How to determine stocks like a pro

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How to determine stocks like a pro

Wednesday, 20 February 2019 | Hima Bindu Kota

Fundamental analysis is a bottoms-up  valuation technique used to determine the market value of a stock

Picking fundamentally strong and undervalued stocks is an art as well as science. Long-term investors, who invest for more than a year in markets, should pick fundamentally strong stocks unlike short-term investors, who invest for less than a year, taking cue from price movements. Fundamental analysis will only answer the question “what to buy”; whereas a technical analysis will throw light on “when to buy.” A combination of fundamental and technical analysis is required to make the right decision.

The main aim of fundamental analysis is to analyse the intrinsic value of a stock, identify and buy ones that are undervalued (having market value less than the intrinsic value) and sell or avoid, for the time being, ones that are overvalued. Determining the intrinsic value of a stock is one of the most vital aspects. Also extremely difficult is the part of value investing as only estimates are used in calculations. When figuring out a stock’s intrinsic value, cash is the king and most models that calculate the fundamental value of a stock factor in variables largely pertaining to cash, ie, dividends and future cash flows, utilise the time value of money.

Fundamental analysis uses qualitative as well as quantitative factors. Quantitative factors use more of numbers and can be analysed using ratio analysis and other valuation methods. Growth rate is one of the important factors that an investor should focus on, like the growth rate of revenues, dividends and earnings, which can be calculated by the Compounded Annual Growth Rate (CAGR). Cash is the main blood of any business and while selecting a stock for investing, we should look how much cash a business is generating. If the operating cash flow is negative, then the company is at risk. We should avoid investing in the stock of such company. For example, Kingfisher Airlines had negative operating cash flows for years and it resulted in bankruptcy.

Price-Earnings Ratio (PE) is another important parameter that represents the value placed by the market on each rupee the market earns. A higher PE compared to market indicates that the stock is expensive; whereas lower PE indicates that the stock is undervalued and this is when we should buy a stock. PE ratios of all stocks tend to be high in a bull market and are lower in a bear market. Debt Equity ratio is a leverage ratio and is used for analysing the extent of leverage used by the company and its ability to meet the obligations. Taking a look at the current India Inc and how some companies have high debt burdens, this ratio is of great significance. If the company takes too many debts, in the absence of meeting its obligations, it may face bankruptcy. It would be prudent for investors to avoid companies with extremely high levels of debt. On a conservative basis, this ratio should be either one or less. Net profit margin is a profitability ratio which is used to find the profitability of a firm based on operations and direct cost. Earnings before interest, tax, depreciation and amortisation margin should be higher as it indicates that a company is efficient as compared to its peers. So when you choose a stock, look for higher Net Profit Margin.

Promoter shareholding is also an important criterion for selection of stock. It is important to determine what the promoter shareholding pattern in a company is. Promoters have the best knowledge of the company as they are insiders. They know what is happening in the company. If the promoters’ stake in the company increases, we should buy the stock as it is a positive signal. It means that the promoters are confident that the company will grow. If the promoter’s stake in the company reduces, then we should sell the stock as it is a negative signal. Before the Satyam scam, holdings of Ramalinga Raju’s were decreasing continuously. He was an insider and he knew something wrong is going to happen. If we want to invest in a stock for a long-term, we should always choose a stock which pays dividend as it is a source of income for investors. When a company earns profits, it shares a part of it with its shareholders as dividend. Generally, companies maintain their dividend levels until something drastically different happens with the businesses. Dividends are mentioned as a percentage, which is reckoned with regard to face value. For example, if a company with face value of Rs 10 declares 30 per cent dividend, it means a dividend of Rs 3 per share. However, if a company with a face value of Rs 2 declares 30 per cent dividend, it means dividend of Rs 0.60 per share. Investors should choose higher dividend yield stocks as it implies that the company is giving dividends to its investors.

This article describes only the quantitative part of fundamental analysis. However, it is very crucial for the investors to read the financial statements of companies very carefully to identify whether account books are managed. However, the ratios discussed in the article are a good way to start, identifying potentially strong companies where one can invest, when the timing is right.

(The writer is Assistant Professor, Amity University)

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