Investing in stocks can be rewarding when you research the issuing companies thoroughly. Gone are the days when information was inaccessible. With the advent of the internet, you have all the information you need about a company, like its revenue stream, products, financials, and other data, at your fingertips. Using this, you can analyse the desired stock in detail to assess whether it is a viable investment or not.
Types of stock analysis:-
1. Fundamental analysis:-
2. Technical analysis:-
How to analyse a stock before investing?
Research the industry in which the company operates:-
Next, analyse the company’s financials – balance sheet, profit and loss account, and cash flow statements of at least the last 5 yrs.
In the profit and loss statement, which details its profitability, look at the trends of the operating cost, revenue, net profit, operating expenses, working capital and other data points. Following is the income statement or the profit and loss statement of RIL.
In the above statement, you can see that RIL’s total revenue has been on an increasing trend except for FY 2022 when it saw a dip. But the following year, RIL recovered the dip and registered a revenue greater than FY 2020.
The balance sheet gives a picture of the company’s overall financial position. Here, analyse the company’s current and long-term assets, current and long-term liabilities, cash in hand, retained earnings, capital expenditures, contingencies, provisions, etc.
Finally, you can study the company’s cash position through the cash flow statement. Find out if it generates more cash than spending or vice versa. If the cash flowing in is more than what is flowing out, it is a good sign. The opposite may not be.
But remember that all these factors should be examined simultaneously and not in isolation. Only then can you draw meaningful conclusions.
For instance, if, in a particular year, the company has had negative cash flow, you need not conclude that it is a bad thing. Instead, try finding out the reasons. One possibility is that the company had made a capital expenditure that year. If this expense aids the company’s growth and adds to its revenue, it is good.
While at it, also evaluate the company’s debt or borrowings. Debt is not entirely a bad thing. For one, it gives access to financial resources that the company can use to fund growth and expansion. Second, it is less expensive compared to equity. However, if debt exceeds a limit, it can weigh down on the company’s performance. The reason is simple, debt carries interest, which eats into profits
Study the management:-
A company is run by a group of people—the management. They are responsible for the future of the company and have the power to make decisions and formulate policies that impact the business. Under good management, a company can do wonders. But under bad management, even a strong company can fall apart. So it makes sense to study the management; find out – how experienced they are, how their decisions have contributed to the company’s growth, and so on.
Stock valuation:-
At this point, gear up to analyse the stock’s intrinsic value. In plain words, intrinsic value means a ‘fair price’. In stock parlance, it indicates whether the share is undervalued or overvalued. Truth be told, a stock has no ‘correct intrinsic value’. It is subjective and depends on the analyst.
Buying a stock at its intrinsic value or lower can give you a relatively higher profit; lower the purchase price, higher the profit and vice versa, provided the selling price remains constant.
While value investors look to buy an undervalued stock, growth investors look at the earning potential of the company. The latter don’t mind buying an overpriced stock, provided it has the potential to grow at a higher rate to justify the high valuations. So it is important first to decide what type of an investor you are and then decide whether to invest or not based on the intrinsic value of a stock.
Here are some financial ratios you can use to determine a stock’s valuation:
P/E ratio: measures the profit per rupee that you can derive by investing in the stock. For a value investor, a lower P/E ratio is more favourable. Note the ideal P/E ratio differs for every sector. So, it would help to compare the stock’s P/E ratio with peers’ or the industry average to get a fair idea about the stock’s valuation.
Return on equity ratio (ROE): measures how efficiently a company generates profit per unit of equity. The higher the ROE, the better it is. However, a company can have a good ROE due to high debt and low equity. So pair this analysis with the company’s debt-to-equity structure.
Debt-to-equity ratio: shows the proportions of equity and debt used by a company to fund its assets. It also suggests whether the company has ample shareholder’s equity to fulfil debt obligations in case the company goes bankrupt. The lower the ratio, the better it is. However, there is no ideal debt-to-equity ratio as it differs across sectors.
Analyse the risk:-
You may have heard a hundred times before that the stock market is risky. And true to its nature, no stock comes with zero risk. It is up to you – how much risk you can take on. So analyse the risks of investing in stock before jumping in. You could ask the following questions:
Is the stock of a small-cap company? If yes, it is probably highly risky for various reasons. Small-cap stocks are new businesses compared to mid and large-caps, which are mature. The latter will have more experience navigating through challenges and market downturns as they would have been in the game for a long. They also tend to be better placed financially compared to small caps.
How prone is the company to change in government policies? If the answer is highly prone, you may want to track how the stock behaves every time the government changes a relevant policy. For instance, housing loan companies are susceptible to RBI’s repo and reverse rate changes. The stock price rises or falls based on how the market reacts to the hike.
Finally, let’s address the elephant in the room – change in the very fundamentals of the company. Such developments can change the narrative altogether and thus impact the business’ growth for years to come. For instance, what if the company appoints a new CEO who wants to change an important aspect of the business model? What if a new, better competitor enters the industry? How well would the company accommodate such changes? Moreover, are you tolerant of such new developments and risks?
Analyse the shareholdings of a stock:-
Shares of a company are held by not only retail investors but also promoters, domestic and foreign institutional investors, mutual funds, employees and so on. A change in the holdings of such stakeholders reveals their outlook on the company. For instance:
Promoters: as key personnel, promoters of a company have great control over its affairs, directly or indirectly. They have high stakes in the company. Therefore, a decreasing promoter holding trend may be a red flag as it can indicate that promoters themselves are not positive about the prospects of the company.
Institutional and mutual fund holdings: these stakeholders transact stock in bulk. Therefore, a change in their holdings also indicates their outlook for the stock. If you see high buying activity in stock, the big investors are probably positive about the company’s growth. The opposite is also true.
Track your investment to take timely decisions:-
Investing is not a one-time thing but an ongoing process. Prudent investors don’t invest in a stock and forget about it; they monitor its performance. From time to time, check on how the stock is performing and how the company’s financial performance is evolving. Have the fundamentals changed? Do its future prospects remain intact, or have they gotten better or worsened? Accordingly, you can stay put or consider exiting. This way, you would not only minimise your losses from remaining invested but also free your funds to bet on better avenues.
Now that you have analysed the company on various fronts, it is time to connect the dots and make a meaningful, well-rounded investment decision. So go ahead. But don’t forget that stock analysis is a vast subject, not restricted to the aforementioned pointers. You can add more steps to your analysis if and when required. The goal is to pick fundamentally strong companies that add value to your investment portfolio.
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