A few benchmarks for stocks - A
quick and easy measuring stick.
These are a few
benchmarks that can help you decide if you should spend more time on a stock or
not. They are easily available and can be of great use in screening good
stocks.
Revenues/Sales growth.
Revenues are how much the company has sold over a given period. Sales are the
direct performance indicators for companies. The rate of growth of sales over
the previous years indicates the forward momentum of the company, which will
have a positive impact on the stock's valuation.
Bottom line growth
The bottom-line is the net profit of a company. The growth in net profit
indicates the attractiveness of the stock. The expected growth rate might
differ from industry to industry. For instance, the IT sector's growth in
bottom-line could be as high as 65-70% from the previous years whereas for the
old economy stocks the range could be anywhere in range of 10- 15%.
ROI - Return on Investment
ROI in layman terms is the return on capital invested in business i.e. if you
invest Rs 1 crore in men, machines, land and material to generate 25 lakhs of
net profit , then the ROI is 25%. Again the expected ROI by market analysts
could differ form industry to industry. For the software industry it could be
as high as 35-40%, whereas for a capital intensive industry it could be just
10-15%.
Volume
Many investors look at the volume of shares traded on a day in comparison with
the average daily volume. The investor gets an insight of how active the stock
was on a certain day as compared with previous days. When major news are
announced, a stock can trade tens of times its average daily volume.
Volume is also an indicator of the liquidity in a stock. Highly liquid stocks
can be traded in large batches with low transaction costs. Illiquid stocks
trade infrequently and large sales often cause the price to rise/fall
dramatically. Illiquid stocks tend to carry large spreads i.e. the difference
between the buying price and the selling price. Volume is a key way to measure
supply and demand, and is often the primary indicator of a new price trend.
When a stock moves up in price on unusually high volumes it could indicate that
big institutional investors are accumulating the stock. When a stock moves down
in price on unusually heavy volume, major selling could be the reason.
Market Capitalization.
This is the current market value of the company's shares. Market value is the
total number of shares multiplied by the current price of each share. This
would indicate the sheer size of the company, it's stocks' liquidity etc.
Company management
The quality of the top management is the most important of all resources that a
company has access to. An investor has to make a careful assessment of the
competence of the company management as evidenced by the dynamism and vision.
Finally, the results are the single most important barometer of the company's
management. If the company's board includes certain directors who are well
known for their efficiency, honesty and integrity and are associated with other
companies of proven excellence, an investor can consider it as favourable.
Among the directors the MD (Managing Director) is the most important person. It
is essential to know whether the MD is a person of proven competence.
PSR (Price-to-Sales Ratio)
This is the number you want below 3, and preferably below 1. This measures a
company's stock price against the sales per share. Studies have shown that a
PSR above 3 almost guarantees a loss while those below 1 give you a much better
chance of success.
Return on Equity
Supposedly Warren Buffet's favorite number, this measures how much your
investment is actually earning. Around 20% is considered good.
Debt-to-Equity Ratio
This measures how much debt a company has compared to the equity. The
debt-to-equity ratio is arrived by dividing the total debt of the company with
the equity capital. You're looking for a very low number here, not necessarily
zero, but less than .5. If you see it at 1, then the company is still okay. A
D/E ratio of more than 2 or greater is risky. It means that the company has a
high interest burden, which will eventually affect the bottom-line. Not all
debt is bad if used prudently. If interest payments are using only a small
portion of the company's revenues, then the company is better off by employing
debt pushing growth. Also note capital intensive industries build on a higher
Debt/Equity ratio, hence this tool is not a right parameter in such cases.
Beta
The Beta factor measures how volatile a stock is when compared with an index.
The higher the beta, the more volatile the stock is. (A negative beta means
that the stock moves inversely to the market so when the index rises the stock
goes down and vice versa).
Earnings Per Share (EPS)
This ratio determines what the company is earning for every share. For many
investors, earnings is the most important tool. EPS is calculated by dividing
the earnings (net profit) by the total number of equity shares. Thus, if AB ltd
has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an
EPS of Rs 2. EPS Rating factors the long-term and short-term earnings growth of
a company as compared with other firms in the segment. Take the last two
quarters of earnings-per-share increase and combine that with the
three-to-five-year earnings growth rate. Then compare this number for a company
to all other companies in your watch list within each sector and rate the
results on how it outperforms all other companies in your watch list in terms
of earnings growth. Its advisable to invest in stocks that rank in the top 20%
of companies in your watch list. This is based on the assumption that your
portfolio of stocks in the "Watch List" have been selected by using some basic
screening tools so as to include the best of the stocks as perceived and
authenticated by the screening tools that you had used.
Price / Earnings Ratio (P/E).
Read about this most important investor tool in the next part of this module.
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The P/E ratio as
a guide to investment decisions
Earnings per share
alone mean absolutely nothing. In order to get a sense of how expensive or
cheap a stock is, you have to look at earnings relative to the stock price and
hence employ the P/E ratio. The P/E ratio takes the stock price and divides it
by the last four quarters' worth of earnings. If AB ltd is currently trading at
Rs. 20 a share with Rs. 4 of earnings per share (EPS), it would have a P/E of
5. Big increase in earnings is an important factor for share value
appreciation. When a stock's P-E ratio is high, the majority of investors
consider it as pricey or overvalued. Stocks with low P-E's are typically
considered a good value. However, studies done and past market experience have
proved that the higher the P/E, the better the stock.
A Company that currently earns Re 1 per share and expects its earnings to grow
at 20% p.a will sell at some multiple of its future earnings. Assuming that
earnings will be Rs 2.50 (i.e Re 1 compounded at 20% p.a for 5 years). Also
assume that the normal P/E ratio is 15. Then the stock selling at a normal P/E
ratio of 15 times of the expected earnings of Rs 2.50 could sell for Rs 37.50
(i.e rs 2.5*15) or 37.5 times of this years earnings.
Thus if a company expects its earnings to grow by 20% per year in the future,
investors will be willing to pay now for those shares an amount based on those
future earnings. In this buying frenzy, the investors would bid the price up
until a share sells at a very high P/E ratio relative to its present earnings.
First, one can obtain some idea of a reasonable price to pay for the
stock by comparing its present P/E to its past levels of P/E ratio. One can
learn what is a high and what is a low P/E for the individual company. One can
compare the P/E ratio of the company with that of the market giving a relative
measure. One can also use the average P/E ratio over time to help judge the
reasonableness of the present levels of prices. All this suggests that as an
investor one has to attempt to purchase a stock close to what is judged as a
reasonable P/E ratio based on the comparisons made. One must also realize that
we must pay a higher price for a quality company with quality management and
attractive earnings potential.
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Fundamental
Analysis
Fundamental Analysis is
a conservative and non-speculative approach based on the "Fundamentals". A
fundamentalist is not swept by what is happening in Dalal street as he looks at
a three dimensional analysis.
The Economy
The Industry
The Company
All the above three dimensions will have to be weighed together and not in
exclusion of each other. In this section we would give you a brief glimpse of
each of these factors for an easy digestion
The Economy Analysis
In the table below are some economic indicators and their possible impact on
the stock market are given in a nut shell.
|
|
Economic
indicators
|
Impact
on the stock market
|
| 1.
|
GNP
-Growth
-Decline
|
-Favourable
-Unfavourable
|
| 2.
|
Price
Conditions - Stable
- Inflation
|
-Favourable
-Unfavourable
|
| 3.
|
Economy
- Boom
-
Recession
|
-Favourable
-Unfavourable
|
| 4.
|
Housing
Construction Activity
- Increase in activity
- Decrease in Activity
|
-Favourable
-Unfavourable
|
| 5.
|
Employment
- Increase
-
Decrease
|
-Favourable
-Unfavourable
|
| 6.
|
Accumulation
of Inventories
|
-
Favourable under inflation
- Unfavourable under deflation
|
| 7.
|
Personal
Disposable Income
- Increase
- Decrease
|
-Favourable
-Unfavourable
|
| 8.
|
Personal
Savings
|
-
Favourable under inflation
- Unfavourable under deflation
|
| 9.
|
Interest
Rates - low
- high
|
-Favourable
-Unfavourable
|
| 10.
|
Balance
of trade
- Positive
- Negative
|
-Favourable
-Unfavourable
|
| 11.
|
Strength
of the Rupee in Forex market
- Strong
- Weak
|
-Favourable
-Unfavourable
|
| 12.
|
Corporate
Taxation (Direct & Indirect
- Low
- High
|
-Favourable
-Unfavourable
|
The Industry Analysis
Every industry has to go through a life cycle with four distinct phases
i) Pioneering Stage
ii) Expansion (growth) Stage
iii) Stagnation (mature) Stage
iv) Decline Stage
These phases are dynamic for each industry. You as an investor is advised to
invest in an industry that is either in a pioneering stage or in its expansion
(growth) stage. Its advisable to quickly get out of industries which are in the
stagnation stage prior to its lapse into the decline stage. The particular
phase or stage of an industry can be determined in terms of sales,
profitability and their growth rates amongst other factors.
The Company Analysis
There may be situations were the industry is very attractive but a few
companies within it might not be doing all that well; similarly there may be
one or two companies which may be doing exceedingly well while the rest of the
companies in the industry might be in doldrums. You as an investor will have to
consider both the financial and non-financial aspects so as to form a
qualitative impression about a company. Some of the factors are
History
of the company and line of business
Product
portfolio's strength
Market
Share
Top
Management
Intrinsic
Values like Patents and trademarks held
Foreign
Collaboration, its need and availability for future
Quality
of competition in the market, present and future
Future
business plans and projects
Tags -
Like Blue Chips, Market Cap - low, medium and big caps
Level
of trading of the company's listed scripts
EPS,
its growth and rating vis-à-vis other companies in the industry.
P/E
ratio
Growth
in sales, dividend and bottom line
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Value, Growth and Income
Growth, Value, Income
and GARP are one of the most rational ways of stock analysis. A brief on each
of them is given here for your understanding.
Growth Stocks
The task here is to buy stock in companies whose potential for growth in sales
and earnings is excellent. Companies growing faster than the rest of the stocks
in the market or faster than other stocks in the same industry are the target
i.e the Growth Stocks. These companies usually pay little or no dividends,
since they prefer to reinvest their profits in their business. Individuals who
invest in growth stocks should make up their portfolio with established,
well-managed companies that can be held onto for many, many years. Companies
like HLL, Nestle, Infosys, Wipro have demonstrated great growth over the years,
and are the cornerstones of many portfolios. Most investment clubs stick to
growth stocks, too.
Value Stocks
The task here is to look for stocks that have been overlooked by other
investors and that which may have a "hidden value." These companies may have
been beaten down in price because of some bad event, or may be in an industry
that's looked down upon by most investors. However, even a company that has
seen its stock price decline still has assets to its name-buildings, real
estate, inventories, subsidiaries, and so on. Many of these assets still have
value, yet that value may not be reflected in the stock's price. Value
investors look to buy stocks that are undervalued, and then hold those stocks
until the rest of the market (hopefully!) realizes the real value of the
company's assets. The value investors tend to purchase a company's stock
usually based on relationships between the current market price of the company
and certain business fundamentals. They like P/E ratio being below a certain
absolute limit; dividend yields above a certain absolute limit;
Total sales at a certain level relative to the company's market capitalization,
or market value. Templeton Mutual funds are one of the major practitioners of
this strategy.
Growth is often discussed in opposition to value, but sometimes the lines
between the two approaches become quite fuzzy in practice.
Income.
Stocks are widely purchased by people who expect the shares to increase
in value but there are still many people who buy stocks primarily because of
the stream of dividends they generate. Called income investors, these
individuals often entirely forego companies whose shares have the possibility
of capital appreciation for high-yielding dividend-paying companies in
slow-growth industries.
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Keep investing, panic not on your
existing stocks
Here's the best tip we
can give you if the volatility in the market has spooked you or if you had seen
a large profit wash away in the falling market: ignore your stocks right now
and keep your investing attention to something else.
Focus all your efforts and time on the company your stock represents. That's
because there are really two elements at work when investing: the stock, which
is part of the stock market, and the company, something the stock is supposed
to represent. But the company works in a different universe from the stock
market, involved more in the real world of profits and losses rather than the
emotional tide of fear and greed, the two major forces behind the stock market.
With the uncertainty prevailing in the market, fear is rampant and some of it
is justified, but there are lots of good companies that might be hammered by
that emotion. That's why you'll do better if you research your companies in
depth rather than trying to figure out if the morning sell off is the beginning
of the end or just a hick up on the road to true wealth. But let's say you've
done all your numbers, and everything looks great. You've checked for the
latest news and you still can't tell why your stock is down. Then you might
want to call the company directly and ask for the Investor Relations
department. Don't expect the investor relations person to tell you any secrets
or unpublished information but you can ask a few questions and get a better
feeling about the company:
1. Why is the stock down so dramatically? Are there rumors the company has
heard?
If so, what is the company's response to them.
2. Is there anything the company can say about the stock being down?
3. Are the officers of the firm buying or selling the stock?
4. Is the company buying its own shares right now?
You will hence get a sense of how the company is responding to its
stock being down, and maybe hear about news that has just been published but
you haven't read. Then, when you've done all you can to determine that the
company in which you've invested is indeed doing everything well, you can
ignore the stock and be assured that this too shall pass. If you determine that
the stock is down for a good reason and seems to be going lower, then you can
sell it and move on to another company. In either case, you can make a decision
based on the company and not the stock.
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Go for quality stocks and not
quantity
New investors often want
to make a quick buck (some old investors do, too). Sometimes you can do that if
you get lucky. But the really big money in investing is made from holding
quality stocks a long time. Many investors ask for information on cheap stocks.
The usual premise is that they don't have much money, and they want to own
thousands of shares of something, that way when it goes up, they'll make big
money. The problem is these stocks don't go up. They're a scam for the brokers,
and the spread between the bid and the ask on these stocks is enormous, making
it impossible to sell them at a profit.
Instead of trying to buy thousands of shares of a worthless stock for Rs 10000,
let's see what else you can do with it. These examples are all split adjusted
and show what that Rs. 10000 can do when you buy the right stocks.
If you had bought Infosys in 1991 for Rs share (split adjusted), you would own
n shares
Obviously it's easy to look back to find great stocks. And you had to hold onto
these volatile issues to reap these rewards. But the point is that quality
stocks are worth holding. In the above examples, the owners have paid no taxes
because there have not been any gains taken. The only commission paid was the
original one. And as long as the stocks continue to produce good earnings,
there's no reason to sell them. Again, it's easy to pick the good ones looking
back, going forward, which stocks are the best ones to own?
Do your research thoroughly. Build a portfolio of stocks, one stock at
a time, even with Rs 10000. Be sure to diversify over several industries over
time. And only buy the best, no matter how few shares that might be. Then be
patient, keep up with the news on the stock, and let the stock grow. That's the
way the big money is made.
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How many stocks should you own?
Buying a large number of
stocks is time-consuming and will distract you from focusing on the absolute
best stocks. Most investors simply cannot keep track of a large number of
stocks, so concentrate on just a few of the best. Use this simple guideline to
determine the number of stocks to own:
| Less than Rs.
20,000
|
1 or 2 stocks |
| Rs. 20,000 to
Rs. 50,000 |
2 or 3
stocks |
| Rs. 50,000 to
Rs. 2,00,000 |
3 to 5
stocks |
| Rs. 2,00,000
to Rs. 5,00,000 |
5 to 7
stocks |
| Rs. 5,00,000
or more |
7 to 10
stocks |
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Some more Stock tips
1. New products,
services or leadership. If a company has a dynamic new product or service, or
is capitalizing on new conditions in the economy, this can have a dramatic
impact on the price of a stock.
2. Leading stock in a leading industry group. Nearly 50% of a stock's price
action is a result of its industry group's performance. Focus on the top
industry groups, and within those groups select stocks with the best price
performance. Don't buy laggards just because they look cheaper.
3. High-rated institutional sponsorship. You want at least a few of the better
performing mutual funds owning the stock. They're the ones who will drive the
stock up on a sustained basis.
4. New Highs. Stocks that make new highs on increased volume tend to move
higher. Outstanding stocks usually form a price consolidation pattern, and then
go on to make their biggest gains when their price breaks above the pattern on
unusually high volume.
5. Positive market. You can buy the best stocks out there, but if the general
market is weak, most likely your stocks will be weak also. You need to study
our "The market talks. Listen, to spot the best." - Module 8 and learn how to
interpret shifts in the market's trend.
6. You should not buy on dips. This is a strategy that doesn't give you
a strong probability of making a profit. Remember a stock that has dipped 25%
needs to rise 33% to recover the loss and a stock that has dipped 50% needs to
double to get back to its old high.
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