A beginner’s guide to shortlist stocks for investment

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If you are someone trying to start stock market investment the right way, you should keep in mind that no matter which companies are making news, or are on your mind, you should always thoroughly analyze the companies about its business, financials, future prospects before investment. Even though a lot could depend on macro and micro economics, government policies, Geo-politics and global market conditions, these things generally leave relatively lower impacts in long term. Thus, a lot depends on the quality of the company itself.

So here I am going to drop a few points that you need to analyze for before shortlisting a company for investment.

Note that when I say investment, it means for a minimum of 10 years of holding period.

1. Business of the company

A lot of people who lose their investments, never thoroughly inquire about the companies. If you don’t understand the business, you would probably be influenced by the trending buzz words, influencers and rumors and would likely end up investing in a wrong company. For instance, in IT, AI is the current buzz word, and you would find several companies mentioning AI in their products or services. However, you should understand how the company is making use of AI in their products or services, or whether those products and services actually are improved by AI or its just a marketing gimmick. Also, find out about who are the users or clients of those products and services, and whether the market size is big enough to give the company a room to grow in long term.

2. Competition

Now that you know about the company business, the next very important thing would be to know about the competition. Whether the company is domestic or global market leader or among largest players. Even if it is, how the competitors are places in the market, whether there are quickly catching up or the company has a significant market share compared to competition. How about the entry barrier, I mean, how easy or difficult it is to challenge the company’s position or business by a new entrant? Entry barrier could be anything that hinders opening up new companies in the sector, be it government policies, distribution, licenses or expertise. Generally, you wouldn’t want to invest in companies where there is lot of close competition or the market barrier is not high. Or if you do, you would have to keep a close eye on the company and its market position.

3. Businesses that you understand

Generally, you would neither invest in one company or one sector, but still it helps to give a preference to the sector(s) you understand either through your qualifications, or interests. For instance, if you are working in banking or pharma, you are likely to understand intricacies of business better than who aren’t. Thus you would be better able to understand which of those companies are placed better in the market. However, working in a sector is not the only way to keep yourself apprise of the business. If you are a consumer, you already understand what products or services sell better in market. Analyze the reasons why, and you will be able to shortlist a few companies.

4. Fundamentals

There is lots of information available about the stocks and you probably want to compare the companies based on most important indicators. I will talk here about the most basic parameters that you must know, that can help you select companies based on their recent or historic performance.

4.1 Market Cap

Market cap(ital) basically gives you an idea of how big is the company in accumulative share value terms, in other words, how much is the total value of all the shares of the company combined. For instance, Nifty50 or Sensex comprise India’s top 50 and top 30 companies respectively by market capital.

A general understanding about the market cap is that, the higher the market cap, the lessor the risk associated would be, which obviously is not always true, but a good enough indicator or risk-reward value. Comparing companies of same sector, but of different market cap, large cap company would be among a market leaders, small could be a new entrant or a regional business. Mid caps would lie somewhere in between.

Ideally, you would want to distribute your portfolio among large, mid or small caps for reasonable risk and returns.

Take this as a vague indicator of market cap categorization: companies below 10K Cr of market cap would be small cap, companies with up to 50K Cr of market cap would be mid cap and above that would be large cap companies.

4.2 P/E

PE Multiple, or simply PE, is an indicator of how the current value of stock is in ratio of it’s per-share-earning. You should generally compare this indicator with Industry PE, which is an average PE of all the companies of that industry. However, note that the company may be an aggregate of businesses and thus Industry PE may not give a good picture. For instance, Reliance works in different sectors like oil, telecom, retail etc and each industry would have a different PE, but that would not reflect company’s average PE and can not be correctly compared with industry PE.

Higher PE, generally means expensive valuation. Among companies of same business, buying a company of lower PE means buying juice at DMart, while buying a company of higher PE would mean buying it at in-flight price.

However, that does not mean a company with high PE can not be bought. If a company is able to justify its PE because of higher YoY, QoQ growth, high profit margins and high future projections as compared to competition, it could be considered.

4.3 P/B

Book value is basically = (assets – liabilities), meaning value of assets left after settling all the company liabilities, per share. In other words, if company were to liquidate today, how much money share holders will receive. Wait, that’s just book value.

Price to book value ratio indicates how expensive is stocks compared to its book value. In most calculations or comparisons, you can treat this ratio similar to PE. As PE shows the multiple of earnings per share, this tells us book value per share. Similar to PE, this should also be compared against industry PB.

4.4 RoCE

Return on capital employed, or RoCE, shows how efficient the company is in terms of earnings from the money it’s put to use in business operations. The money includes loans and other borrowings as well while it excludes cash not deployed in operations.

RoCE = Earnings (before interest and taxes) / Capital Employed,

If RoCE is high, it means, company is able to generate high returns from the capital. Since this calculation includes debt as well, for debt free companies, this parameter can be ignored.

4.5 ROE

ROE = Net Earnings / Shareholder’s Equity

ROE shows how much is company earnings from it’s investors money. Similar to RoCE, ROE is also an indicator of company’s financial efficiency. So a higher ROE is desirable.

4.6 D/E

Debt to equity ratio tells you how much money company as borrowed as compared to investors’ money. Generally, a debt free company should be in your preference, but debt is also not always bad as reasonable debt might be required for expansions. Lower the D/E, the better it would be. However, note that, for financial institutions this parameter should be ignored, as in this case, the debt is a part of business operation and thus it would always be higher.

5. Recent or Historic Performance

All those above mentioned parameters when looked from a historic perspective, give you an idea of how the company’s fundamentals have been in past years and whether a good or bad quarter/year is not just an anomaly.

Companies are required to publish their quarterly and annual results, from which you can gain significant insights about their current performance, compare that with the past numbers and you’d know how the company’s performance has been and what can you expect in future.

Look at how the past performance of the company has been in terms of Sales growth, Profit Growth, Profit Margins, EPS, Expenses, along with Short term and long term liabilities, and how the future projections are. Generally, we can only look at past data, but the companies that have been performing well for years have good probability of doing well in future as well, however, that’s not true always, otherwise Motorola and Nokia wouldn’t have been lost. As a good practice, you need to be following company updates and read quarterly results.

This article is meant to cover the absolute basics in a layman language. I will keep updating this to make it an exhaustive guide to help you with your investments, so keep this in your bookmarks for future updates.

I hope you liked reading this. If you did, please share it with your friends. You can also drop a comment below in the comment box to tell me what you did or did not like.

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