakdowns, higher attrition or lagging deadlines? If
any company has a history of serious problems, it does not make a good buy
because chances are high it may have similar problems again. History is a good
predictor of future! It is also extremely important to find out the historical
financial performance of the company – growth in revenues, profits (earnings), profit
margins, stock price movements etc.
Step-4: Perform competitive analysis of the firm
with its Competitors
This is most important step in analyzing a stock.
Unfortunately, most of the retail investors do not bother to do this. It takes
time to do this step but it worth trying if you don’t want to loose your money.
Many investors buy a stock because they have heard about the company or used
the products or think companies have excellent technologies. However, if you do
not evaluate or compare those features of the company with other similar firms,
how will you figure out whether the firm is utilizing them effectively or is
better/worse than others? We also need to find out whether company is growing
rapidly or slowly or has no growth. We would like to cover couple of
financial ratios here in brief and explain how to use them to figure out a good
stock.
P/E: Price-to-earnings ratio is the most widely used ratio
in stock valuation. It means how much investors are paying more for each unit
of income. It is calculated as Market Price of Stock / Earnings per share. A
stock with a high P/E ratio suggests that investors are expecting higher
earnings growth in the future compared to the overall market, as investors are
paying more for today's earnings in anticipation of future earnings growth.
Hence, as a generalization, stocks with this characteristic are considered to
be growth stocks. However, P/E alone may not tell you the whole story as you
see it varies from one company to another because of different growth rates.
Hence, another ratio, PEG (P/E divided by Earnings Growth rate) gives a better
comparative understanding of the stock.
PEG = Stocks P/E / Growth Rate
We do not want to go into the calculation part as values for
P/E are available on internet for most of the companies.
A PEG of less than 1 makes an excellent buy if the company
is fundamentally strong. If it is above 2, it is a sell. If PEG for all the
stocks are not very different, one with lowest P/E value would be a great BUY.
Step-5: Read and evaluate company’s Financial
statements
This is the most difficult part of this process. It is
generally used by sophisticated finance professionals, mostly fund managers who
can understand different financial statements. However, there are few things
that even you should keep in mind. There are three different financial
statement- balance sheet, income statement and cash flow statement. You should
focus only on balance sheet and cash flow statement.
Balance Sheet: It summarizes a company’s assets, liabilities
(debt) and shareholders’ equity at a specific point in time. A typical Indian
firm’s balance sheet has following line items:
• Gross block
• Capital work in progress
• Investments
• Inventory
• Other current assets
• Equity Share capital
• Reserves
• Total debt
Gross block: Gross block is the sum total
of all assets of the company valued at their cost of acquisition. This is
inclusive of the depreciation that is to be charged on each asset.
Net block is the gross block less accumulated depreciation
on assets. Net block is actually what the asset is worth to the company.
Capital work in progress: Capital work in
progress sometimes at the end of the financial year, there is some construction
or installation going on in the company, which is not complete, such
installation is recorded in the books as capital work in progress because it is
asset for the business.
Investments: If the company has made some
investments out of its free cash, it is recorded under it.
Inventory: Inventory is the stock
of goods that a company has at any point of time.
Receivables include the debtors of the company, i.e., it
includes all those accounts which are to give money back to the company.
Other current assets: Other current
assets include all the assets, which can be converted into cash within a very
short period of time like cash in bank etc.
Equity Share capital: Equity Share
capital is the owner\'s equity. It is the most permanent source of finance for
the company.
Reserves: Reserves include the free
reserves of the company which are built out of the genuine profits of the
company. Together they are known as net worth of the company.
Total debt: Total debt includes the long
term and the short debt of the company. Long term is for a longer duration,
usually for a period more than 3 years like debentures. Short term debt is for
a lesser duration, usually for less than a year like bank finance for working
capital.
One need to ask-How much debt does the company have? How
much debt does it have the current year? Find out debt to equity ratio. If this
ratio is greater than 2, the company has a high risk of default on the interest
payments. Also, find out whether the firm is generating enough cash to pay for
its working capital or debt. If total liabilities are greater than total
assets, sell the stock as the firm is heading for disaster. This debt to equity
ratio is extremely important for a company to survive in bad economy. What is
happening now-a-days should make this extremely important. Companies having
higher debt ratio have got hammered in the stock market. Look at real estate
companies- their stocks are down by almost 90% from all time highs made in 2007
- 2008. This is because they have high debt level which means higher interest
payments. In case of liquidity crisis and global slowdown, it would be
extremely difficult for such companies to survive. Remember, a weak balance
sheet makes a company vulnerable to bankruptcy!
Step-6: Buy or Sell
Follow all the steps from 1 to 5 religiously. It will take
time but worth doing it. If you do it, you won’t have to see a situation where
you loose more than 50% of stock value in a week! Buying or selling will depend
on how your stock(s) perform on the above analysis.
Happy Investing
Source;Saralgyan
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