In the stock market, everyone wants to buy cheap and sell expensive but it is not as easy as it looks. When I say that people should buy quality and undervalued stocks it doesn’t mean that you should only focus on penny stocks for value investing. We have different parameters based on which you can choose a stock that can take you towards value investing and there will be a higher chance of good returns.
When I say we should buy cheap or undervalued stocks then it can be a 10 penny/stock or $100/stock, so it’s clear that cheap doesn’t mean that stocks in less money and stock worth $1000 can be a cheap stock in compare to a stock of $1. From now I won’t use cheap stocks instead will use quality or undervalued stocks.
How to Choose Quality/Value Stock:
Now the question arises that how we can identify and buy quality stocks? Here in this article, we will discuss various methods and parameters by which you can derive your own conclusion that a stock is worth buying or not. These methods are used in fundamental analysis of stocks. Most successful investors and institutions use these methods to buy stocks.
Let’s explore methods and parameters for value investing one by one with an explanation:
1. Price to Earnings Ratio (P/E Ratio)
A measure of value which is most commonly used is the P/E ratio—for a company and similar stocks and industry peers. A higher P/E ratio suggests that market participants are interested in that particular stock and stock is expected to give good future earning returns which make the stock bullish.
A lower P/E value can suggest an undervalued stock or a stock where people are not interested and are bearish on the company’s earnings in the future.
These methods of P/E calculation and subsequent valuation need to do based on sector or P/E should be compared with peer companies. For example, suppose the IT Sector has a P/E ratio of 20 then all IT companies should be valued on the P/E ratio of 20. Calculation of P/E ratio is very simple, suppose a stock is valued $100 and earnings per share (EPS) is $5 then P/E ration will be 20 ($100/$5).
2. Price to Book Ratio (P/B Ratio)
Price to Book Ratio or P/B ratio is calculated based on the closing price of any share divided by book value of the stock. The book value of a company is the difference between that company's total assets and total liabilities.
We use price to book value ratio to compare a company’s market capitalization to its book value. P/B ratio is widely used by investors for decades at traditionally a P/B ratio value less than 1 is considered as undervalued stock and in some cases, P/B Ratio of up-to 3 can be considered valued fairly based on that industry and peers.
3. Earnings per Share
An Earnings per Share (EPS) is the amount in an absolute term which can be allocated to per shares. A higher EPS suggests that each outstanding share company is generating more and more earnings. Earnings per Share can be calculated in 2 ways:
If a company doesn’t give dividend:
EPS = Net Income after Tax/Total number of Outstanding Share
If a company offers a dividend
EPS = (Net Income after Tax-Total Dividends)/Total number of Outstanding Share
EPS ratio indicates the room a company has for increasing its existing dividend. EPS is a very important and crucial tool for investors, but it should not be the only criterion for an investor to decide about any investment. EPS of a company should always be considered in relation to other peer companies in the same sector in order to make a more informed investment decision.
4. Return on Equity
Return on Equity (ROE) is a measurement of a company’s ability to generate income using available equity. Higher the ROE better the stock but higher ROE also pushes the valuation of stock on the higher side as everyone attracts towards a stock which gives a good return on equity. An ROE of 15%-25% is considered good and worth investing.
5. Debt to Equity Ratio
The ratio of the total long term debt and equity capital in the business is called the debt-equity ratio or D/E Ratio. A low debt to equity ratio is attractive to investors as it is less risky in times of increasing interest rates.
A high debt-equity ratio can be good because it shows that a firm can easily service its debts obligations and other borrowings by utilizing cash flow and is using the leverage to increase equity returns on the same terms if a company has a D/E ratio that’s too high. In this case, any losses will be compounded and the company may not be able to service its debt obligations.
6. Promoters Holdings
Promoter’s holding shows the percentage of stake in a company. Promoters and promoter groups are entities that have a significant influence on a company. They may have a major or even a controlling stake in the company and they may also hold senior executive positions and can influence the company’s decision making in a major way. Also, a higher stake gives voting rights to the promoters which play a very crucial role in the day to day activity as well as major decision making of executives. Any stakes more than 50% are considered comfortable and any increase in the stake of promoters is more positive.
Sometimes, promoters can pledge their shares for capital to meet the company’s activities. Lowering of stakes and pledging is considered negative for stock prices and on the opposite side when promoters buy more stakes it suggests that promoters are having increased interest and have confidence in the company’s future prospects.
Conclusion:
There are too many parameters to evaluate any company's fundamentals and based on that stocks can be selected for investing. Here we have covered some prominent and most used parameters. These methods can be used in conjunction and we should not only rely on one or two methods only. Any company should be evaluated on all points and then based on investor's risk appetite, decisions should be taken.
Disclaimer: The opinions expressed in the Blog are for general informational and educational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product.
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