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.com
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