An investor requires two things up his arsenal – one, the willingness to invest and shoulder some risk and second, the patience and mindset to do their homework. One cannot blindly expect to be a master at investing in the share markets and generate returns right from the get go. For most investors, the first most important question that arises in their minds is – how should you pick the right stock? How would you know what approach is best for you?
Let’s look at it qualitatively
1. The first parameter is to define your portfolio.
Determine what you require in accordance with your needs as an investor.It also depends on your risk profile, and the amount of time and money you’re willing to invest into it. Whether you are trying to find the best stock for intraday trading, or you prefer other styles like swing trading, position trading or long term investment – your pick of the stock comes down to your style and purpose of investment.
2. Everything boils down to the fundamentals.
A true investor does not place all his bets on just one source of information. Thoroughly examining all information about firms and reaching conclusions about the underlying value that the information implies is fundamental analysis and the investor who relies on fundamental analysis is a fundamental investor.
Do your research on a particular stock before you think about investing in it. Look at how the company is performing in the market. Do you hear positive information about it in the news? If it’s being talked about a lot over the news, then chances are market perception about it will change in reaction to positive or negative news, which could lead to changes in prices.
Compare the stock’s performance to that of its competitors and check for changes in management of the company or key financing details. One great tool you have for any company – is the balance sheet, which can give you a perfect idea of the company’s financials. Also, look out for how the company pays dividends to its shareholders. An investor might be tempted when any company offers huge dividends, but that is also something to look out for – a company might just be doing that to lure investors in and it might not be a reflection of its true earnings.
3. Make sure you remember to diversify!
You understand a business, let’s say IT – and you have a good knowledge about it. It does not mean though, that you should pick up stock all based in one sector alone. Create your portfolio across different industries and sectors, and that should make you manage risk better.
4. Do not let your emotions sway you.
Don’t buy stocks based on rumours or what everybody is doing. Emotion should not be the deciding factor while buying stocks. If you’ve done your research, then minute changes in stock prices should not lead you to make a panic decision.
5. Follow news and articles, but keep your eyes open.
There will be tons of people who advise you about trading – your relatives, friends and various stock analysis reports and news reporters. You have to filter out some of the unnecessary information and stick to the trusted sources.
6. Be prepared.
The story doesn’t end after you’ve simply picked the right stock. You need to be preparing for different scenarios as well. Creating a list of possible scenarios helps you mentally prepare for a number of different outcomes and work out in advance whether a possible future event would raise or lower a company’s share price.
The quantitative metrics matter too –
We talked about fundamental analysis a bit – which also involves looking into some of these metrics to understand the stock better.
1. P/E ratio ( Price-Earning ratio)
It determines how expensive a particular stock is. P/E ratio is simply, the actual price of a share divided by earnings per share. The one month P/E ratio for Nifty 50 is 21 – that is how much you pay for every rupee of profit.
This ratio determines whether a company is under or overvalued. If a stock has a high P/E ratio – it can mean that the stock is overpriced. Compare the company’s ratio to that of the industry, and you can get a good picture of where it stands.
On the flipside, if a company’s P/E ratio has been high continuously, then it doesn’t necessarily mean that it is overpriced. It can also mean that the company has been doing well over time and investors expect the earnings to increase. Another metric is the PEG ratio (Price to Earnings Growth Ratio), which measures price in relation to the earnings growth in the future. It can also be a good indicator to determine growth potential of a company.
2. Balance sheet figures
In a company’s financials, look at the revenues they are generating over a period of time. It gives a good idea about the operations of the company and whether it is sustainable. Look for trends in a company’s earnings growth. Over time, do the earnings generally increase? If so, it’s a pretty good indication that the company is doing something right. Look at the debt to equity ratio. If it is less than 1, it means the company is in a position to pay off its debts.
3. 52 week low/52 week high
If you’ve ever checked out stocks on different websites, this is one common indicator that you’ll find everywhere. A year comprises 52 weeks. So 52 week low is nothing but the lowest the price has fallen in a year, and 52 week high is the highest it has gone. A huge difference in these metrics tells us the volatility of a stock. It also gives us a metric to compare changes of the stock price with the 52 week high/low value.
4. ROE (Return on equity) and ROCE (Return on capital employed)
ROE is a value which gives a percentage return of a company’s net profit with respect to the equity. For example, if ROE is 10%, that means Rs.10 of profit is earned for every Rs. 100 of equity.
ROCE talks about how much income is being generated solely out of the capital employed in business. The capital employed is how many assets it has minus its current liabilities – telling us basically, how much value is deployed in the business. A company with high ROE and ROCE values signals great growth potential.
5. PBV (Price to book value)
Measures the current market price against the company’s book value. A ratio higher than 1 may indicate overvalued shares.
Right Stocks requires the Right Approach
Armed with all these metrics and analysis, any investor is in a good position to pick the right stocks and start investing. There may be other metrics as well which determine a firm’s success, but this basic knowledge should help you make the right decision.
But even with the right information, one should always proceed with caution, as the investing game is all about volatility, and uncertainty. By now you know that a low P/E ratio is generally better than a high P/E ratio, that a company with low debt is better and that recommendations or analyst’s reports should always be taken with a grain of salt. Other things that you should watch out for are the general price trends, economic conditions and new ventures or mergers that company is taking.
The world’s most famous investor, Warren Buffet’s advice is to always look for companies that have sustainable competitive advantage, because that is what makes or breaks any company. Look at Apple for example – it has been able to distinguish itself, has a strong brand name and considerable pricing power. If a company is better than its competitors, then it is certainly valuable.
If you still have difficult picking up stocks, then check out index funds or ETFs, and track the stocks those funds invest in. The top holdings will easily be available to you with a single search. Always remember, that “price is what you pay, but value is what you get.” For any stock, paying the price is the first step and only then can you expect greater values over time. Over time, investing also becomes simpler, and as we were told in school – never forget to do your homework!