It is often said that the secret behind a happy marriage is finding the right partner. The same rationale applies to your stock market investments as well. If you find the right stocks your portfolio and wealth is bound to flourish in the long run. But how do you go about finding the right stocks? Should you simply go for the trending stocks or replicate your colleague’s or friend’s stock picks?
Does not matter if you are driving a hatchback or a luxury sedan, if the wheels of the car do not have enough air, you are not going to go far enough. Similarly, in stock investments, irrespective of valuation, market rumours, star ratings, etc. if the company under consideration is not fundamentally strong, your stock investment is not going to bear fruits. But how do you check the fundamental strength of a company? You go with numbers. Financial ratios help you analyze a company from a 360-degree perspective. They cover a wide range of aspects ranging from stability, operational efficiency, profitability, liquidity, etc. They let you add meaning to raw financial numbers.
Here are the top seven financial ratios that would help you decide whether the company in question deserves your time and hard-earned money.
Earnings Per Share or EPS
Debt to Equity Ratio
Return on Equity or ROE
Price to Earnings Ratio (P/E)
Price to Book Ratio (P/B)
Price to Sales Ratio (P/S)
These financial ratios are like the written entrance examination you have to clear before you qualify for your interview round! Once you find that the company has performed well on the above parameters, it is time to move to the other parameters.
You might be wondering, if a company is fundamentally strong, is that not a good enough reason to invest in it. Why bother with additional steps or efforts. While the question is valid, the limitation of many financial ratios is that they are a lag indicator. They tell you how the company has done in the past and not much about its future prospects. Hence, it is important to look at other factors to make sure you choose the right stocks.
2)Your understanding of the company
Do you understand the company? Its products or services, business model, competitors, market standing, etc? In order to ascertain the future prospects or growth plans of any company, you need to understand it in great depth. For instance, does the company have an offering which will be required even after two decades? For example, if someone had invested in a typewriter company’s stocks decades back, where would he or she stand now. The product has a limited shelf life and is no longer in use. However, if you take the example of a product like soap, it is going to be in use forever. There may be new versions, but the basic product will continue to exist.
Hence, it is important to choose a company that you understand and whose offerings have a long lifespan. Stocks of such companies have the potential for superior growth (thanks to the strength of compounding)
3) Look for the “moat”
If you have visited any fort or castle, you would have noticed a deep and wide ditch around it (earlier filled with water or ferocious reptiles). The purpose of the moat was to act a defence in times of attaching and protect the kingdom. When you look for companies to invest in, you need to look for a similar moat. This economic moat arises from a company’s distinct advantage over its competitors. It helps the business to be sustainable as well as earn higher profits. So, go for a company with a wider economic moat around it.
4) Depth of debt
Remember when Bee Gees crooned How deep is your love! You need to ask how deep is the debt of the company. Debt financing is a great way to generate funds but if not kept within limits, it is as dangerous as a ticking time bomb. It is extremely important to look at the company’s financial statements such as balance sheet. Companies with huge debt as they can be a risky proposition. Remember, in the event of the company winding up or becoming bankrupt, creditors will get priority to recoup their money.
Pro Tip: Debt can be worded differently in different sectors. For instance, check for NPAs (Non-Performing Assets) in the financial statement of Banks or NBFCs.
5) Captain(s) of the ship
You could have the best product/service, strong fundamentals and a great Unique Selling Proposition. But if you do not have the right people at the help of the company, all the good things will come crashing down. It is crucial to analyze the company’s management and the core team.
Get answers to these questions:
i) What is the strategy of the company?
You should know where is the company headed and what are its goals. The vision, mission, value statements and Employee Value Proposition would give you a fair idea about this aspect.
ii) How stable is the management team
A long and steady tenure is often considered as an indicator of a healthy and robust company.
iii) Promoters and share buybacks
Promoters possess the deepest knowledge of the company. If you find them giving up their shares, it is a red flag. You should dig deep as it may be a signal that the promoters do not have trust in the stock’s potential to grow. Though that may not be the reason always. They may need funds to start another venture! The idea is to ask tough questions, get the answers and make well-informed decisions.
Again financial ratios come to your rescue. Look at Return on capital employed (ROCE) in addition to ROE (Return on equity) to determine how efficiently are the investments being translated into revenues and profits.
v) Qualitative aspects
Transparency, honesty and integrity may not be quantified but play a significant role in strengthening the management of the company. You can assess these factors by looking at how the core team has handled tough market conditions, bad results or economic sluggishness.
When you consider all these factors (in unison), you will end up with a great stock. Add the concept of valuation that we discussed earlier and you cannot go wrong with your stock investments. Remember though, all that shines is not always gold. Just because a stock is cheap does not make it a good investment opportunity. Its intrinsic worth should be the determining factor.
Finding the right stocks can be a cumbersome or tiring process. But the result of that hard-word is extremely sweet.
As an investor, you look for various investment assets like equities, bonds, real estate and others to invest in. There are various investment options available in the market that can suit varying risk-return requirements. Mutual fund is one such investment option that fits into every investor’s needs. With more than 2,500 mutual fund schemes available in India, mutual funds as an investment vehicle has become popular over the past few decades.
What are mutual funds?
Mutual fund is an investment avenue that pools money from investors with a common objective and invests the pooled money into various asset classes like stocks, bonds and other assets based on the objective of the scheme.
Fundamentally, a mutual fund is a trust consisting of investors with similar objectives and the pool of money by them is invested and managed by Asset Management Companies (AMC). Asset Management Company employs professional fund managers for managing each mutual fund scheme using their expertise. The Asset Management Companies are approved and regulated by Securities and Exchange Board of India (SEBI).
Mutual fund trust includes sponsor, trustees, custodian and asset management company (AMC). Here is a basic structure of mutual funds in India –
How mutual funds work?
When you consider investing in mutual funds, it is important to know how it works. You first need to understand a few important terminologies that can help you understand the concept of mutual funds thoroughly.
Mutual fund unit: Mutual fund unit denotes extent of your ownership in that particular fund just like an equity share that represents your extent of ownership in the company.
Net Asset Value (NAV): Net asset value or NAV is the fund’s per unit price. NAV is calculated on a daily basis at the end of market hours as the value of underlying securities in mutual fund investments change every day. Basically, NAV is calculated by dividing the total net asset value (asset – liabilities) by the number of units outstanding.
Assets under Management (AUM): Assets under management (AUM) is the total investment value or market value of assets that a mutual fund holds.
Fund Portfolio: Fund portfolio is collection of investments held by a mutual fund which is invested in different asset classes by the fund manager.
Fund Manager: Fund manager is a professional appointed by the asset management company for implementing investment strategy and taking decisions to buy and sell securities using the market expertise.
Working of mutual funds is quite simple. Here is a simple step-by-step guide that can help you understand the concept or working of mutual funds.
Like minded investors like you invest in a mutual fund scheme by pooling money.
Mutual fund trust that collects the money allots you fund units based on the amount of investment you make. Price of each unit is referred to as net asset value (NAV).
Fund managers appointed by the Asset Management Company (AMC) take the decision of investing money in various securities like stocks, bonds, money market instruments and other asset classes depending on the investment objective. Fund manager also decides on the allocation of the fund portfolio.
Depending on the capital market performance, buying and selling decisions of fund managers, investments made in securities will generate profit or income.
Returns earned from the investments into securities are passed back to the investors.
The following chart explains the concept of mutual funds in the simplest way.
You can also understand the concept of mutual funds easily with an example below.
Let’s say SBI Mutual Fund launches a new equity-oriented mutual fund scheme. Let’s say a fund collects INR 10 crores from 1000 investors assuming each investor invests INR. 1 lakh. In the next step, Asset Management Company allocates units. Let’s assume, the company issues units at the net asset value of INR 10. That means, if you have invested INR. 1 lakh in the fund, you would get 10,000 units. Total of 1Cr units will be allocated to all the investors. Fund managers will now invest INR 10 crores into various stocks, say about 10 stocks which form the portfolio of the fund. Fund managers will also maintain some liquid cash to deal with redemptions. Let’s say after a few days the portfolio of stocks grows to INR 11 crore, assuming that there is no change in the portfolio and number of investors. That means, the net asset value of the fund is now INR 11 (INR 11 cr/1 cr). If you redeem, you would get INR 1.1 lakh, which means INR 10,000 would be your gain.
This is just an illustration for easy understanding of the concept; in actual scenarios there may be buying and selling on a daily basis. Understanding the investment and its concept can help you make informed and rational investment decisions.
A wise person once said that to make money in the stock market, you must have the vision to see them, the courage to invest in them and patience to hold them! But to have a clear vision, you need to be through with the basics. Here are the top five things that you need to know to get started:
Shares (also referred to as stocks) entitles the holder to become an owner (proportionate to the invested amount) of the issuing company. Shares can be bought either during IPOs (Initial Public Offering) or in the secondary market (i.e. stock markets).
Primarily, there are three types of shares:
i) Preference Shares
Preference Shares, true to their name, give the shareholders a “priority pass” in certain situations. For instance,
At the time of dividend distribution, preference shareholders are the first ones to receive the same.
In case of liquidation, these shareholders get priority for capital repayment.
ii) Equity Shares
Equity shares (also known as ordinary shares) are the most commonly traded shares in the stock market. If you invest in equity shares, you become a part-owner of the company and get the right to vote and receive dividends (as and when declared). However, equity shareholders receive dividend only after the preference shareholders have been paid their dividend.
iii) Shares with differential voting rights (DVR)
These shares too come with voting rights, however, their privileges are generally lesser than common or equity shareholders. Such shareholders usually get compensated with a higher dividend payout. Compared to equity shares, DVRs trade at a lower price level.
Dividend refers to the sum of money periodically given by a company to its shareholders as a reward for investing in their venture. This payment can be made out of the company’s profits or even reserves.
Debentures are issued by a company when it raises money from the public in the form of a loan. They form part of the company’s debt and hence give no ownership or voting rights. Debenture holders receive pre-fixed interest. This interest is paid prior to dividend payouts. Debentures come with a pre-determined maturity date. Debentures can be categorized basis:
Secured Debentures are secured against the company’s assets. In case of insolvency, the debenture loan amount can be repaid from the sale proceeds of the concerned asset. Unsecured Debentures do not have such protection and remain at par with other unsecured lenders of the company, in the event of a re-payment default.
Debentures can be converted into shares (equity or preference) basis the level of permitted conversion. On the basis of convertibility, debentures can be classified as Non-Convertible, Partly Convertible, Fully Convertible or Optionally Convertible.
Redeemable debentures are issued with a redemption option – on demand, after completion of a fixed period or through a periodical drawing system. In the case of irredeemable debentures, the borrower does not have to repay the loan amount within a specified period.
Registered debentures are issued in the name of a specified individual who is registered as the debenture holder. The name of the person is mentioned on the debenture note or certificate. They can be transferred after completing all necessary formalities required as per Companies Act. Bearer debentures are made out to a bearer (rather than a particular individual). They are transferrable by mere delivery.
3) Bull and Bear Market
Broadly speaking, there are two types of market phases – the bull market and a bear market. In a bull market, prices increase or are expected to increase. In general, there is an upward or growth trend in the market. In terms of investor sentiment, there is widespread optimism, confidence and positivity. For instance, the period starting December 2011 till March 2015 is characterized as a bull market. The Indian Sensex jumped up by over 98% during this time. A bear market is the exact opposite of the bull market. Stock prices continuously go down (more than 20%) or are expected to do so in the near future. These times are usually marked with rampant negative sentiment amongst the investors. For instance, the dot com bubble burst (the early 2000s) and the fall of the US housing market (2008) led to a bear phase.
One important factor in both these market phases is that the trend (whether growth or fall) needs to be for a sustained time period, to be characterized as a phase.
4) Pre-requisites for stock trading
If you are eligible to enter into a contract, you can buy or sell shares as well. In order to do the same, you need to get a
i) Trading Account
Trading Account is the account through which you will place your trading bids in the stock market. It can also be used to make other online investments such as mutual funds, etc.
ii) Demat Account
This account will act as a common repository wherein all your shares are stored in a digitalized or electronic manner. In our country, these accounts are maintained by Depository Participants – NSDL (National Securities Depository Limited) and CDSL (Central Depository Services Limited).
5) Risk Tolerance
Risk tolerance is one of the most important deciding factors in stock market trading. It refers to the quantum of fluctuation in returns or principal investment value that you are willing or able to bear. In simple words, how much risk (or losses) can you comfortably absorb.
This factor is influenced by a host of factors –both positively as well as negatively. For instance, aspects such as education, professional qualification, income levels, wealth etc. generally have a positive impact on your risk tolerance. As these factors witness an increase, your risk-taking ability also rises. Factors such as age tend to have a negative impact on your risk tolerance. As you grow older (and take on more responsibilities) you tend to be wary of taking risks.
Your investment choice should be in sync with your risk profile. For instance, if you have a healthy risk appetite, you can opt for higher equity exposure. Debt schemes are suitable for conservative investors with low-risk tolerance.
Learning is a never-ending process. But these five aspects will get you started on your stock market trading journey!
Stock markets can often evoke feelings of dread and daunt, especially if you are a newbie to the world of investing. There are complex charts, too many options, technical jargons and above all fear of losing your hard-earned money. We too have been there and completely understanding the pains. Hence, we have collected our wisdom in the form of seven golden rules that you should follow when investing in stock markets.
When it comes to stock markets, you need to have a long-term orientation. If you are looking to earn just a quick buck (and are not a professional investor) or have a myopic approach to the stock market, you will not be able to realize the optimal potential of the investment. The aspiration to become an instant millionaire is the root cause of most debacles in the stock market. Stocks are not lottery tickets!
But then what happens in the long run? The answer is compounding. The power of “compounding” is immense. (Remember your mathematics teacher telling you how compound interest is more than simple interest?) When you hold on to your investment, then you earn interest not only on the principal contribution but also the interest earned thereon. Hence, it is like you can have your cake and eat it too!
The longer you remain invested, higher is the potential impact of the compound performance. As the business tycoon Warren Buffett put it, “Stock markets are a device to transfer wealth from the impatient to the patient”. So, be patient.
Rule 2: Emotions are not bae
Remember Rajesh Khanna saying, “Pushpa I hate tears”. Stock markets feel the same for emotional investing. Emotions cloud your judgement and often lead to wrong decisions. Whether it is the greed of wanting more (in a bull market) or fear of losing out (during bearish phase), if your decisions are not backed by solid judgement and in-depth research, you are likely to burn your fingers badly. There have been umpteen cases where investors have gone into a panic mode due to a slump in the market and sold off their investment at rock-bottom valuations. Always remember that markets are cyclical in nature. Even the worst of days are followed by sunshine. So do not take any decisions guided by emotions.
Rule 3: Know Your Investment (KYI)
Every fund house needs to mandatorily complete KYC (Know Your Customer) of the investor before bringing them on board. Did you know that it makes sense vice versa as well? Before investing in any stock, you should have detailed information about the company, its USP, competitors, market share or industry positioning, growth plans, management, etc. As they say, you do not invest in a stock, you invest in the business.
Rule 4: Quality over quantity
Stock selection plays a crucial role in determining your investment’s earning potential. Remember that form is temporary but class is permanent. Invest in stocks which are backed by fundamentally strong businesses, led by capable resources and with robust practices. Just because a stock is available at a cheap price does not make it a good investment. You need to understand the reason for the valuation of the company and then decide accordingly. It is not a bad idea to be a bargain hunter, but you need to see the value. Value investing (propagated by Warren Buffett) looks for undervalued stocks which are inherently strong and have a higher intrinsic value. It is always better to put your hard-earned money in a good stock which is reasonably priced rather than invest in a reasonable stock available at a good price.
Rule 5: Stay away from the herd
Stock market investments should not be as fashion trends. You should not put your hard-earned money in a stock just because your friend, relative or colleague is doing so. Following the herd will backfire strongly in the long term. You should stick with your overall investment plan. Do not give in to the temptation of investing in the “popular” stocks if they do not align with your financial goals, risk appetite or investment horizon.
A wise person once said, “if you invest and do not diversify, you are literally throwing out your money”. When you venture into stock market investing, the risk is inevitable. However, there are ways and means to manage or distribute the same. Diversify your portfolio across multiple asset categories (equity, debt, etc.), instruments, market capitalization (large-cap, mid-cap and small-cap), sectors or even geographies to minimize the risk and maximize the returns. Different asset classes respond differently to market fluctuations and phases and hence under-performance of one can be compensated by others’ good returns.
The only caveat is beware of over-diversification. Too many stocks in your portfolio can become an unnecessary management burden and bring down your earnings rather than protecting them.
Rule 7: Discipline
Discipline may be rarely enjoyable but is almost always profitable. You might be tempted to “time” your investment decisions to get the best side of the market or skip some of your periodic contributions. But resist those thoughts. Timing your investments is a utopian concept which does not work out in reality. All it does it justify your need for procrastination and reduce your earning potential. If you are banking on catching the highs and lows, you are in for a rude surprise. The mantra for success is to adopt a disciplined and systematic approach to investment. Keep calm (or patience) and the rewards will roll in the long run. Slow and steady definitely wins the race when it comes to stock market investing.
In stock markets, there will be ups and there will be downs. But if your investments follow these simple yet effective ground rules, you will be able to cross even the most tumultuous times and accomplish your financial goals.
Now you know the different type of shares available in the stock market. But you might be wondering, why would the company’s owners be ready to give up their ownership rights, have strangers vote for critical matters concerning their company and share their profits? The answer is quite simple – funds! As a company grows, it needs more and more funds to finance its expansion and growth plans. There are two paths it can take – debt financing or equity financing.
In debt financing, companies basically take a loan (either from financial institutions or by issuing bonds). They need to re-pay the borrowed amount along with interest to the lenders. In the equity financing, companies give up a part of their ownership by issuing shares. One major advantage of taking this route is that companies do not need to pay any fixed interest and can rather share their profits (in the form of dividend), basis for their financial and growth plans. Moreover, there is no maturity date upon which the company needs to repay the principal amount to the investors.
But it is not a one-sided love affair. Rather equity financing can be a win-win situation for both the parties – issuing company as well as investors. When the company does well, investors receive higher dividend payouts and the value of their investment appreciates. As a result, they stand to make a substantial gain by selling their stocks in the secondary market.
What is stock valuation?
Wealth creation is as much science as an art. Investing in the right stocks can truly change your fortunes. But one of the most common concerns for a lot of investors is to understand the stock’s real value. Stock valuation is the process of determining the stock’s true or intrinsic worth. The criticality of this valuation is due to the fact it is not derived or has any attachment to the current market price. If you are able to ascertain the stock’s true value, you would be able to easily determine if the stock is under-valued (a steal deal) or over-valued (waste of your money). Ultimately, it would help you to make well-thought-through and informed investment decisions, which are in the best interest of your hard-earned money.
But the question arises, how are stocks valued? If you find scratching your head, continue to read as we de-mystify the process.
There are two ways of stock valuation:
1) Absolute Valuation Method
In this valuation method, the calculation of the stock’s intrinsic value relies heavily on the fundamental financial information available about the company. Such information is accessed from the company’s financial reports, etc. They take into account aspects such as cash flows, growth rates and dividend payouts.
The two methods used for absolute valuation are:
i) DDM (Dividend Discount Model)
This model is based on the premise that the stock’s value is equivalent to the present value of the company’s future dividend payouts. This calculation remains applicable only in cases where the company distributes dividend on a regular and stable basis.
ii) DCF (Discounted Cash Flow Model)
This model follows the theory that the intrinsic value can be calculated by discounting the future cash flows of the company. This method of valuation can be used for companies with unpredictable or irregular dividend distribution.
2) Relative Valuation Method
Albert Einstein laid out the theory of relativity. Little did anyone know, that the concept would apply to stock market investment as well. Relative valuation stresses on the fact that investing in a particular stock is a choice that is not made in silos. Hence, to determine a stock’s value, you need to compare certain critical aspects with other similar companies. It takes into account financial ratios to determine the relative worth of stock.
Some common ways of relative or comparable stock valuation are:
i) Price Earning (P/E) Ratio
The P/E Ratio enables you to determine the stock’s value in relation to the company’s earnings. In simple terms, it shows you the number of years it will take for you to recover your investment, provided there is no change. A higher value can be interpreted as the willingness of investors to pay a higher price today basis the progressively larger growth expectations in the future. It is calculated as:
P/E Ratio = Market value per sharedivided by Earning per share
However, do remember this caveat – if you are using the P/E Ratio valuation method, make sure that the comparison is between similar sectors, markets or industries.
This ratio is also sometimes referred to as the earnings or price multiplier.
ii) Price/Earnings to Growth Ratio (PEG)
This valuation metric takes into account three variables –
Price of the concerned stock
Earnings per share or EPS
The growth rate of the company.
It is calculated by using this formula:
PEG Ratio = P/E Ratio
growth rate in the EPS.
When you compare stocks using this metric, you are basically comparing how much you are paying for the growth in each stock. For instance, if you have stock with PEG of 1, it means that there the stock’s current market value is perfectly co-related to the earning growth rate. However, if you have a stock with higher PEG (let us say 2), it indicates that you need to pay twice as much for a similar growth trajectory. In simple words, the second stock is over-valued.
iii) Price /Sales Value
This valuation methodology helps to interpret the stock value in comparison to the sales or revenue produced by the company. Stocks with a lesser P/S score are interpreted as cheaper investment options as compared to stocks with a higher P/S value. One major limitation of this methodology does not take into account other critical factors such as costs or profitability. Hence it is advisable to look at this value not solely but in combination with other ratios.
It is calculated as:
Price/Sales Value = Price per sharedivided byTotal sale revenue.
Price / Book Value
The book value of the stock (the difference between the company’s assets and liabilities) is considered a comparatively stable parameter. Hence, using that for a stock’s valuation is a good idea. The Price / Book Value metric looks at the market value of the stock in relation to its net-worth. It is also known as the price-equity ratio. A stock with low P/B Value is often considered as an under-valued stock.
It is calculated as:
Price/Book Value = Price per share divided bybook value per share.