Investing in equity has been perceived as a source of wealth maximization. However, identifying good stocks can be a difficult exercise. It is an art that one needs to develop overtime. This article covers the following:
Equity markets can seem puzzling and investing in multibagger stocks can put budding investors in a dilemma. Sometimes the market price of a stock might not reveal true picture about the company. It might be selling cheap either because of being undervalued or it could simply be worthless to buy it.
In other scenario, a stock might be selling at a high price because of over expectation from the investors is spit of having a skewed fundamentals. Hence, depending only on market price for stock selection might put you in trouble. Instead of being impulsive, you need to delve deeper to find out the real worth of the stock.
You should study the company fundamentals and analyse properly before finalising on stocks. It doesn’t matter whether you had a financial background or not. The only thing required is patience and an eye for detail. You can start your analysis by looking at the company’s financial statements. It is better to venture into sectors and markets which you know like back of your palm. It gives you a competitive edge over naive and uninformed investors.
Stock-picking is an art that you may require quite some time to develop. Here are a few things that you need to consider to select stocks which give you consistent returns:
While researching on a stock, the foremost factor to be considered is the Earnings per Share (EPS). It is important because it divides the net income of the firm based on the number of equity shares outstanding. In this way, you get to know the amount of profit which the company makes on each share. Ideally, good stocks are those whose EPS has grown over a said period of time say 5 years. On the contrary, inferior stocks are the ones which have a stagnant or gradually decreasing EPS.
Veteran equity investors understand that buying a stock is like owning a company and its business. So whatever business risks the company is facing, the investor’s portfolio will also carry the same when he buys the stocks.
Thus, while studying the company’s balance sheet, you need to ensure that it has a stable business model. A company having large revenue flows of say at least Rs 1000 crore in sales and a big customer base has a higher probability of survival in the long run. Automatically, it will have a relatively lower business risk as compared to it competitors.
Financial risk occurs from a lot of debt on the balance sheet. Basically, debt is an essential component in the growth of a company. It gives a leverage to the company and helps to increase return on capital employed. However, if the company gets into too much of a debt to the extent that it becomes unmanageable, it can backfire.
You may perceive it like a hole which might sink the ship if not plugged on time. While shortlisting stocks, look for companies which do not carry high debt and in turn less risky. You may use two ratios i.e. the debt-equity ratio and current ratio to identify over-leveraged companies. If the company has a debt-equity ratio of say more than 30%, then perceive it as a risky proposition.
While deciding to invest in a stock you need to ensure that the company is constantly creating value for its customers. It can be looked in such a way that it has a competitive advantage in its domain that the peers cannot achieve easily. Warren Buffet has popularised a term for this known as “Moat”. It was like a ditch filled with water situated outside a fort to prevent enemies from entering a king’s territory.
You should look for such unique selling propositions which the company has created for itself. It can be understood as a company which is able to earn more than its cost of capital. You may use Return on Equity (RoE) as an indicator of management’s performance. Go for companies which have a RoE of at least more than 15%.
There is one thumb rule that you should always follow in equity investments i.e. never lose money. It can be understood as never end up paying more than what you actually get in return. Additionally, you need to take steps to prevent the portfolio value from falling more than your target. You may use a ratio called Dividend Yield to get an answer for the above. A dividend refers to the part of profits shared by the company with its investors.
If you find that the dividend paid by the company is stable and increasing, then it shows that company is experiencing a good cash flow and a positive outlook for the future. A decreasing dividend, on the other hand, means the company wants to retain some cash to meet other expenses. Look for companies with a high dividend yield.
a. While looking for growth stocks, you might come across stocks which are selling cheap and others which are expensive. It is reflected in the Price-Earning ratio of the stock.A stock having a low P/E might seem an attractive proposition. But instead of jumping to a conclusion, try to find out reason for the low P/E. Probably it lacks growth potential in future. Conversely, stocks having a high P/E might not always be a bad opportunity.
b. The aggressively risk-seeking investors may try their hands in mid-cap stocks. These companies possess the capability to become a large-cap company in near future. Unlike large-cap stocks which might be facing saturation, mid-caps have immense unexplored growth potential.
c. Relying solely on quantitative data and financial ratios might be inadequate. Because these simply indicate past performance which may or may not be repeated in future. Go for a holistic analysis by incorporating qualitative aspects also.
While venturing into stocks, don’t blindly believe anyone else’s advice. Conduct a thorough analysis before buying any stock. Do not invest more than 10% in any single company. Many a time investing in equity becomes complex.
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