How to pick a Stock for Investment

Posted on 19th Sep 2018
by Team TopShareBrokers

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Picking stock for investment is an art rather than a science. There is no foolproof system for picking stocks, however, there are a certain set of criteria based on which you can pick the stock for a higher rate of returns than the market’s overall average. Here we will mostly be talking about quantitative aspects of a company.

Company’s fundamental analysis is the most important cornerstone of investing. You can be a fundamental analyst too as long as you develop some basic skills to understand the financial statements of the company and can be able to understand the business of the company with respect to the industry in which it operates and some basic mathematics. You as an investor should have an idea to check company’s financial health through financial statements of the company. It includes company’s profit and loss statement, balance sheet, income statement, and cash flow statement. All investments made based on fundamental analysis require the investors to stay committed for the long term.

How to check the financials of a company?

Here is the easy to understand checklist of the financial performance of the company:

  1. Revenue Growth:

    First thing to check in the PnL Statement is the Revenue of the company. If it is increasing every quarter as well as annually or it's stable but not negative then it is a good stock. Also, the revenue growth should be in line with the profit growth. Compounded Annual Growth Rate CAGR gives you a sense of how the company is evolving and growing across business cycles. Companies that are growing (Revenue and PAT) over and above 15% on a CAGR basis are good companies to invest in.

  2. Profit:

    Then look for the Net Profit of the company. Profit is calculated before tax and after tax. Profit before tax PBT refers to the net operating income after deducting operating expenses but before deducting taxes and interest. The net operating profit after tax PAT is the company’s operating profit after deducting its tax liability. If it's increasing every quarter as well as annually then it is a good stock. Suppose a company was posting losses every financial year, but suddenly this year it has posted a profit. Then it can be a stock to consider for investing. Do check the company’s Gross Profit Margins evolved over the years. More than 20% GPM is a good sign.

  3. Earnings Per Share (EPS):

    The earnings per share represent the profitability on a per share basis. The EPS and PAT growing at a similar rate indicates that the company is not diluting the earnings by issuing new shares, which is good for the existing shareholders. One can think of this as a reflection of the company’s management’s capabilities.

  4. Debt Level and Reserve Capital :

    We now look through the Balance Sheet items. Look into company’s Debt level and Reserve Capital. High debt means the company is operating on high leverage. Plus the finance cost eats away the earnings. The company should not be highly leveraged.

    Suppose the Debt of a company was 100 crores in 2014, 90 crores in 2015, 70 crores in 2016, 50 crores in 2017 and its Reserve Capital in 2013 was 210 crores in 2014, 218 crores in 2015, 226 crores in 2016, 240 crores in 2017, here you are seeing the Debts of this company is decreasing every financial year and the Reserve Capital is increasing every financial year. So, it's a safe company to invest in. If a Company has zero debt but has good Reserve capital then it's a Golden stock to invest. Suppose, the company had huge debts but every quarter it's decreasing its debt, then it can be a turnaround stock to buy.

  5. Return on Equity (ROE):

    Return on Equity (ROE) measures in percentage the return generated by the company keeping the shareholder's equity in perspective. In a sense, ROE measures how successful the promoters of the company are for having invested their own funds in the company. Companies that have an ROE of over 20% are good ones to pick.

  6. Shareholding Pattern:

    Now see Shareholding Pattern of that stock. See the percentage of stock promoter’s holding and public. Suppose in 2014 Promoter Holding is 66% and Public or Institutions holding is 34%, in 2015 Prom Holding 70% and Public and ins 30%, In 2016, Promoters holding 72% and public and inst 28%, and in 2017 Promoters holding is 75% and public and inst 25%. So it is a very less risky stock because promoters holding has increased every year so they have faith in their company and If FIIs holding also increases every quarter or annually then additional good point for stock.

  7. P/E Ratio:

    The P/E ratio measures a company’s current share price relative to its per-share earnings. It’s calculated by dividing the market value per share by earnings per share. A good rule of thumb for value investors is to look for stocks with a P/E less than 40% of the stock’s highest P/E over the previous five years.

    Now see company’s P/E ratio and also check its Industry P/E ratio. Suppose there is a Pharma stock trading at 200 rupees and its P/E ratio is 9 and Its Industry P/E ratio is 27. It means that the stock has the potential to triple from here because its Industry P/E ratio is thrice its own P/E ratio.

  8. Pledging of Shares by Promoters:

    Next point is to check if Promoters have pledged its shares. Suppose the company is posting very good results every year but most of its shares are pledged by promoters then simply avoid that stock.

  9. Book Value:

    Now, next see its Book Value. Book Value is Total Assets of a company Divided by its total no of shares. Suppose its Book value is 85 and the share is already trading at 450. For me, it is already an overvalued stock because it is trading way above its book value. Even though it is a good company, the risk element is high for investment. Now, Suppose the BV of a stock is 300 and it's currently trading at 75. It is a good pick for investment because its BV is still 4 times its current price. But you have to check other above-mentioned factors also to invest. Only if it’s BV is higher than its current price doesn't mean that stock is good.

Conclusion

    It is to conclude here that this equity research process helps you comprehend the numbers and actually evaluate if both the nature of the business and the financial performance of the business complement each other. If you are able to develop a comfortable opinion based on facts, then the business surely appears to have investable grade attributes and therefore worth investing. However, before you go out and buy the stock, you should also ensure the price is right.

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