Spend, Save and Invest Smartly

Investing in Stocks



Everybody is asking whether it is the right time to invest in stock market. The argument in favor of investing right now is that Sensex is trading at an all time low and most of the stocks appear to be undervalued. So the enthusiastic buyers are in the favor of buying these stocks which have seen a fall of 40-90% in their values in the last one year. I do believe that a number of stocks are undervalued and will see a rise or bull run soon – probably after mid January 2009. I would recommend buying defensive stocks (Power and FMCG firms) at the moment while avoiding stocks with high volatility. The following article will help you understand, analyze and pick good stocks from those currently trading on the stock exchange.

Before we move further let’s think about this– why do we invest in stock? How to invest in stocks? Which stocks to buy? When to buy or sell? Most people do not do the required analysis before making their investment decision. They generally follow the herd principle i.e. follow the crowd and buy what others are buying. This is the single biggest mistake one can make while investing their hard earned money. Studies after studies have indicated that retail investors generally invest when market is already pretty high or over-valued. Hence, they risk loosing their investment before the market corrects itself. But don’t be mistaken that only normal and non-finance guys make such mistakes. Even highly trained, Ivy school business graduates end up doing the same thing!.

The rule of a successful investment is both an art and science. One needs to do the required technical (financial analysis) of the stock before buying or selling it. When to buy or sell probably is an art that comes with age and experience. In this article I have tried to help you understand the things you need to keep in mind while doing your research and number crunching. Remember there is no short cut to the investment.

Step-1: Before you decide to invest in a company’s stock, find out how the company makes money

This is probably the easiest of all the steps. Do your due-diligence honestly. Read company’s annual and quarterly reports, newspapers and business magazines to understand the various revenue streams of the firm. Stock price reflects the firm’s ability to generate consistent or above expectation profits/earnings from its ongoing/core operations. Any income from unrelated activities should not affect the stock price. For example- Unitech is second largest real estate firm in India. However, it has several other arms as well. It recently sold its wireless license to a foreign player. But it has not made a single penny from its telecom operation. Investors will pay for its earnings from its core real estate operations, which is its strength and stable operation, and not from the one-time sale of telecom license. Thus, you need to find out which operations of the firm are generating revenues and profits. If you do not know that you are bound to get a hit in future. Warren Buffet once said that “if you do not understand how a company makes money, do not buy its stock- you will always end up loosing money”. He never invested even a single dime in technology stocks and yet made billions and billions of dollars both during tech bubble and bust.

Step-2: Find out which sector the company is in. Then, figure out what all factors affect the performance of the sector

First is to figure out which sector the stock is in. For example, Infosys is in IT services sector, NTPC is in Power sector and DLF is in Real Estate sector. Half of what a stock does is totally dependent on its sector. Hence, it is extremely important to understand the sector – good and bad factors for the sector. Simple rule-Good factors help stocks while bad factors hurt stocks. Let’s take an example of real estate sector. Factors that affect this sector are interest rates, economy and prices. If interest rates are high, buyers would not go for home loans and hence the demand for properties would be low. This would make the sector less attractive because there would be less scope of growth for the firms. Now let’s talk about the airlines industry. The factors that affect it are fuel prices, growth in air traffic and competition. If fuel prices are high, tickets would be expensive and hence fewer people will fly. This will hurt the airlines sectors and firms equally. The idea is to find out the good and bad factors for the sectors and figure out how much they will affect the stock and how. What we are really looking at are reasons that will make stock price good or bad or a company look more or less valuable, even though nothing about the company changes. This will give you a broader view whether the stocks will do well or poorly in the future.

Step-3: Examine the recent as well as historical performance of the stock and the company

By performance I mean both operational and financial performance of the company. Take out some time to find out how the company has done in its business over the years. Were there issues with its operations such as labor strike, frequent breakdowns, higher attrition or lagging deadlines? If any company has a history of serious problems, it does not make a good buy because chances are high it may have similar problems again. History is a good predictor of future! It is also extremely important to find out the historical financial performance of the company – growth in revenues, profits (earnings), profit margins, stock price movements etc. Use the following table to understand the stock movement.

Step-4: Perform competitive analysis of the firm w.r.t. other major players in the same sector or business

This is extremely important step in analyzing a stock. Unfortunately, most of the retail investors do not bother to do this. It takes time to do this step but it worth trying if you don’t want to loose your money. Many investors buy a stock because they have heard about the company or used the products or think companies have excellent technologies. However, if you do not evaluate or compare those features of the company with other similar firms, how will you figure out whether the firm is utilizing them effectively or is better/worse than others? We also need to find out whether company is growing rapidly or slowly or has no growth. I would like to cover couple of financial ratios here in brief and explain how to use them to figure out a good stock.

P/E: Price-to-earning ratio is an extremely important and most widely used ratio in stock valuation. It means how much investors are paying more for each unit of income. It is calculated as Market Price of Stock / Earnings per share. A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market, as investors are paying more for today\'s earnings in anticipation of future earnings growth. Hence, as a generalization, stocks with this characteristic are considered to be growth stocks. However, P/E alone may not tell you the whole story as you see it varies from one company to another because of different growth rates. Hence, another ratio, PEG (P/E divided by Earnings Growth rate) gives a better comparative understanding of the stock.

I do not want to go into the calculation part as values for P/E are available on internet (www.moneycontrol.com) for most of the companies.Calculate average value for P/E and PEG values. Compare the PEG values of stock X with its peers Y and Z. Also, compare X with the average value to find out whether it is over-valued or under-valued w.r.t. to the industry average. A PEG of less than 1 makes an excellent buy if the company is fundamentally strong. If it is above 2, it is a MUST SELL. If PEG for all the stocks are not very different, one with lowest P/E value would be a great BUY.

Step-5: Read and evaluate company’s income statement, balance sheet and cash flow statements

This is the most difficult part of this process. It is generally used by sophisticated finance professionals, mostly fund managers who can understand different financial statements. However, there are few things that even you should keep in mind. There are three different financial statement- balance sheet, income statement and cash flow statement. You should focus only on balance sheet and cash flow statement.

Balance Sheet

It summarizes a company’s assets, liabilities (debt) and shareholders equity at a specific point in time. A typical Indian firm’s balance sheet has following line items:

Gross block is the sum total of all assets of the company valued at their cost of acquisition. This is inclusive of the depreciation that is to be charged on each asset.

Net block is the gross block less accumulated depreciation on assets. Net block is actually what the asset is worth to the company.

Capital work in progress, sometimes at the end of the financial year, there is some construction or installation going on in the company, which is not complete, such installation is recorded in the books as capital work in progress because it is asset for the business.

Investments: If the company has made some investments out of its free cash, it is recorded under it.

Inventory is the stock of goods that a company has at any point of time.

Receivables include the debtors of the company, i.e., it includes all those accounts which are to give money back to the company.

Other current assets include all the assets, which can be converted into cash within a very short period of time like cash in bank etc.

Equity Share capital is the owner\'s equity. It is the most permanent source of finance for the company.

Reserves include the free reserves of the company which are built out of the genuine profits of the company. Together they are known as net worth of the company.

Total debt includes the long term and the short debt of the company. Long term is for a longer duration, usually for a period more than 3 years like debentures. Short term debt is for a lesser duration, usually for less than a year like bank finance for working capital.

One need to ask-How much debt does the company have? How much debt does it have the current year? Find out debt to equity ratio. If this ratio is greater than 2, the company has a high risk of default on the interest payments. Also, find out whether the firm is generating enough cash to pay for its working capital or debt. If total liabilities are greater than total assets, sell the stock as the firm is heading for disaster. This debt to equity ratio is extremely important for a company to survive in bad economy. What is happening now-a-days should make this extremely important. Companies having higher debt ratio have got hammered in the stock market. Look at real estate companies- their stocks are down by almost 90%. This is because they have high debt level which means higher interest payments. In the current liquidity crisis and global slowdown, it would be extremely difficult for them to survive. Remember, a weak balance sheet makes a company vulnerable to bankruptcy!

Step-6: Buy or Sell

Follow all the steps from 1 to 5 religiously. It will take time but worth doing it. If you do it, you won’t have to see a situation where you loose more than 50% of stock value in a week! Buying or selling will depend on how you stock(s) perform on the above analysis

Things to remember

Do not buy or sell stocks just because your friends or relatives are buying or selling them – do your own research using above steps.

Do not blindly believe what management says about their firm; most of them are always optimistic about their future- avoid being overly optimistic

Do not buy a stock just because it is trading at its yearly low – the stock price might just drop even further

Do not buy a stock just because it appears to be glamorous or media covers it regularly; look for fundamentals of the stock, the sector and the company

Market sentiments affect stock prices to a great extent- even a good stock may not have enough buyers in an uncertain market. Trick is to buy them and hold on for a long period

Last but not least, do not put all your eggs in the same basket i.e. have proper asset allocation- invest in both stocks and government instruments such as bonds, PPF and PF

Remember there is no short cut to investments in equity market. It is a place where you can make millions while loose all your money in a single day. You should think how hard it is to earn money at the end of the day. I hope you do not want to loose your savings in the market due to your laziness or lack of homework. So, I would request you to do some basic groundwork before investing in stocks. My model will just help you in doing so.

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