In the financial world there is reward for every bit of risk taken while investing in the share market. The statement “Higher Risk, Higher Return” has quite often heard and seen. This statement remains true till the time an investor is taking his/her decisions rationally and after taking into consideration all the parameters of the stock market. If it is not being done, then it may happen that soon the risk will transform itself into the heavy losses and thus reward can turn into punishment.
Now to make the rational and logical decision certain parameters are provided such as analysing the Price-Earnings Ratio of the company, Price-Earnings to growth ratio, peer analysis etc. all these factors of investing comes into fundamental analysis of the company’s profits and growth in the future. Therefore, after understanding the necessity of the factors let’s understand them one by one and understand how they help in determining to buy best stock .
Revenue & PAT
Profit earning or revenue generating companies are always preferred by the investor. To invest in stock it is very important to know whether the company is generating profits or not and what are the future prospects of the company.
If the company is generating adequate profit then only it would be able to offer dividends and bonus to their investor and can expand and grow the business further. Investor would also provide the necessary fund to the companies only when the company will show the positive growth.
This analysis can be done by looking into the financial statements of the company. Balance Sheet and Profit and Loss account can give the required details to analyse the company’s performance. Few ratios that can be used under this analysis are EBITDA, Net Profit Ratio.
EBITDA ratio is earnings before interest, tax, depreciation and Amortisation. It is the profit of the company before incurring other expenses. Obviously, the company which is having higher ratio should be chosen for the investment. Net Profit is the factor which helps an investor to determine the company’s financial position i.e. profit after meeting its entire obligation.
Sales and revenues are the way companies March towards growth. Yes, technological innovation, barriers to entry in the business and customer satisfaction are important but none is as important as the sales made by the company. Cutting down costs or bringing economies of scale in businesses is also very important but that should be secondary and will only help in bringing the margins of the company higher. But the real growth comes from the revenue which the company makes year on year.
Revenues of companies that are accelerating around 25% or greater year-on-year are the ones that should be singled out for making investments. If we speak of sequential growth the % growth should be closer to around 8% per quarter.
Profits after tax reveals the earnings that are available to the shareholders and this is what is used to understand the real earning potential of the investor. The general rule of thumb should be that profits too should see a growth of over 5-8% every quarter and above 15% per annum. These are good starting points for investors to construct their universe of stocks that they can choose from.
A book by William O’Neil encapsulates these principles clearly with the C-A-N-S-L-I-M model. Those of you who are interested must read this book in order to know more about the concept.
Price to earning ratio is the fundamental factor which is often considered while deciding the validity of an investment into the stock. It is the ratio which suggests how much an investor is willing to pay for a particular stock to earn the respective profit form that company. P/E Ratio is helpful in analysing the value or price that a stock is worth of.
It is calculated by taking into account the relativity of company’s market value per share with respect to the earning per share of the company.
Price Earning Ratio = Market Value per share/Earnings per share
Market value of shares can be obtained by the respective stock exchanges like NSE and BSE. The earnings per share can be obtained by simply dividing earnings of the company by total number of outstanding shares in the market or currently trading in the market.
P/E ratio is often calculated for the income oriented companies and a company with higher P/E ratio means that the future prospects of the company is good and thus it encourages an investor to pay higher price for the particular company’s share.
For Example, let’s say that two companies A and B has market value of their shares Rs 50 and Rs 45 and earnings per share are Rs 2 and Rs 3 respectively. Therefore, the P/E ratio of company A is Rs 25 and B is Rs 15.
It simply means that to earn every Rs 2 per share of company A, an investor is willing to pay Rs 25, similarly, to earn every Rs 3 of company B, an investor is willing to pay only Rs 15. So it is to be noted that Company A has higher P/E ratio as compared to B. This can be interpreted with different perspectives. It cannot and should not be looked at in isolation.
One perspective is that investors are willing to a higher price for Company A as compared to company B for every rupee of earning. This could be for multiple reasons, it also might be that the company B does not have a brighter future in the eyes of the investors so even though it has better earnings per share, the investors value Company A more than company B.
The second perspective here is that, even though Company B has higher earnings per share than company A, it is available for the investors at a cheaper value as compared to company A. This perspective would be valid if company A has a similar business model as company B or they both are from the same industry.
It is important for Investors to always look at P/E Ratio or other ratios in conjunction to one another. This provides the investor a clearer picture of a company versus its peers or as compared to other options in the market. When looked at in isolation, no ratio makes any sense whatsoever as it will just be a number.
If the current earnings per share are taken into account then the P/E ratio is called Trailing P/E ratio. Similarly, if future expected earnings per share is taken into account then, the P/E ratio is called Forward P/E Ratio.
Profit Earning to Growth Ratio
Profit earning and growth ratio is the deeper and enhanced form of P/E ratio. It factors the P/E ratio of the company by future expected annual growth, which helps investor to find out whether the company’s stocks are overvalued or undervalued. It helps in analysing the intrinsic value of the company.
Profit Earning to growth ratio = Price Earning Ratio/Annual Growth
If the price of the share is less than the growth rate, then it clearly means that in future the chances of future earnings is more and prices will rise in near future to match the growth rate of the company, hence stocks are undervalued. However, if the prices are on higher side as compared to growth rate, then it indicates that growth should be faster to justify the price of the particular stock of the company, if not, then the prices will fall in near future, thus it is overvalued.
The ideal ratio of PEG ratio is 1. If PEG ratio is less than 1 then, stocks are undervalued and should be bought and vice versa.
For Example the P/E ratio of PQR Ltd. is 30 and growth rate is 20% and XYZ Ltd.’s P/E Ratio is 40 with annual growth rate of 50% then, PEG ratio of PQR Ltd. is 1.5 and XYZ Ltd. is .8. So, we can say that PQR stocks are overvalued and should be sold and XYZ Ltd. shares are undervalued and should be bought.
As mentioned before in the article that investors make investments in the stock market for gains.These gains could either be in the form of capital appreciation or through dividends received from the company. In my personal experience in the wealth management sector I have come across clients who build a dividend oriented portfolio from the very start of their earning days. For instance, we had a client who held over 17500 shares of Coal India and around 1250 shares of OFSS. He was very clear on his objective from the investment. Coal India historically has given dividends over INR 20 per annum (many times the number is way above this). One can just imagine the gains of my client from purely dividends.
I would like to add that an investor should choose a fundamentally strong company, which has a competitive edge in its area of business as well as a positive operational cash flow for a number of years. This strategy should be followed even if the investor is solely buying the stock to receive the dividend. It is generally the large cap or blue chip companies that have a regular and healthy dividend payout.
Dividend yield ratio shows what percentage of the market price of a share a company annually pays to its stockholders in the form of dividends. It is calculated by dividing the annual dividend per share by market value per share. The ratio is generally expressed in percentage form and is sometimes called dividend yield percentage.
Given below are the top 10 companies that have had the highest Dividend Yield in the Financial Year 2017 (Data compiled till 3rd March 2017).
|Company Name||Dividend Yield (%)|
|RURAL ELECTRIFICATION CORPORATION LTD.||11.17|
|POWER FINANCE CORPORATION LTD.||10.25|
|HINDUSTAN ZINC LTD.||8.96|
|COAL INDIA LTD.||8.53|
|HINDUSTAN PETROLEUM CORPORATION LTD.||6.8|
|INDIABULLS HOUSING FINANCE LTD.||6.34|
|BHARAT PETROLEUM CORPORATION LTD.||4.88|
|OIL INDIA LTD.||4.83|
Peer as the word itself says the other competitors in the market under the same industry. Peer analysis simply means that an investor while investing into the stock of a company of a particular industry, should analyse the other competing companies in the same industry. The ratios defined above can be used as a parameter to analyse the performance of the various companies under the same industry.
Let’s say that if an investor wants to invest in IT sector, then the various companies of that sector such as Wipro, Infosys, TCS etc. should be analysed by using the fundamental ratios to analyse their performance and keeping in mind the other external factors which can affect the industry as a whole.
By saying external factors, it means that there are several factors such as economic, political which can affect the performance of the industry.
For example, recently H1B visa are the major concern for the IT industry. So given the same condition an investor should analyse and see which company is performing well and have proper back up in case of any unfavorable situation occurs.
Moats around business
Moats around business simply means the competitive advantages enjoyed by the companies operating in the same industry. It shows the unique feature of the company so that it can effectively manage its resources and adjust itself according to the adverse situations in the economy.
A very good example of this is Banking and Finance industry. In this LIC India has the monopoly in the insurance sector, as it is backed by the government and customer has a different kind of approach towards it as compared to other insurance companies. As LIC India has its base in the insurance sector for the longer period of time as compared to its peers, so whatever be the circumstances, LIC India always manages to earn better than the other insurance companies and thus investor look toward its stock as a good investment opportunity.
Therefore these factors should always be considered while investing in the stocks of the company. Situation changes, policies changes, therefore it is very important that an investment should be done in that company which has the potential to stand before the changing circumstances in the stock market. To conclude, it can be said that if all these points are covered then, the risk adjusted return will be higher and rewards will be generated in the volatile stock market.