Overview:
To almost all new investors, traders, and stock market enthusiasts, how to analyze a stock is a mystery. There are many parameters like financial ratios, technical trends, candles, annual reports, etc. available for every single stock in the stock exchanges.
I find some of the techniques of stock analysis make no sense at all. It also depends on what type of investment you want to make; it may be long term for more than a year, short term for a few weeks or months, or intraday and F&O. You cannot analyze a stock blindly without fixing your objective of investment.
Nowadays, people are not interested in considering the fundamentals while purchasing a stock. You may get a random tip that a stock is going to return 20% in a week or month. Only after purchasing that stock, you will realize that you had made a wrong investment. Most of the famous financial websites will send you their pick of the month or whatever. The strategy might be a marketing gimmick, or it could be a piece of genuine advice.
As an Equity Research Analyst, I usually follow the fundamental analysis for selecting a stock. Nevertheless, I also use technical analysis to benefit from the price fluctuations of the stocks. You should be experienced to use the technical analysis as there is an equal chance of trend reversing and you ending up on the losing side.
Top Four Financial Parameters:
To help you find out or analyze a stock on your own, I am providing the important parameters I consider before purchasing any stock. These are the four most important ratios that I use for fundamental analysis.
Price to Earnings Ratio:
The Price-Earnings ratio or P/E ratio is one of the most important, noticeable, and easy measurements for analyzing a stock. It is the ratio of the price of a stock trading in the market and its annual earnings. It signifies how expensive the stock is trading in the market.
Simply put, it is the amount you are willing to spend on a stock or asset in advance for its return every year. For example, a stock with P/E equal to 10 means investors/buyers are willing to spend ten times than the returns made from it. It would be the price of ten rupees and its earnings are 1 rupee. It is recommended to buy shares with a low P/E ratio. The shares of blue-chip companies trade at higher P/E than small caps of the same industry and PSUs.
Price to Book Ratio:
The Price to Book ratio or P/B ratio is another crucial ratio to check before purchasing a stock. It is the ratio of the price of a stock and its book value mentioned in the company’s balance sheet. It also represents whether the stock is trading at a high premium or not compared to its book value or net worth of that stock.
For example, a stock with P/B equal to 2 means people are willing to spend two times its net worth. Software, Fast Moving Consumer Goods, and some large-cap & Blue-chip stocks trade at high P/Bs compared to PSUs and small-cap stocks.
Debt to Equity:
The Debt to Equity is the ratio of the total debt of that company and the net worth or equity of the company. It is a solvency ratio that measures the ability of the company to pay back its debt with its accessible balance cash and asset reserves.
In the case of small-cap companies, it’s better to choose the stocks with low debt to equity ratios, usually less than 0.5 should be fine. For large caps, the ratio might be in between 1 and 2. Usually, a company with low debt to equity ratio will be able to pay back its debt in tough economic situations without much hassle.
Current Ratio:
Current Ratio is the ratio of current assets to current liabilities. It is the measure of liquidity, whether the company can meet its current or short term obligations with assets that can be convertible into cash within a year.
The higher the current ratio, the better is the stock to invest. For small and mid-cap stocks, the value should be more than 1.5; for large-cap stocks, the value might be between 0.8 to 1, depending on the relevant sectors.
I have addressed the four most important ratios I go through before selecting a stock. This is the most basic interpretation of the financial parameters. You should also be to analyze a stock following these parameters.
In the future, I will be discussing each of these ratios in more detail. We shall talk about other important parameters like Interest Coverage Ratio, Return on Equity, Enterprise Value, and Dividend Yield in the next column.
Disclaimer:
I provide the information and my views on the website only to educate new investors, stock market enthusiasts, and the common public on equity or stock market investments. Please consult your financial adviser before making any investments in the stock market. In case of any queries, you can contact me via email ID or Contact Form.
7 Comments