We have often seen many people losing money in the stock markets.Those people then slowly refrain from investing in the stock market.When you ask them about investing in the stock market they will discourage you from investing in the stock markets saying that its is a gambling den and people should invest in safe avenues like Bank FD’s. But with inflation being high fixed income instruments hardly provide you cushion and will slowly erode your savings. Therefore it is imperative that people invest a part of the money in equity instruments. Investors should know the basics of investing before they enter the stock market directly.In case they lack the required skills they are better off investing through the mutual fund route.In this article we give you criteria’s for stock selection which will help you to zero in on the right stock for your long term gains.
The best way to pick winning stocks is to evaluate companies financial parameters before zeroing on the right stock. Many investors who are new to stock markets simply look at share price, its 52 week high & low and the PE multiple to invest which never really works in the stock market. An investor must always look at the size of the opportunity, industry growth rates and compare the same with the company’s standing in the industry apart from its management credibility and track record. Here we discuss some of the key parameters to zero in on stocks that can strike riches for you.
Criteria for Stock Selection.
Promoter Track record
A good track record will always give investors the confidence to invest in the company.But companies with such track record always trade at steep premium and does not return superlative returns. So investors look up to to buy stock in an unknown company. It is best to look up the accounts for about 5 years and also read the company’s annual report and most importantly the management discussion and analysis. One should also do a Google search on the company and its promoters to see if they have ever been involved in shady or dubious deals.
Cash flow is the amount of money coming in or going out of the business in a given period of time, say, one financial year. Cash Flows helps to determine how much liquidity the company has. If a company is “cash flow positive”, it means that it is generating more cash from the business than it is paying out. This is a positive sign because it means the company has bargaining power. It is selling to its customers and receiving payment early while it is buying from the suppliers and paying them late.
If a company is “cash flow negative”, it is a dangerous sign because it means that the company has no liquidity and is desperately dependent on its suppliers and creditors.
EBITDA stands for “Earnings before interest, taxes, depreciation and amortization”. EBITDA tells the investor, the profit that the company is making from its operations. If the EBITDA is negative, then it is a very negative sign because it means that the company is losing money in its core profitability.
The EBITDA margin is computed as a percentage of sales and EBITDA. For instance, in a company had sales of Rs. 100 and an EBITDA of Rs. 12, its EBITDA margin would be 12%. The higher the margin, the better it is.
EPS (Earning Per Share) = Net Profit / Number of Outstanding Shares
There are variants such as the “Diluted EPS” which means that even the shares that will be issued in the future pursuant to outstanding warrants or bonds are also considered.
“Cash EPS” is worked out by taking the operating cash profits (without reducing non-cash expenditure such as depreciation).
The Price-Earnings (PE) Ratio is a valuation ratio of the company’s current share price compared to its earnings per share (EPS). In other words, how of a multiple of the EPS is one paying to buy the stock.
This criteria helps to identify, how cheap or expensive a stock is compared to its peers.
The PE is usually calculated on the EPS of the previous 12 months (the “trailing twelve months” (TTM).
The PE ratio can be used to benchmark companies within the same Industry or sector. For example, if one is comparing two PSU banks, if one has a PE of 5 and the other has a PE of 8, the question is why one is paying a premium for the second one and whether there is a valuation aberration somewhere that an investor can take advantage of.
Return on Equity (ROE)
ROE or Return on Equity indicates how efficiently the management is able to get a return from the shareholders’ equity. ROE is calculated with the following formula:
Net Income / Shareholders’ Equity
Example: Suppose a company earned Rs. 2,000 in profit and the total equity capital is Rs. 4000. The ROE is 2000/4000 = 50%.
Suppose another company in the same sector/ industry earned a ROE of 30%. You know which company uses its capital efficiently.
A variation of the same concept is the Return on Net Worth of RONW in which we take in not only the equity capital but also the reserves.
Debt Equity Ratio
Debt Equity Ratio is the proportion of debt to equity used to run the company’s operations. It is calculated using the following formula:
Total liabilities / equity share capital + reserves
When examining the health of your business, it’s critical to take a long, hard look at company’s debt-to-equity ratio. If Debt Equity ratios are increasing, meaning there’s more debt in relation to equity, Company is being financed by creditors rather than by internal positive cash flow, which may be a dangerous trend.
The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as capital goods, power generation, auto manufacturing tend to have a debt/equity ratio above 2, while IT companies / Consumer Goods companies with high brand equity have a debt/equity of under 0.5.
=CMP * total number of shares
It is the value which you pay for the entire company to be bought in the stock market. It is derived by multiplying the total number of equity shares by the market price of each share.
‘Dividend Yield’ is a financial ratio that shows how much the company pays out in dividends each year relative to its share price. It is calculated by using the following formula:
=Interim dividends + Annual Dividends in the year/CMP x 100
If you find that company is paying consistent dividend year after year with dividend yield of above 8%, you can think to invest in such stocks instead of blocking your money in fixed deposits. Here, you can think of capital appreciation in stock price along with 8% returns on yearly basis through dividend payment.
Investors should check whether the company has a dividend policy and the dividend payout ratio which will help them to determine whether the dividend is sustainable.
No ratio individually should be used to make investments in the stock market. The above criteria’s can help you to invest reasonable safely if you follow proper risk management and asset allocation strategies which will help you to strike rich from the stock market.