This is a very interesting question. Every investor keeps asking this question. However, as happens with other existential questions in life, there is no right answer to this question. In other words, it all depends on your judgment.
An investor may expect good earnings from a stock going forward and buy it at a high P/E. Another investor may not share the same enthusiasm and consider it an expensive stock. The right P/E depends on what you consider the earning potential of a stock.
Generally, P/E ratios of 12 to 20 are considered normal across companies with neutral to positive outlooks. Legendary Investment Guru Benjamin Graham said that 20 P/E the maximum one should pay for an investment purchase of a common stock. Many times you see that the P/E ratio of certain companies, sectors or a whole market traverses to dangerous levels. Generally, it happens when emotions run high and people forget the basics of stock valuation. In 2000-2001, we saw how technology companies were trading at 60-90 times their current earnings. These ratios are not sustainable in the long term. Event the best companies cannot deliver the growth required to justify the P/E ratios of 60-90 on consistent basis. Many times investors get into a frenzy of buying stocks that everybody else is buying and pay very dearly for this mistake.
If the P/E ratio of a sector or a company is higher compared to the historical average P/E, you have a reason to investigate the reason for this abnormal behavior. If there is a valid reason for such a high P/E, you may consider buying it otherwise stay away from it. Generally, whenever a sector or a whole market goes beyond its historical average P/E, there is a correction, unless there is a fundamental change in the business scenario. Therefore, when you see a stock with high P/E, you must ask how justified earning expectations are from the stock.
Different industries have different P/E ranges based on their earning potential. You will see many metal companies operating at low P/E ratios. That’s because they have low margins and there’s very little for them to differentiate from their competitors. Hence, their ability to command a price premium from their customers is limited. On the other hand, technology companies generally sell at a higher P/E multiple as people have high expectations from them. These companies in general are able to grow at a faster clip too. Hence, variations in the P/E ranges of different industries are acceptable. One pertinent point here is that high P/E ratio makes a company risky too as its high stock price is based on future expectations rather than its past or current earnings. This is generally true of new technology companies. Many value investors stay away from technology companies as they cant put a price on the value of the technology. Frankly, it’s not an easy task to predict evaluate the business value of a technology with certainty, as tech space keeps changing very quickly. You should, however, not treat all technology companies equally. A few of them like Microsoft, Google, Oracle, etc have developed product portfolios and brand equity that helps them ensure that they have a predictable earning stream. If you can understand how a company is making money and how sustainable its earnings are, you can put a value to its stock. Otherwise, you will be indulging in speculation by buying a stock that you don’t understand.
Cyclical industries generally have varying average P/E ranges based on the phase of the industry. Steel industry goes through a cycle or 8-10 years during which demand in the market goes from low to high to low again. The industry also goes through a complete cycle of high capacity utilization, high capacity creation and low capacity utilization, which leads to further variations in the financials of the companies.
You should also note the limitations of using P/E ratio. Earnings are not cash flow. Many a times, company management try to fool the investors by manipulating earnings in a particular year, as it’s an accounting measure. While you must have a look at the P/E of a stock before making your investment decision, P/E ratio in isolation is not an indicator of the worth of a stock. You must look at the past earnings, changes in the accounting policy and free cash flow of the company to counter this problem.
On its own, P/E ratio is meaningless. It’s an indicator of the value of a stock. It’s not the cause of the value of the stock. It’s an effect. Understand the difference. There must be a fundamental reason why a stock is priced the way it is. Your analysis should help you find this reason. You will also see that some of the companies in a sector trade at a relatively higher P/E than others. There must be a reason for this difference in the companies. May be the companies with a higher P/E are more efficient. Or they have a strong brand that ensures that customers keep flocking to them. If a company is going to launch a potential market-winning product, there is a reason for a high P/E. If a stock has got a low P/E, this is not a reason enough for you to invest in the stock. If there is a regulatory change that’s going to make life difficult for a company, there is a reason for a low P/E. Therefore; you must try to understand the underlying reason for a stock’s P/E variation from the norm. If you are able to get to the root of the variation, you will be in a position to make your own decision on the stock.
Monday, October 5, 2009
Monday, September 28, 2009
What is Price to Earning Ratio: Interpreting P/E Ratio of a stock
P/E ratio is a very popular term amongst stock investors. Anybody who is considering investing in stocks does usually find out the P/E ratio of the stocks he is researching. At the same time, strange as it may sound, very few people are able to use the P/E ratio well in their investment decisions. In this post, we will try to understand what P/E Ratio means and how it can help an investor make sound investment decisions.
Calculating PE Ratio:
First things first, let’s understand how we arrive at the P/E ratio of a stock. The formula is
P/E Ratio = Stock Price/ Earning Per Share
Let’s say that a stock has annual Earning per Share of $10, and is trading at $120. In this case, the P/E ratio will be 12. A conservative investor will prefer using earnings from the previous four quarters, while calculating P/E ratio. In fact you can choose to take an average of last 3-5 years of annual earnings, if you really want to act like a true value investor. Averaging helps remove aberrations from the earnings of a stock. However, many analysts consider expected earnings for the next four quarters. A flaw, that too a major one, with this approach is that expected earnings are ‘EXPECTED’ earnings. They can change faster than your mood. And then, everybody has different expectations.
Interpreting PE Ratio:
Simply put, in the example above, assuming that the stock returns the same level of earnings year after year, you should get back your money in 12 years. If you reverse the PE ratio, you will get the Earning Yield of the stock. Earning Yield is a measure of the return from a stock. In this example, you are getting a return of 100/12 or 8.3% per annum on your investment. Remember that all earnings of a company belong to shareholders. Irrespective of what dividend is being paid out to shareholders in the short term, ultimately all the earnings should flow back to the shareholders. Earning yield is a good measure to consider if you are thinking about choosing between other investment options and stocks for investing your money.
P/E ratio gives you an idea of what the market is willing to pay for the company’s earnings. By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits too move up, the ratio stays the same. The ratio moves only when price and profits become disconnected.
For this reason, when the P/E ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because market is expecting a change – a change in the performance levels of the company in either direction going forward or a change in the market sentiment. You must make a note of these changes.
A higher P/E means that the market is willing to pay more for a stock compared to another stock with a lower P/E. An interpretation of a high P/E could be that the stock is overpriced. On the other hand, this could also mean that the market has high hopes from the stock in future, and it is factoring in the future earnings of the stock in its current price. Similarly, a low P/E may indicate a stock with low expectations from the market or it could mean an undervalued stock that has been overlooked by the market. Value investors hunt this kind of undervalued stock. Note, however, just because a stock is trading at a low P/E does not mean you should buy it. If it is an undervalued stock, it might be a good bargain. However, if it is a stock, which is not expected to do well in future, you may want to do a little research before you buy it.
You should, however, never consider P/E ratio in isolation. It’s a good measure if you use it for comparison between competitors or with the market or with the same company at different points in time. However, if you choose a telecom company over a steel company based on the difference in their P/E ratio, it may not be a very fruitful exercise.
Different types of P/E Ratios:
Many analysts will use different types of P/E ratios resulting in utter confusion. These can be trailing P/E ratio based on earnings of the last four quarters or forward P/E ratio based on expected earnings of the next four quarters. Using past earnings might not be a great indicator of the future earnings of a stock. However, in reality, past earnings have been better indicators of the future earnings of a stock than the earning forecasts made by stock analyst. It’s not easy to manipulate the value of trailing P/E ratio, as there is no guesswork or wishful thinking involved in calculating it, which is why value investors prefer using trailing P/E while making their investment decisions.
I hope the above post is able to give you a basic understanding of the P/E ratio. The next question in your mind could be what the right P/E for a stock is. I will answer this question in my next post. Stay tuned.
Calculating PE Ratio:
First things first, let’s understand how we arrive at the P/E ratio of a stock. The formula is
P/E Ratio = Stock Price/ Earning Per Share
Let’s say that a stock has annual Earning per Share of $10, and is trading at $120. In this case, the P/E ratio will be 12. A conservative investor will prefer using earnings from the previous four quarters, while calculating P/E ratio. In fact you can choose to take an average of last 3-5 years of annual earnings, if you really want to act like a true value investor. Averaging helps remove aberrations from the earnings of a stock. However, many analysts consider expected earnings for the next four quarters. A flaw, that too a major one, with this approach is that expected earnings are ‘EXPECTED’ earnings. They can change faster than your mood. And then, everybody has different expectations.
Interpreting PE Ratio:
Simply put, in the example above, assuming that the stock returns the same level of earnings year after year, you should get back your money in 12 years. If you reverse the PE ratio, you will get the Earning Yield of the stock. Earning Yield is a measure of the return from a stock. In this example, you are getting a return of 100/12 or 8.3% per annum on your investment. Remember that all earnings of a company belong to shareholders. Irrespective of what dividend is being paid out to shareholders in the short term, ultimately all the earnings should flow back to the shareholders. Earning yield is a good measure to consider if you are thinking about choosing between other investment options and stocks for investing your money.
P/E ratio gives you an idea of what the market is willing to pay for the company’s earnings. By relating share prices to actual profits, the P/E ratio highlights the connection between the price and recent company performance. If prices get higher and profits too move up, the ratio stays the same. The ratio moves only when price and profits become disconnected.
For this reason, when the P/E ratio is higher or lower than normal we know that recent profit levels are no longer the main factor in pricing. This might be because market is expecting a change – a change in the performance levels of the company in either direction going forward or a change in the market sentiment. You must make a note of these changes.
A higher P/E means that the market is willing to pay more for a stock compared to another stock with a lower P/E. An interpretation of a high P/E could be that the stock is overpriced. On the other hand, this could also mean that the market has high hopes from the stock in future, and it is factoring in the future earnings of the stock in its current price. Similarly, a low P/E may indicate a stock with low expectations from the market or it could mean an undervalued stock that has been overlooked by the market. Value investors hunt this kind of undervalued stock. Note, however, just because a stock is trading at a low P/E does not mean you should buy it. If it is an undervalued stock, it might be a good bargain. However, if it is a stock, which is not expected to do well in future, you may want to do a little research before you buy it.
You should, however, never consider P/E ratio in isolation. It’s a good measure if you use it for comparison between competitors or with the market or with the same company at different points in time. However, if you choose a telecom company over a steel company based on the difference in their P/E ratio, it may not be a very fruitful exercise.
Different types of P/E Ratios:
Many analysts will use different types of P/E ratios resulting in utter confusion. These can be trailing P/E ratio based on earnings of the last four quarters or forward P/E ratio based on expected earnings of the next four quarters. Using past earnings might not be a great indicator of the future earnings of a stock. However, in reality, past earnings have been better indicators of the future earnings of a stock than the earning forecasts made by stock analyst. It’s not easy to manipulate the value of trailing P/E ratio, as there is no guesswork or wishful thinking involved in calculating it, which is why value investors prefer using trailing P/E while making their investment decisions.
I hope the above post is able to give you a basic understanding of the P/E ratio. The next question in your mind could be what the right P/E for a stock is. I will answer this question in my next post. Stay tuned.
Sunday, May 10, 2009
Fundamental Analysis for Investing in Stocks
There are many investment styles- technical, fundamental, growth investing, value investing, speculating, etc. Fundamental Analysis, as the term suggests, is about the fundamentals of a stock. It focuses on understanding the prospects of the business underlying the stock by analyzing the financials of a company, qualitative factors like management quality and economic factors affecting an economy and industry. The aim of Fundamental Analysis is to uncover the intrinsic value of a stock.
Technical analysis is another type of investment analysis that focuses on the momentum of a stock and doesn’t bother too much with the underlying business. Price history of a stock, current momentum, liquidity in the market, investor sentiments, etc are the key factors in technical analysis. A long-term investor should never bother with technical analysis, as short-term trends do not matter in the long run.
Many investors depend on a combination of technical analysis and fundamental analysis for making decisions regarding stock investment. If you are a long-term investor, and are willing to put in some effort in order to make a decent amount of profit from investing in stocks, you will do a world of good to yourself by doing some fundamental analysis before you invest any money.
To be a good fundamental analyst, one needs to master the art of interpreting financial statements. Fundamental analysis starts with analysis of financial statements and various ratios. It takes into account operating cash flows, earning per share, Price to earning ratio, capital structure, earning estimates, current ratio, debt to equity ratio, etc. A fundamental analyst tries to derive the value of a business based on various valuation models. Some of these models are discounted cash flow model and dividend discount model. Apart from analyzing the past financial data of a business, most models depend on assumptions regarding the future growth and risk associated with the business. This factor makes even fundamental analysis very subjective, leading to divergent views about the value of stock in the eyes of different analysts. For knowing more on these stock evaluation models, you can google the terms highlighted above.
Value investing is not very different from fundamental analysis. If you go through the lessons on how to select stocks, you would have covered a major part of fundamental analysis.
It is very difficult to cover the topic of fundamental analysis in one post. Suffice to say that fundamental analysis involves understanding the businesses behind stocks and presents an investor with opportunities to invest in undervalued stocks. For knowing more on fundamental analysis, you can go through other posts on this blog.
Technical analysis is another type of investment analysis that focuses on the momentum of a stock and doesn’t bother too much with the underlying business. Price history of a stock, current momentum, liquidity in the market, investor sentiments, etc are the key factors in technical analysis. A long-term investor should never bother with technical analysis, as short-term trends do not matter in the long run.
Many investors depend on a combination of technical analysis and fundamental analysis for making decisions regarding stock investment. If you are a long-term investor, and are willing to put in some effort in order to make a decent amount of profit from investing in stocks, you will do a world of good to yourself by doing some fundamental analysis before you invest any money.
To be a good fundamental analyst, one needs to master the art of interpreting financial statements. Fundamental analysis starts with analysis of financial statements and various ratios. It takes into account operating cash flows, earning per share, Price to earning ratio, capital structure, earning estimates, current ratio, debt to equity ratio, etc. A fundamental analyst tries to derive the value of a business based on various valuation models. Some of these models are discounted cash flow model and dividend discount model. Apart from analyzing the past financial data of a business, most models depend on assumptions regarding the future growth and risk associated with the business. This factor makes even fundamental analysis very subjective, leading to divergent views about the value of stock in the eyes of different analysts. For knowing more on these stock evaluation models, you can google the terms highlighted above.
Value investing is not very different from fundamental analysis. If you go through the lessons on how to select stocks, you would have covered a major part of fundamental analysis.
It is very difficult to cover the topic of fundamental analysis in one post. Suffice to say that fundamental analysis involves understanding the businesses behind stocks and presents an investor with opportunities to invest in undervalued stocks. For knowing more on fundamental analysis, you can go through other posts on this blog.
Friday, April 10, 2009
Value Investing: How to find a value stock
Whenever somebody talks about ‘Growth Stocks’, he or she also talks about ‘ Value Stocks’ in the same breath as both these types of stocks are considered two primary types of investment worthy stocks. In my last post, I talked about ‘Growth Stocks’. It’s but natural that this post is about Value Stocks and the philosophy behind picking a value stock i.e. Value Investing.
My whole blog is primarily about value investing because this is perhaps the most robust and least risky way of investing in stock marekt. Legendary investment guru Benjamin Graham and his equally legendary disciple Warren Buffett have made ‘Value Investing’ very popular amongst investors. Practising value investing requires some amount of effort and patience from an investor. Which is why though value investing is a much talked about term, it’s not really widely practiced despite its obvious advantages.
The concept of value investing revolves around investing in stocks that are trading at a price levels lower than their ‘intrinsic value’ or their real worth. The fundamental thing to remember in value investing is that when you are buying a stock of a company, you are essentially investing in the business of the company. You should buy a stock only if you believe that the business behind the stock will be able to give you good returns on your investment. Before investing in its stock, you should assess the business fundamentals, earning stability and growth, financial structure, dividend record and the management quality of the company. A value investors pays special attention to the principle of margin of safety before investing in a stock. A company can be running a great business, but if its stock is priced at a higher level than its intrinsic value, it’s not worth investing in it. Similarly, a company might be in under distress and may have lost the confidence of investors for a temporary period; but it could be a great buy if the intrinsic value of the stock is much higher compared to the current stock price after taking into account the risk factors.
For a full understanding of how you should go about selecting a value stock, you can read the series of posts on ‘How to Select a Stock for Investing’ on my blog as given below:
How to Select a Stock - Part I- Understanding a Business
How to Select a Stock - Part II- Success Levers
How to Select a Stock- Part III- Earning Record
How to Select a Stock- Part IV- Financial Stability
How to select a stock- Part V- Retained Earnings and Dividend Income
How to Select a Stock- Part VI- Management Quality
How to select a stock- Part VII- Finding the right price of a stock
A value investor doesn’t pay attention to trends in the stock market. There are various reasons why a stock price moves in the stock market in the short term. However, in the long run, it is the fundamentals of the company that drive the stock price. If you have done your analysis thoroughly following the value investing philosophy and you are a long-term investor, the chances of your investment going awry are almost zero.
My whole blog is primarily about value investing because this is perhaps the most robust and least risky way of investing in stock marekt. Legendary investment guru Benjamin Graham and his equally legendary disciple Warren Buffett have made ‘Value Investing’ very popular amongst investors. Practising value investing requires some amount of effort and patience from an investor. Which is why though value investing is a much talked about term, it’s not really widely practiced despite its obvious advantages.
The concept of value investing revolves around investing in stocks that are trading at a price levels lower than their ‘intrinsic value’ or their real worth. The fundamental thing to remember in value investing is that when you are buying a stock of a company, you are essentially investing in the business of the company. You should buy a stock only if you believe that the business behind the stock will be able to give you good returns on your investment. Before investing in its stock, you should assess the business fundamentals, earning stability and growth, financial structure, dividend record and the management quality of the company. A value investors pays special attention to the principle of margin of safety before investing in a stock. A company can be running a great business, but if its stock is priced at a higher level than its intrinsic value, it’s not worth investing in it. Similarly, a company might be in under distress and may have lost the confidence of investors for a temporary period; but it could be a great buy if the intrinsic value of the stock is much higher compared to the current stock price after taking into account the risk factors.
For a full understanding of how you should go about selecting a value stock, you can read the series of posts on ‘How to Select a Stock for Investing’ on my blog as given below:
How to Select a Stock - Part I- Understanding a Business
How to Select a Stock - Part II- Success Levers
How to Select a Stock- Part III- Earning Record
How to Select a Stock- Part IV- Financial Stability
How to select a stock- Part V- Retained Earnings and Dividend Income
How to Select a Stock- Part VI- Management Quality
How to select a stock- Part VII- Finding the right price of a stock
A value investor doesn’t pay attention to trends in the stock market. There are various reasons why a stock price moves in the stock market in the short term. However, in the long run, it is the fundamentals of the company that drive the stock price. If you have done your analysis thoroughly following the value investing philosophy and you are a long-term investor, the chances of your investment going awry are almost zero.
Sunday, April 5, 2009
How to find a Growth Stock- what makes a stock a Growth Stock
A growth stock, by definition, is a stock that has a growth rate much superior to average growth rate of the stock market. Ideally, the earning growth demonstrated by a growth stock should be growing at far higher rate than an average stock in the stock market. When people talk about growth stocks, they invariably talk about value stocks in the same breath. The key difference is that much of the valuation of a growth stock depends on its future performance and the valuation of a value stock depends primarily on its past performance.
You should be very clear about two things. First, what growth a growth stock is, and second, whether what people are claiming as a growth stock is really a growth stock.
Let’s try to first understand what a real growth stock is. A real growth stock is a stock that has been showing an above average growth rate in its earning and sales over the last 4-5 years consistently without compromising on its business fundamentals and financial future. If a company has been funding its growth through unsafe loans, which will cripple its earning capacity in near future, it can’t be called a growth stock. You should also pay attention to growth in per share earning on diluted basis ( earning per share after taking into account preferential shares, warrants, stock options, etc). The earnings overall might have grown, but have earnings per share grown? If not, then, the stock can’t be called a growth stock. After all, you will pay premium for the expected growth of earning per share in future. If the company management has not grown per share earning in the past, you can’t just trust it to do so in future.
A growth stock should never be considered for its growth alone. Consistent growth in earnings could be a reason why you want to evaluate it for investment purpose. However, make sure that you analyze the stock thoroughly the way you will analyze any other stock. You can be a little liberal in assessing a growth stock in a few parameters like Price to Earning Ratio or Dividend Payment. However, there should not be any let up in the assessment of the financial stability and management quality.
In a growth stock, the earning growth should more than make up for the liberal PE ratio or lower dividend payment. While evaluating a growth stock, be especially careful to take into account a few other factors like:
· Net Current Asset Value in order to determine the financial viability of the firm in question
· Current Asset Value in order to determine short-term financial viability of the firm
· Debt to equity ratio
· Quality of the Current Assets.
· Performance and the credibility of the management
· Change of management in recent years and its impact
How should you find whether a so-called growth stock is really a growth stock or not? If you browse through recommendations of many investment analysts in the current environment, you will find that many of them claim that they are following growth-investing philosophy while recommending stocks. Most of them have favorite stocks that have shown promise in recent years. These stocks would have grown their sales and earnings at exponential rates in the last 2-3 years. Based on this sudden spurt in their performance in the recent past, analysts start recommending these stocks as growth stocks. As is expected, many lay investors blindly jump in to investing in these so called ‘growth stocks’ without even understanding the businesses behind these stocks. These stocks are not growth stocks; instead they are fashion stocks. Every once in a while stock markets come up with their favorite fashion stocks which are bought and sold blindly without any consideration to their underlying business value. A little peek into the history should keep us sane as most often these misinformed investment result in disastrous returns and heartbreaks. Before investing in any stock, you need to analyze it thoroughly to be confident of its value as explained in this post earlier.
You should be very clear about two things. First, what growth a growth stock is, and second, whether what people are claiming as a growth stock is really a growth stock.
Let’s try to first understand what a real growth stock is. A real growth stock is a stock that has been showing an above average growth rate in its earning and sales over the last 4-5 years consistently without compromising on its business fundamentals and financial future. If a company has been funding its growth through unsafe loans, which will cripple its earning capacity in near future, it can’t be called a growth stock. You should also pay attention to growth in per share earning on diluted basis ( earning per share after taking into account preferential shares, warrants, stock options, etc). The earnings overall might have grown, but have earnings per share grown? If not, then, the stock can’t be called a growth stock. After all, you will pay premium for the expected growth of earning per share in future. If the company management has not grown per share earning in the past, you can’t just trust it to do so in future.
A growth stock should never be considered for its growth alone. Consistent growth in earnings could be a reason why you want to evaluate it for investment purpose. However, make sure that you analyze the stock thoroughly the way you will analyze any other stock. You can be a little liberal in assessing a growth stock in a few parameters like Price to Earning Ratio or Dividend Payment. However, there should not be any let up in the assessment of the financial stability and management quality.
In a growth stock, the earning growth should more than make up for the liberal PE ratio or lower dividend payment. While evaluating a growth stock, be especially careful to take into account a few other factors like:
· Net Current Asset Value in order to determine the financial viability of the firm in question
· Current Asset Value in order to determine short-term financial viability of the firm
· Debt to equity ratio
· Quality of the Current Assets.
· Performance and the credibility of the management
· Change of management in recent years and its impact
How should you find whether a so-called growth stock is really a growth stock or not? If you browse through recommendations of many investment analysts in the current environment, you will find that many of them claim that they are following growth-investing philosophy while recommending stocks. Most of them have favorite stocks that have shown promise in recent years. These stocks would have grown their sales and earnings at exponential rates in the last 2-3 years. Based on this sudden spurt in their performance in the recent past, analysts start recommending these stocks as growth stocks. As is expected, many lay investors blindly jump in to investing in these so called ‘growth stocks’ without even understanding the businesses behind these stocks. These stocks are not growth stocks; instead they are fashion stocks. Every once in a while stock markets come up with their favorite fashion stocks which are bought and sold blindly without any consideration to their underlying business value. A little peek into the history should keep us sane as most often these misinformed investment result in disastrous returns and heartbreaks. Before investing in any stock, you need to analyze it thoroughly to be confident of its value as explained in this post earlier.
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Saturday, March 21, 2009
What is the right time to buy a stock?
How should an investor decide the right time to buy a stock? Many investors are interested in entering the stock market, but are not very sure about their timing.
Let’s try to work around this problem.
In the short term, nobody knows which direction a stock price is going to move in. It can go up or down depending on various factors including stock market sentiments, liquidity in the market, etc. However, if you have done a good amount of research on a stock and are convinced that the stock is undervalued presently and offers good margin of safety, you should go ahead and buy the stock. Here, I am assuming that you are not a short-term investor (that’s an oxymoron though- an investor can only be for long term. For short term, you have speculators) and you have sufficient patience to be able to reap the rewards of your efforts in future. If you keep holding the stock and your research on the stock was sound, the market will discover the true value of the stock and reward you with good return on your investment. The key here is to buy cheap and have patience.
If you are looking to make money in short term, there is no sure fire strategy. You can as well try your luck in a casino.
Many retail investors start thinking about entering the stock market when the market is in a bull phase. This is a general tendency of beginners as they see many people making profits (some realized and much unrealized!) on their stock market investments. During the peak of a bull phase, stock markets see entry of all kind of investors and speculators. At this stage, you will see that anybody and everybody, who doesn’t know anything about stocks, is talking about purchasing shares and giving tips on which stocks to buy. At such times, stock prices get very heated as there is huge demand for stocks and many stocks see unrealistically high prices that do not justify their underlying business valuation. You will still see promising companies but you will rarely see any stock that can be bought at a cheap price with a good margin of safety. In such times, you should not buy a stock or think about entering the stock market. In fact, this is the time to get out of the stock market, as a fall may not be far away.
A corollary of the above discussion is that a bear market is a good time to buy stocks for a long-term investor. You will find that many good businesses that are generating good returns consistently have come under the spell of bears. Fortunately or unfortunately, investors act in hordes. Even great businesses can be found trading at huge discounts in a bear market. As an investor, you should hunt for bargain stocks in a bear market. You will not be disappointed. The key again is to ensure that you are confident about the value of the stock and the business behind it.
Let’s try to work around this problem.
In the short term, nobody knows which direction a stock price is going to move in. It can go up or down depending on various factors including stock market sentiments, liquidity in the market, etc. However, if you have done a good amount of research on a stock and are convinced that the stock is undervalued presently and offers good margin of safety, you should go ahead and buy the stock. Here, I am assuming that you are not a short-term investor (that’s an oxymoron though- an investor can only be for long term. For short term, you have speculators) and you have sufficient patience to be able to reap the rewards of your efforts in future. If you keep holding the stock and your research on the stock was sound, the market will discover the true value of the stock and reward you with good return on your investment. The key here is to buy cheap and have patience.
If you are looking to make money in short term, there is no sure fire strategy. You can as well try your luck in a casino.
Many retail investors start thinking about entering the stock market when the market is in a bull phase. This is a general tendency of beginners as they see many people making profits (some realized and much unrealized!) on their stock market investments. During the peak of a bull phase, stock markets see entry of all kind of investors and speculators. At this stage, you will see that anybody and everybody, who doesn’t know anything about stocks, is talking about purchasing shares and giving tips on which stocks to buy. At such times, stock prices get very heated as there is huge demand for stocks and many stocks see unrealistically high prices that do not justify their underlying business valuation. You will still see promising companies but you will rarely see any stock that can be bought at a cheap price with a good margin of safety. In such times, you should not buy a stock or think about entering the stock market. In fact, this is the time to get out of the stock market, as a fall may not be far away.
A corollary of the above discussion is that a bear market is a good time to buy stocks for a long-term investor. You will find that many good businesses that are generating good returns consistently have come under the spell of bears. Fortunately or unfortunately, investors act in hordes. Even great businesses can be found trading at huge discounts in a bear market. As an investor, you should hunt for bargain stocks in a bear market. You will not be disappointed. The key again is to ensure that you are confident about the value of the stock and the business behind it.
Saturday, March 14, 2009
How to select a stock- Part VII- Finding the right price of a stock
In this post, we will learn about how to find the right price for a stock. Many people confuse good companies with a good stock. If they like a company’s business model, they purchase its stock without any consideration of the price it is trading at. What matters more in investment is that you have bought a stock at the right price. If you have bought stocks of a great company at a very high price level, it may not turn out to be a great investment. On the contrary, if you have bought stocks of a good company at a good price level (cheap), you may get good return on your investment. It’s important to buy cheap.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!
A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.
The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.
Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.
With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.
Sunday, March 8, 2009
How to Select a Stock- Part VI- Management Quality
While investing in stocks, one very important issue is that whether you can trust the management of the company for taking it to greater heights in future. If you can’t trust the management, you can’t trust the stock for giving you good returns. Let me explain. Imagine that you are going on a cruise, and, suddenly, you found out that the captain of the ship has been through three shipwrecks earlier; and on all three occasions he saved his life and left all passengers to die. What will you do? Of course, you will cancel your plans of going on that cruise. You got the point. Even if the business fundamentals are strong for a company, poor management can, and will, take it down.
There are a few things that you need to assess in the management of the company.
Focus: A sound management focuses on key issues that drive value for the business. If a management understands its role and the requirement of a business well, it will focus on taking actions that will drive growth and profitability of the business. However, if you notice that the management is focusing on unimportant or inexplicable issues, you should be wary of investing in such companies. If you notice that the management is not able to do justice to its current business and is trying to diversify into seemingly unrelated businesses, this could be an indication that the management is indulging in diversionary tactics to avoid attention to their non-performance in the existing line of business. A sound management knows its business well and focuses on building it by venturing into territories it can traverse well.
Past record & Consistency: Check out the past record of the management and see how they have grown business in the past. Go through past annual reports, dig into the management discussion and analysis section and see how they have been faring on their plans and promises on year-on-year basis. If you see lack of consistency on promises, plans, actions and results, there is a reason for you to investigate further.
If the management has been indulging more in media activities than on business, there might be a need to look into the capabilities of the management further. If there has been
a change in the top brass of the company recently, you need to check the past records of the recently joined management personnel.
Do look into the share buy-backs announced by the company. If the share buy back has happened at the time when the stock prices are down and below the ‘intrinsic value’, it’s a great thing for a stockholder. It will most probably result in increased value for shareholder in future. However, if the share buy-backs have been announced in a bull market when the prices are hyped and beyond the reasonable value of the stock, you should be careful.
Check out how the management has grown the company year on year. If the company has allocated its retained earnings well and increased its profit with better-than-usual market rate, it’s a sign of a good management. However, if the company has not been able to grow its profits on consistent basis, and has not shared its earnings with the shareholders in the form of dividend, you have a reason to question the ability of the management.
Integrity: Make sure that the company you are investing in has got a management with unquestionable integrity. With many corporate frauds being discovered in these days, you don’t want to get trapped in a company that has falsified its records or has got management that can go to any extent to hide their actual performance. A little bit of internet search on the names of the management along with key words like ‘fraud’, ‘court case’, ‘criminal case’, etc will unearth enough details for you to consider.
Instances of crises actually give you a very good understanding of the character of the management. If the management has been candid in accepting the issues, handled the situation with maturity, and proactively taken steps to overcome difficulties, you can rest assured about the quality of management.
You should also check out management rewards announced by the company. If there are instances of management rewarding itself with plump bonuses and obscene stock options without a credible link to growth in profits of the company, you have a reason to worry.
In conclusion, though judgment on the management quality of the company is based on many qualitative factors, you should do everything in your limits to understand this factor as it going to be the key factor that will decide the future earnings through your stock.
In the next post, which is going to be the last post in this series of ‘how to select a stock for investing’, I will explain a few basic things that will help you decide how you can identify a right price for a good stock.
There are a few things that you need to assess in the management of the company.
Focus: A sound management focuses on key issues that drive value for the business. If a management understands its role and the requirement of a business well, it will focus on taking actions that will drive growth and profitability of the business. However, if you notice that the management is focusing on unimportant or inexplicable issues, you should be wary of investing in such companies. If you notice that the management is not able to do justice to its current business and is trying to diversify into seemingly unrelated businesses, this could be an indication that the management is indulging in diversionary tactics to avoid attention to their non-performance in the existing line of business. A sound management knows its business well and focuses on building it by venturing into territories it can traverse well.
Past record & Consistency: Check out the past record of the management and see how they have grown business in the past. Go through past annual reports, dig into the management discussion and analysis section and see how they have been faring on their plans and promises on year-on-year basis. If you see lack of consistency on promises, plans, actions and results, there is a reason for you to investigate further.
If the management has been indulging more in media activities than on business, there might be a need to look into the capabilities of the management further. If there has been
a change in the top brass of the company recently, you need to check the past records of the recently joined management personnel.
Do look into the share buy-backs announced by the company. If the share buy back has happened at the time when the stock prices are down and below the ‘intrinsic value’, it’s a great thing for a stockholder. It will most probably result in increased value for shareholder in future. However, if the share buy-backs have been announced in a bull market when the prices are hyped and beyond the reasonable value of the stock, you should be careful.
Check out how the management has grown the company year on year. If the company has allocated its retained earnings well and increased its profit with better-than-usual market rate, it’s a sign of a good management. However, if the company has not been able to grow its profits on consistent basis, and has not shared its earnings with the shareholders in the form of dividend, you have a reason to question the ability of the management.
Integrity: Make sure that the company you are investing in has got a management with unquestionable integrity. With many corporate frauds being discovered in these days, you don’t want to get trapped in a company that has falsified its records or has got management that can go to any extent to hide their actual performance. A little bit of internet search on the names of the management along with key words like ‘fraud’, ‘court case’, ‘criminal case’, etc will unearth enough details for you to consider.
Instances of crises actually give you a very good understanding of the character of the management. If the management has been candid in accepting the issues, handled the situation with maturity, and proactively taken steps to overcome difficulties, you can rest assured about the quality of management.
You should also check out management rewards announced by the company. If there are instances of management rewarding itself with plump bonuses and obscene stock options without a credible link to growth in profits of the company, you have a reason to worry.
In conclusion, though judgment on the management quality of the company is based on many qualitative factors, you should do everything in your limits to understand this factor as it going to be the key factor that will decide the future earnings through your stock.
In the next post, which is going to be the last post in this series of ‘how to select a stock for investing’, I will explain a few basic things that will help you decide how you can identify a right price for a good stock.
Sunday, February 22, 2009
How to select a stock- Part V- Retained Earnings and Dividend Income
When you are thinking about investing in a company by owning its common stock, you need to see whether the company is using the profit generated in the best possible manner. There are two ways in which a company can make use of its earnings- return a part of the profits to its shareholders by paying dividend or use the earnings profitably to grow the earnings of the future.
Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.
You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.
You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.
You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.
You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.
We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.
Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.
You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.
You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.
You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.
You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.
We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.
Saturday, February 14, 2009
How to Select a Stock- Part IV- Financial Stability
In this post we will try to learn how we can ensure that the money we are going to invest in a company doesn’t go down the drain. Essentially, we will try to evaluate the intrinsic financial soundness of the company and understand the financial ratios or filters that we need to apply to remove risky companies from our consideration set.
Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.
Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.
Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.
Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.
Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.
While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.
Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.
Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.
Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.
Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.
Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.
While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.
Sunday, February 8, 2009
How to Select a Stock- Part III- Earning Record
When you are investing in the stock of a company, you need to understand the past earning record of the company. The objective should be to avoid the companies that have been losing money from your consideration set.
Grab last five- ten years annual reports of the company you are researching and go through them. If you are not able to get the annual reports, with a little research on the internet, you will find many sources where you can get last ten years earning record of all listed companies.
The company should have a consistent record of positive earnings for the last ten years. Many companies are able to give one or two years of good performance, and then they start giving erratic performance. Do not trust these companies with your money.
Consistent record of positive earning is a necessary condition but not necessarily a sufficient one for you to trust a company with your money. Ideally, a company should be considered only if it has been growing its earnings over the last ten years. Adding this filter will help you make your consideration set a lot safer.
Another thing to look for in a company’s past performance is the cash it is generating from operating activities. You will get these details in the Cash flow statement of the company. There are three heads of cash flow- Operating Activities, Financing Activities and Investing Activities. Cash flow from the operating activities is the most important cash flow component. This is the actual cash the company is generating from its business. Cash flow from investing activities is the cash flow from investment in financial markets or the cash consumed by investment in capital assets such as machinery, plant, etc. Cash flow from financing activities is the cash flow resulting from issuing stock dividends, taking or paying debt and issuing stocks. If a company is not able to fund its growth from the cash it generates from its business, and is instead relying on loan, it may not be a great thing. Of course, if a company is in its early stages, it may have to fund its growth through loans or issuance of stocks. However, growth funded through cash generated from operating activities is a lot safer than the growth funded through cash generated from financing activities. Here, you need to take a call based on your own judgment of the situation.
Understanding the stability and growth of earnings of companies helps you wean out the losers from your list of stocks to invest in and ensures that you are not investing in stocks that may bleed you later.
This is it for today..
Grab last five- ten years annual reports of the company you are researching and go through them. If you are not able to get the annual reports, with a little research on the internet, you will find many sources where you can get last ten years earning record of all listed companies.
The company should have a consistent record of positive earnings for the last ten years. Many companies are able to give one or two years of good performance, and then they start giving erratic performance. Do not trust these companies with your money.
Consistent record of positive earning is a necessary condition but not necessarily a sufficient one for you to trust a company with your money. Ideally, a company should be considered only if it has been growing its earnings over the last ten years. Adding this filter will help you make your consideration set a lot safer.
Another thing to look for in a company’s past performance is the cash it is generating from operating activities. You will get these details in the Cash flow statement of the company. There are three heads of cash flow- Operating Activities, Financing Activities and Investing Activities. Cash flow from the operating activities is the most important cash flow component. This is the actual cash the company is generating from its business. Cash flow from investing activities is the cash flow from investment in financial markets or the cash consumed by investment in capital assets such as machinery, plant, etc. Cash flow from financing activities is the cash flow resulting from issuing stock dividends, taking or paying debt and issuing stocks. If a company is not able to fund its growth from the cash it generates from its business, and is instead relying on loan, it may not be a great thing. Of course, if a company is in its early stages, it may have to fund its growth through loans or issuance of stocks. However, growth funded through cash generated from operating activities is a lot safer than the growth funded through cash generated from financing activities. Here, you need to take a call based on your own judgment of the situation.
Understanding the stability and growth of earnings of companies helps you wean out the losers from your list of stocks to invest in and ensures that you are not investing in stocks that may bleed you later.
This is it for today..
Tuesday, February 3, 2009
How to Select a Stock - Part II- Success Levers
In my previous post I tried to explain how you could understand a business. The next step is to research a company and try to figure out whether its stock can be a good investment bet or not.
I am trying to stay away from giving specific examples, as I don’t want to bias you towards or against any specific stocks. Secondly, specific stocks from a geography may not make sense to readers from another geography. This makes my job a bit tougher as specific examples aid a lot in understanding a concept. But I shall try and make my posts as simple to understand as possible.
First of all, you need to understand what differentiates the company you are researching from its competitors. There are various levers of attracting customers that an organization can use to grow its revenue and profits- brand, research and development, customer service, cost advantage, economy of scale, efficient operations, etc. You need to understand which of these levers a company is using and how successfully.
If the company is using operational efficiency, cost advantage or economy of scale as its lever, it is going to attract customers who are cost conscious. Hence, it will be extremely important for the company to be able to stay at the forefront of operational efficiency by investing in its supply chain management, adopting new processes and keeping its cost of production or service low. You need to ask whether the company will be able to maintain its lead over its competitors by investing in the necessary upgrades or initiatives. This lever gives advantage to a company but requires them to continuously work hard and stay ahead of the competition.
If the company is using customer service and experience as its success lever, you need to understand the company’s capability in maintaining the loyalty of its customers by providing excellent customer experience every time a customer interacts with it. Generally, this lever is very strong and provides a long term advantage to the company as the customers start bonding with the company and don’t leave it until the company gives them strong reasons to defect.
Research and development provides another success lever to companies. Many product companies use this lever to create loyalty amongst customers. These companies focus a lot on creating a culture of innovation within the organization. However, you should be able to ascertain whether the company in question is designing products or conducting research keeping the interests of the customers in mind. Many companies get trapped in new technology development without knowing how they are going to use it. This proves to be fatal for them. Research and Development lever can be used successfully by continuously engaging in customer focused research and product development.
At the end of this analysis, you should be able to answer this question- if a customer has to buy a product or service, which is also offered by the company you are researching, will he buy it from the company? If yes, why? And what will make him coming back?
If your answers to these questions are in the favor of the company you are researching, you have found a potential winner. But this is not the end of your quest for finding a winning stock. There are a few more things you need to do. I will cover them in my coming posts. If you have any queries regarding this post, let me know.
I am trying to stay away from giving specific examples, as I don’t want to bias you towards or against any specific stocks. Secondly, specific stocks from a geography may not make sense to readers from another geography. This makes my job a bit tougher as specific examples aid a lot in understanding a concept. But I shall try and make my posts as simple to understand as possible.
First of all, you need to understand what differentiates the company you are researching from its competitors. There are various levers of attracting customers that an organization can use to grow its revenue and profits- brand, research and development, customer service, cost advantage, economy of scale, efficient operations, etc. You need to understand which of these levers a company is using and how successfully.
If the company is using operational efficiency, cost advantage or economy of scale as its lever, it is going to attract customers who are cost conscious. Hence, it will be extremely important for the company to be able to stay at the forefront of operational efficiency by investing in its supply chain management, adopting new processes and keeping its cost of production or service low. You need to ask whether the company will be able to maintain its lead over its competitors by investing in the necessary upgrades or initiatives. This lever gives advantage to a company but requires them to continuously work hard and stay ahead of the competition.
If the company is using customer service and experience as its success lever, you need to understand the company’s capability in maintaining the loyalty of its customers by providing excellent customer experience every time a customer interacts with it. Generally, this lever is very strong and provides a long term advantage to the company as the customers start bonding with the company and don’t leave it until the company gives them strong reasons to defect.
Research and development provides another success lever to companies. Many product companies use this lever to create loyalty amongst customers. These companies focus a lot on creating a culture of innovation within the organization. However, you should be able to ascertain whether the company in question is designing products or conducting research keeping the interests of the customers in mind. Many companies get trapped in new technology development without knowing how they are going to use it. This proves to be fatal for them. Research and Development lever can be used successfully by continuously engaging in customer focused research and product development.
At the end of this analysis, you should be able to answer this question- if a customer has to buy a product or service, which is also offered by the company you are researching, will he buy it from the company? If yes, why? And what will make him coming back?
If your answers to these questions are in the favor of the company you are researching, you have found a potential winner. But this is not the end of your quest for finding a winning stock. There are a few more things you need to do. I will cover them in my coming posts. If you have any queries regarding this post, let me know.
Saturday, January 24, 2009
How to Select a Stock - Part I- Understanding a Business
In my previous post, I wrote that you need to make intelligent guesses to select a good stock. How do you do that is the topic of this post. There are many factors you should consider before you take a decision to invest in a stock. In this post I will talk about the most important thing you need to do before you take a decision.
You need to understand the business you want to invest in. You can ask why should you do that. After all, a stock price is just a number that keeps changing on a ticker. All you need to figure out is when and how this number changes. There are short cuts and there are long-winded ways to figure this out. Unfortunately, I am a believer in old-fashioned long-winded ways of doing things. Fortunately, these methods work. After having invested in stock market for some time and observing various players in the market, I have come to believe that all short cuts fall short of making money for you on a consistent basis. You need to face a reality here. If you want to invest in a stock, understand that you are going to own a company (even if you own only one share of a company, you technically become a partial owner of the company!) Does that make you want to buy a stock now? J Now, owning a business is not easy. You don’t want to own a business without knowing how it works. Try finding out everything you can to figure out the details of the business- key success factors, dynamics of the business, which companies are doing well, why they are doing well, what’s future going to look like, etc. And if all of this looks overwhelming, let me assure you it’s not. Even if you spend 2 hours every day for a week, you will be able to collect sufficient information on any business. To make it easy, start with a business you are already familiar with. This could be an industry you work in, or a business you are interested in, or any business you somehow have managed to understand to an extent.
If you are not willing to do this much of research, I am afraid you should not be thinking about investing in stocks. It’s very easy for me to tempt you into investing assuring you that you don’t need to devote much time. But that will be a lie- a lie that many people have used to fool innocent beginners- a lie that has been causing misery to many retail investors for decades. But if you are willing to invest some time in conducting research, I can assure you that you will reap rich rewards. Every second you invest in conducting research will be worth it.
Now, let’s talk about ways to understand a business. A very simple way could be using Google. You can read through industry reports, analyst reports, articles, etc on the industry and company to understand the basic dynamics of a business and relative standing of the company you are focusing on. A caveat though, use stock analyst reports only for understanding the dynamics of the business. You don’t have to believe their recommendation entirely. Stock analysts have their own reasons to recommend a stock.
Other ways of understanding a business could be speaking to somebody who is currently in the same business. You could also go through the annual reports of the company you are researching to understand the intricacies of the business.
At the end of your research you should be able to answer these questions:
1. What are the things that are required for a company to succeed in this business?
2. Who are the main players and what is their relative standing in the market?
3. Which companies have got competitive advantage over others in the industry and why?
3. What can change the fortunes of a company in this business?
4. How the future looks like for the business and the company?
5. If you come to know about an important event related with economy or industry, will you be able to assess its impact on the business?
If you are able to understand a business, you have taken your first step towards being a retail investor. There are a few more steps like past financial performance, quality of management, future growth potential, etc which you need to understand before you select a stock. I will discuss about them in my next few posts.
Till then, have fun.
You need to understand the business you want to invest in. You can ask why should you do that. After all, a stock price is just a number that keeps changing on a ticker. All you need to figure out is when and how this number changes. There are short cuts and there are long-winded ways to figure this out. Unfortunately, I am a believer in old-fashioned long-winded ways of doing things. Fortunately, these methods work. After having invested in stock market for some time and observing various players in the market, I have come to believe that all short cuts fall short of making money for you on a consistent basis. You need to face a reality here. If you want to invest in a stock, understand that you are going to own a company (even if you own only one share of a company, you technically become a partial owner of the company!) Does that make you want to buy a stock now? J Now, owning a business is not easy. You don’t want to own a business without knowing how it works. Try finding out everything you can to figure out the details of the business- key success factors, dynamics of the business, which companies are doing well, why they are doing well, what’s future going to look like, etc. And if all of this looks overwhelming, let me assure you it’s not. Even if you spend 2 hours every day for a week, you will be able to collect sufficient information on any business. To make it easy, start with a business you are already familiar with. This could be an industry you work in, or a business you are interested in, or any business you somehow have managed to understand to an extent.
If you are not willing to do this much of research, I am afraid you should not be thinking about investing in stocks. It’s very easy for me to tempt you into investing assuring you that you don’t need to devote much time. But that will be a lie- a lie that many people have used to fool innocent beginners- a lie that has been causing misery to many retail investors for decades. But if you are willing to invest some time in conducting research, I can assure you that you will reap rich rewards. Every second you invest in conducting research will be worth it.
Now, let’s talk about ways to understand a business. A very simple way could be using Google. You can read through industry reports, analyst reports, articles, etc on the industry and company to understand the basic dynamics of a business and relative standing of the company you are focusing on. A caveat though, use stock analyst reports only for understanding the dynamics of the business. You don’t have to believe their recommendation entirely. Stock analysts have their own reasons to recommend a stock.
Other ways of understanding a business could be speaking to somebody who is currently in the same business. You could also go through the annual reports of the company you are researching to understand the intricacies of the business.
At the end of your research you should be able to answer these questions:
1. What are the things that are required for a company to succeed in this business?
2. Who are the main players and what is their relative standing in the market?
3. Which companies have got competitive advantage over others in the industry and why?
3. What can change the fortunes of a company in this business?
4. How the future looks like for the business and the company?
5. If you come to know about an important event related with economy or industry, will you be able to assess its impact on the business?
If you are able to understand a business, you have taken your first step towards being a retail investor. There are a few more steps like past financial performance, quality of management, future growth potential, etc which you need to understand before you select a stock. I will discuss about them in my next few posts.
Till then, have fun.
Friday, January 16, 2009
How to select a stock- Value and Price of a stock
While many of you are aware that by owning a stock you own a company partially, I am not sure if everybody knows how a stock is valued or how its price is determined. For most of us, it is a number that keeps moving up and down based on the whims and fancies of some unknown factors. Most retail investors invest in a stock not on the basis of their research, but on the basis of tips and market rumors. Which is what makes investing in stocks a thrilling but self-defeating activity for most of them.
I think it’s important that we learn how a stock is valued and priced. This should give us an insight into how to select a promising stock later.
So, what is the value of a stock? Plainly put, it is the cumulative present value of the money the company makes at present and in future, divided by the number of total shares with various shareholders. How do you calculate it? Again putting very simplistically, you need to know the amount of cash the company is currently generating and will be generating in future. Calculate the present value of all this cash and divide it by the number of shares (I will not be getting into detailed calculations, as it’s not required. If you are more interested in finding out actual calculation, you can google ‘calculate intrinsic stock value’.) And you got the intrinsic value of a stock. Another method would be looking at the possible dividend stream of the company (current and future) and calculating its present value. Does this give you the actual price of a stock? No. I know you are disappointed with this answer and are wondering why on earth did I explain all this if the answer was going to be a ‘No’.
Let me try to explain.
When you calculate the value of a stock using any of the two methods given above, you have found out ‘intrinsic’ or ‘fair’ value of a stock. Unfortunately, calculating this value requires you to assume quite a few things including possible growth rate of the earnings as well as average discount rate (the rate of return for a risk free investment like government bonds). These assumptions vary based on each individual’s perception of the future. Therefore, agreeing on one particular value of intrinsic or fair value of a stock itself is a difficult task.
There are some other factors too. You would have seen stock prices moving by more than 10 to 20% in one single trading session for a few stocks. Does that mean that the value of a stock has changed in a single session? No. But the perceived value of the stock has changed. And all of us may have different perceived values for the same stock. Which is what matters as none of us know the actual intrinsic value of a stock. All of us can make guesses. Some of us make intelligent guesses. Some of us make foolish guesses. The difference in perceived values of a stock in the eyes of different people keeps a stock price moving. Factors like supply and demand of a stock, economic conditions, market sentiments, liquidity in the market, etc apart from the intrinsic value play a major role in determining the price of a stock at any point in time. You would have seen many stocks tanking by more than 30%-50% in the recent economic downturn. This is because now the perception about the future of these stocks has changed in the eyes of the investors.
All this is fine. But how can we ensure that we make money in the stock market. The answer is simple- by making intelligent guesses rather than foolish ones. How do we do that- that will be the subject of my next post. Till then, think about what I have written in this post.
I think it’s important that we learn how a stock is valued and priced. This should give us an insight into how to select a promising stock later.
So, what is the value of a stock? Plainly put, it is the cumulative present value of the money the company makes at present and in future, divided by the number of total shares with various shareholders. How do you calculate it? Again putting very simplistically, you need to know the amount of cash the company is currently generating and will be generating in future. Calculate the present value of all this cash and divide it by the number of shares (I will not be getting into detailed calculations, as it’s not required. If you are more interested in finding out actual calculation, you can google ‘calculate intrinsic stock value’.) And you got the intrinsic value of a stock. Another method would be looking at the possible dividend stream of the company (current and future) and calculating its present value. Does this give you the actual price of a stock? No. I know you are disappointed with this answer and are wondering why on earth did I explain all this if the answer was going to be a ‘No’.
Let me try to explain.
When you calculate the value of a stock using any of the two methods given above, you have found out ‘intrinsic’ or ‘fair’ value of a stock. Unfortunately, calculating this value requires you to assume quite a few things including possible growth rate of the earnings as well as average discount rate (the rate of return for a risk free investment like government bonds). These assumptions vary based on each individual’s perception of the future. Therefore, agreeing on one particular value of intrinsic or fair value of a stock itself is a difficult task.
There are some other factors too. You would have seen stock prices moving by more than 10 to 20% in one single trading session for a few stocks. Does that mean that the value of a stock has changed in a single session? No. But the perceived value of the stock has changed. And all of us may have different perceived values for the same stock. Which is what matters as none of us know the actual intrinsic value of a stock. All of us can make guesses. Some of us make intelligent guesses. Some of us make foolish guesses. The difference in perceived values of a stock in the eyes of different people keeps a stock price moving. Factors like supply and demand of a stock, economic conditions, market sentiments, liquidity in the market, etc apart from the intrinsic value play a major role in determining the price of a stock at any point in time. You would have seen many stocks tanking by more than 30%-50% in the recent economic downturn. This is because now the perception about the future of these stocks has changed in the eyes of the investors.
All this is fine. But how can we ensure that we make money in the stock market. The answer is simple- by making intelligent guesses rather than foolish ones. How do we do that- that will be the subject of my next post. Till then, think about what I have written in this post.
Sunday, January 11, 2009
Make money by Investing in Stocks
A new investor always grapples with a lot of questions like:
How can I start investing in stocks?
What are the things to know before I start investing?
How should I research a stock?
How much risk should I take?
How long should I invest in a stock for before selling it?
Should I invest in stocks, or mutual funds or derivatives?
How should I select a stock for investing?
How can I ensure that I don’t lose money in the stock market?
So, if you are a new investor, and you are having these questions, don’t worry. All the investors face these questions and struggle finding right answers of these queries. In this blog, I will try to help you find your own answers of these questions to the best of my abilities. However, before we start discussing how to invest in stocks, let’s discuss a few basic issues, which are very important and will lay the foundation of our discussion.
Research: Buy stocks only if you are willing to spend some time researching stocks. If you don’t do research yourself, but still want to invest in stocks, then you should invest in equity oriented mutual funds. Hopefully, you will get decent returns on your money. Finding a good mutual fund in itself will require you to do some research on its past performance vis-à-vis its competitors, current philosophy of investing and fund management. In that sense, there are no free lunches- a little bit of effort is required if you want to make money anywhere. But once you have identified a good mutual fund, you don’t need to actively research stocks.
Investing in stock based on tips, or what others are buying or saying, is like gambling. And you don’t want to gamble with your money. If you still want to go ahead with gambling, then there so many other places to lose money.
Day trading: Only people who benefit from day trading on continuous basis are stockbrokers. They make money irrespective of your loss or profit, as they earn a percentage on every transaction you do. I have not seen anybody else making money consistently in day trading. If you have been lucky, may be you will make a few quick bucks. After that, the law of averages will catch up with you. To my mind, it’s a big farce and pure gamble that has been created to get people hooked to the stock market and keep up the volume of trades. Therefore, if you are thinking that I am going to give you tips on how to make some quick bucks, sorry to disappoint you. If anybody knows where exactly a stock is going to be in next one hour or two, he would not be advising you. Instead he will play the game himself and become a billionaire. This should help you understand the reality of day trading.
Derivatives: While finance professionals talk fondly about derivatives as investment instruments, these are complicated products and work primarily on speculation of large players in the stock market. You don’t have a good chance to make money in derivatives, as it’s not a level playing field. A retail investors should stay as far from derivatives as possible.
Short-term Vs Long-term: Short term investing is not investing; it’s speculation. At the cost of sounding repetitive, let me say again that short-term investment is gambling. There is a chance that you can make money in short term, but that will be pure chance. A stock price at any point in time is dependent on its intrinsic value (the real and reasonable potential of a stock), sentiments in the market, liquidity in the market, etc. When you are investing in a stock, you are trying to believe that the market will value this stock more in future and reward you for your early discovery. In a sense, you buy a stock at a price below its intrinsic value, and you will sell it when the market realizes that the stock is worth more. However, if you bought a stock when the liquidity and sentiments were good. And, suddenly, everything changes. The stock market crashes, liquidity dries up and everybody looks pessimistic about future. What happens to your stock? It tanks in the short term. However, sooner or later, things will get better and liquidity, sentiments will be positive; and you will find that the stock realizes its real potential. If you were a short-term investor, you would have sold the stock when the it tanked and lost money. However, if you invested for long term, you would hold on as you believe in the value of your investment and finally make money on your stock when things get better. Therefore, your chances of making money on a stock in long term are better than those in short term irrespective of the market sentiments and bull or bear phases. This is assuming that you have identified a good stock and bought it at a price, which is cheaper than its intrinsic value. A corollary is that if you need your money back in short term, you should not invest in stocks; instead you should invest in safe financial products like FD, debt oriented mutual funds, government bonds, etc.
It’s been a long post and I can go on and on. However, you should take rest and think about the points I discussed so that you can digest them and develop your own thoughts. Whatever I discussed today sets the tone for the things to come. Stay tuned.
How can I start investing in stocks?
What are the things to know before I start investing?
How should I research a stock?
How much risk should I take?
How long should I invest in a stock for before selling it?
Should I invest in stocks, or mutual funds or derivatives?
How should I select a stock for investing?
How can I ensure that I don’t lose money in the stock market?
So, if you are a new investor, and you are having these questions, don’t worry. All the investors face these questions and struggle finding right answers of these queries. In this blog, I will try to help you find your own answers of these questions to the best of my abilities. However, before we start discussing how to invest in stocks, let’s discuss a few basic issues, which are very important and will lay the foundation of our discussion.
Research: Buy stocks only if you are willing to spend some time researching stocks. If you don’t do research yourself, but still want to invest in stocks, then you should invest in equity oriented mutual funds. Hopefully, you will get decent returns on your money. Finding a good mutual fund in itself will require you to do some research on its past performance vis-à-vis its competitors, current philosophy of investing and fund management. In that sense, there are no free lunches- a little bit of effort is required if you want to make money anywhere. But once you have identified a good mutual fund, you don’t need to actively research stocks.
Investing in stock based on tips, or what others are buying or saying, is like gambling. And you don’t want to gamble with your money. If you still want to go ahead with gambling, then there so many other places to lose money.
Day trading: Only people who benefit from day trading on continuous basis are stockbrokers. They make money irrespective of your loss or profit, as they earn a percentage on every transaction you do. I have not seen anybody else making money consistently in day trading. If you have been lucky, may be you will make a few quick bucks. After that, the law of averages will catch up with you. To my mind, it’s a big farce and pure gamble that has been created to get people hooked to the stock market and keep up the volume of trades. Therefore, if you are thinking that I am going to give you tips on how to make some quick bucks, sorry to disappoint you. If anybody knows where exactly a stock is going to be in next one hour or two, he would not be advising you. Instead he will play the game himself and become a billionaire. This should help you understand the reality of day trading.
Derivatives: While finance professionals talk fondly about derivatives as investment instruments, these are complicated products and work primarily on speculation of large players in the stock market. You don’t have a good chance to make money in derivatives, as it’s not a level playing field. A retail investors should stay as far from derivatives as possible.
Short-term Vs Long-term: Short term investing is not investing; it’s speculation. At the cost of sounding repetitive, let me say again that short-term investment is gambling. There is a chance that you can make money in short term, but that will be pure chance. A stock price at any point in time is dependent on its intrinsic value (the real and reasonable potential of a stock), sentiments in the market, liquidity in the market, etc. When you are investing in a stock, you are trying to believe that the market will value this stock more in future and reward you for your early discovery. In a sense, you buy a stock at a price below its intrinsic value, and you will sell it when the market realizes that the stock is worth more. However, if you bought a stock when the liquidity and sentiments were good. And, suddenly, everything changes. The stock market crashes, liquidity dries up and everybody looks pessimistic about future. What happens to your stock? It tanks in the short term. However, sooner or later, things will get better and liquidity, sentiments will be positive; and you will find that the stock realizes its real potential. If you were a short-term investor, you would have sold the stock when the it tanked and lost money. However, if you invested for long term, you would hold on as you believe in the value of your investment and finally make money on your stock when things get better. Therefore, your chances of making money on a stock in long term are better than those in short term irrespective of the market sentiments and bull or bear phases. This is assuming that you have identified a good stock and bought it at a price, which is cheaper than its intrinsic value. A corollary is that if you need your money back in short term, you should not invest in stocks; instead you should invest in safe financial products like FD, debt oriented mutual funds, government bonds, etc.
It’s been a long post and I can go on and on. However, you should take rest and think about the points I discussed so that you can digest them and develop your own thoughts. Whatever I discussed today sets the tone for the things to come. Stay tuned.
Saturday, January 10, 2009
Basics of investing in stocks
Welcome to Basics of Investing in Stocks for beginners. This site will provide tips, insights and techniques for investing in the stock market to help beginners make money without losing sleep. If you want any particular topic to be covered or have any specific question, you can post a comment mentioning the same. I will try to answer your queries honestly and to the best of my abilities.
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