Investing in the stock market is a bucket list task for most and is often regarded as the key to financial freedom, when done right. Unfortunately, many people jump into investing with no real knowledge of evaluating companies or the business models underneath. This, combined with the herd mentality that typically plagues the market, is the perfect recipe for disaster. It is therefore essential to understand the basics before considering investing in stocks, even those recommended by seasoned brokers/investors. That said, investing can be made much safer if every investor were equipped with enough knowledge to separate the wheat from the chaff.
Benjamin Graham, legendary investor and the founding father of Value Investing defined investing as an operation, which upon thorough analysis, promises safety of principal and adequate return.
While thorough analysis is both time consuming and demanding in terms of financial knowledge, there are a few basic, critical parameters which can help understand if the company in question is worth investing in.
1. Return On Equity (RoE): Equity is the pool of money that was put up by the promoters and shareholders for starting the business combined with the subsequent profits it generates via its operations.
When you buy a share in a company, you own a part of its equity. Therefore, the amount of profit a company is generating for a given year divided by the total equity is an important number because it highlights how efficiently the management is utilizing the money it has.
So,
RoE= Net Profit/ Equity
An RoE of 20% or more is often regarded as a company with some sort of competitive advantage over the others.
2. Debt to Equity: Debt is the amount of money a company owes it’s lenders. There can be both short and long term debt. The Debt to Equity ratio is exactly as the name suggests:
Debt to Equity= Total Debt/ Equity
If this number is above one and increasing over time, it is a definite red flag and such a company is better avoided.
Debt can destroy even the best businesses overnight. The case of Bear Sterns in ’08 is an effective example. Just months before the crisis it was trading at it’s lifetime high of $172.
3. Shareholding Pattern: No one knows a company better than its own promoters. When promoters buy shares of their own company (Share Buyback) the market perceives it as promoter confidence which is usually a good sign. Always check for Foreign Institutional Investors who have invested in the company. They have tremendous researching capability and the market usually follows their footsteps.
If promoter holding has been falling consistently one must dig deeper. In the Satyam Scam, how the promoters offloaded shares leading up to the scam is worth looking into.
4. Valuation: This is single handedly the most misunderstood notion in the market! There is always a fair price to buy a good company. The price to earnings ratio (PE ratio) is a
quick way to judge valuation.
Price to Earnings Ratio= Current Market Price/ Earnings per share of company
The PE ratio in itself isn’t very useful. However, when compared against the industry average, it can give some insight into whether the share price is over or under valued. Good companies usually trade at a premium over the others. HDFC Bank is usually found to be trading at a premium over its competitors. There is no hard and fast rule to evaluate valuation. It is more an art than an exact science.
While these basic parameters can help in eliminate bad choices and identify potentially good investments, there are many more numbers to be crunched!
The best source for all information about a company are its financial statements (which are
available in their annual report) comprising of the Balance Sheet, Income Statement and the
Cash Flow Statement.
To underscore the importance of reading financial statements, legendary investor Warren Buffett once quipped, “Some men read Playboy, I read Annual Reports”!
It is also crucial to understand the underlying business model and the impact of macroeconomic effects on the business. This combined with sound knowledge of evaluating annual reports can then yield significant returns in the investing world.
PS: For more rigorous analysis of Stocks, there are websites like www.screener.in, moneycontrol.com and bseindia.com.
Happy Investing!
– Bhaskar