Spend, Save and Invest Smartly
Which is the best time to buy stock…..??? Don’t you have this question in mind…??? The answer is very simple today or this moment is the right time to buy the stock. If you have a look at stock market graph of last 5 to 10 years, you can see that the trend is upward, there can be downfalls in between but over a period of time the share price will increase. This is the common logic of investing but there are some other factors to be considered such as why do we invest in stock? How to invest in stocks? Which stocks to buy? etc.
Most people do not do the required analysis before making their investment decision. They generally follow the traditional principle i.e. follow the crowd and buy what others are buying. This is the biggest mistake you can ever make while investing your hard earned money. Studies have proved that retail investors generally invest when market is already pretty high or over-valued. They feel that since the market is touching new heights this is the right time to buy, think for a moment while doing this. If something is valued the most, will it touch the new heights….? Answer is a BIG NO…!!! Don’t be mistaken that only normal and non-finance guys make such mistakes. Even highly trained school business graduates end up doing the same thing! Successful investment is both an art and science. One needs to do the required technical (financial analysis) of the stock before buying or selling it. When to buy or sell probably is an art that comes with age and experience. In this article we have tried to help you understand the things you need to keep in mind while doing your research and number crunching. Remember there is no short cut to the 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
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.
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.
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.
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. I 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.
We do not want to go into the calculation part as values for P/E are available on internet for most of the companies. What I want you to do is fill up the following table for every stock.
|Stocks||P/E (1)||Growth Rate (2)||PEG (1/2)|
Calculate average value for P/E and PEG values. Compare the PEG values of stock X with its peers Y and Z. Also, compare X with the average value to find out whether it is over-valued or under-valued with reference to the industry average. A PEG of less than 1 makes an excellent buy if the company is fundamentally strong. If it is above 2, it is a MUST SELL. If PEG for all the stocks are not very different, one with lowest P/E value would be a great BUY.
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
• Other current assets
• Equity Share capital
• Total debt
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.
If the company has made some investments out of its free cash, it is recorded under it.
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.
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%. This is because they have high debt level which means higher interest payments. In the current liquidity crisis and global slowdown, it would be extremely difficult for them to survive. Remember, a weak balance sheet makes a company vulnerable to bankruptcy!
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 you stock(s) perform on the above analysis.
Remember there is no short cut to investments in equity market. It is a place where you can make millions while loose all your money in a single day. You should think how hard it is to earn money at the end of the day. We hope you do not want to loose your savings in the market due to your laziness or lack of homework. So, we would request you to do some basic groundwork before investing in stocks. our model will just help you in doing so.