While considering investments, investing in direct equities on the stock market seems to be a very attractive investment option. For investors seeking to earn high returns and also have a good risk appetite, investment in stocks has the potential to provide good returns as well as increase the capital investment of the investor in the long run. But for this, the investor needs to understand how to analyse a stock to ensure maximum profitability of their investors.
The most common way to analyze the stock is fundamental analysis and technical analysis. This requires a detailed understanding of these concepts. Investors can also take the help of professional financial analysts for the same. Read these expert tips on how to analyze a stock to invest better.
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What is stock analysis?
Stock analysis is the process of evaluating a company’s financial health and future growth potential to decide whether to invest in its stock. By examining factors such as the company’s profits, debts, competitors, and market trends, investors can make informed decisions about buying, holding, or selling stocks, with the aim of earning returns on their investment.
Types of stock analysis
The most common ways to analyse a stock are broadly categorized under two categories. The measures of stock analysis adopted under these categories can be used by expert analysts as well as novice investors who wish to handle their own investment portfolios. Given below are the details of the same.
Technical analysis, as the name suggests, involves the measurement of the company’s or stock’s profitability through various parameters like the volume or price of the stocks. This type of analysis is usually done by experts with the help of charts or oscillators which can indicate the future price trends. Historical trading data is the basis of such analysis to ascertain the future trends of the stock movements or the industry movements.
There are a few basic assumptions for such technical analysis which are mentioned below.
Repetitive price movement patterns
One of the main assumptions in technical analysis is that the price movements are repetitive and that the history of such price movements will be repeated. Prices of the stocks are influenced by the market psychology which eventually leads to such repetition. Investors can therefore refer to the historical charts of the stocks to make sound technical analysis.
Another assumption of technical analysis is that the market price of the stocks is inclusive of all the factors that can have any influence on such prices. All the factors that can affect the prices of the stock have been incorporated to arrive at the final price.
Trend analysis is given huge impotence in technical analysis. It is assumed that the future prices of a stock will follow the market trend once it is clearly established.
Fundamental analysis involves analyzing the financial health of the company to determine the current as well as the future value of its stocks. This measure uses many key financial ratios to ascertain the correct position of the company which in turn can tell the investors if the value of the stock in the market reflects its true picture.
Some of such key financial ratios and their interpretation are mentioned below.
Price to Earnings Ratio
Price to earnings ratio or P/E Ratio is among the most common measures used by investors to value a stock. P/E ratio is derived by dividing the market value per share by the earnings per share. The investors can then compare the PE ratio of the competitors to decide on a stock to invest in. The stock of the company performing better in PE terms as compared to its competitors or industry, in general, is to be selected for investment.
Earnings Per Share
The simplest explanation of earnings per share is the value that can be earned by each shareholder for each share held by them. It is a measure of the profitability of the company. As a thumb rule, if the EPS of the company is better than its competitors or the industry average, the shares of the company can be considered to be of value. Investors will see the company as a growing company and can be assured of good returns on their investment.
Return on Equity
Return on equity (ROE) is the measure of the returns that can be earned by the shareholder on the equity or the rate of profitability that shows the optimum utilization of the assets of the company. A company providing consistently higher ROE is considered to be a good investment by experts.
Price to Earnings to Growth Ratio
Price to Earnings to Growth Ratio (PEG Ratio) is a refined or enhanced measure as compared to a PE ratio to measure the value of the company or its stocks. It considers the growth of the company along with the PE ratio to measure profitability. PEG ratio is calculated by dividing the PR ratio by the yearly growth rate of the company. If the PEG is lower than 1 then the stocks are considered to be of value.
Dividend Payout ratio
The dividend payout ratio is a percentage of the earnings of the company that are paid out to its shareholders. The balance earnings are known as retained earnings which can be used by the company to settle its debts, reinvest in the company, buy back shares, etc.
Price to Book ratio
The price to book ratio is the measure of the market value of the shares divided by the book value of the shares. This ratio is mainly used to flush out companies with high growth potential that are undervalued. The book value of shares, in this case, is arrived by deducting the book value of liabilities from the book value of assets. A company with a low P/B ratio will indicate that the stock is potentially undervalued.
What is the importance of stock analysis?
Stock analysis is the starting point for an investment in the stock market. An investor has to ensure a thorough analysis of stock to make sound investment decisions. An investor has to look at the past performance of the stock as well as the historical data of the company to make suitable assumptions about trends that the stock may follow.
A correct analysis of the stocks and the market will tell the investor if the stock is overpriced or underpriced. The intrinsic value or the real value of the stock (which is determined through fundamental analysis) is a good measure of the value of the stock. An overpriced stock is when the market value of the stocks is higher than the intrinsic value of the stock. Whereas, an undervalued stock is when the market price of the stock is lower than its intrinsic value.
Ideally, when the market value of the stock is lower than its intrinsic value, it is the best time to invest in such stocks.
Factors to keep in mind while doing stock analysis
Apart from the above-mentioned measures of analysing a stock, there are certain other considerations that have to be adhered to by the investor while making an investment decision. Some of such factors are discussed below. It’s always better to invest in a good business rather than going for a cheap stock based on tips received from unverified channels. Some of the pointers you must consider are
Must have a strong competitive advantage
A company having a strong competitive advantage in the industry is often viewed as a pioneer in the industry. Such companies have better growth potential and value if their stocks usually follow the upward trend. Investors are assured of higher or consistent returns in such cases.
The company has good management
Management of the company is equally important as much as the product of the company. If the product of the company is profitable but the company is not equipped with good personnel at the top management, the survival of the company can also be under question in the long run. Hence, this is another parameter that has to be considered by investors.
Focus on industry trends
Industry trends have to be carefully monitored as well to make prompt and effective investment decisions. For example, a company spearheading innovation and technology in the IT industry will have an edge over its competition and will see growth in the long run.
Focus on general economic conditions
Stock markets move in sync with the general economic conditions in the country and across the globe. For example: With the ongoing Covid 19 crisis, equity markets are in a slump, but certain sectors like pharma, etc are doing well. So, you should be able to read into the economic conditions and how they could affect your investments.
Limitations of stock analysis
While stock analysis helps investors make informed decisions, it has certain limitations that one should be aware of:
- Future predictability: Stock analysis relies on historical data and trends, but the future performance of a company or market cannot be guaranteed. Unexpected events can significantly impact stock prices.
- Subjectivity: Different analysts may interpret the same data differently, leading to varying recommendations. Personal biases can also influence analysis.
- Incomplete information: Companies may not disclose all relevant information, which can affect the accuracy of stock analysis.
- Market psychology: Investor sentiment and emotions can cause short-term fluctuations in stock prices, making it challenging to predict short-term movements accurately.
- Overemphasis on quantitative data: Focusing solely on financial ratios and metrics may overlook qualitative factors like management quality, industry trends, and competitive advantages.
Being aware of these limitations can help investors approach stock analysis with realistic expectations and a balanced perspective, reducing the risk of making poor investment decisions.
The stock or equity analysis is a powerful method of increasing the possibility of getting a higher return on investment. A mix of fundamental and technical analysis is ideal for the investors to get maximum information which will help them in analysing a stock better. This will eventually assist the investor in making a profitable investment portfolio.
Frequently Asked Questions
What is the formula for EPS?
EPS is derived by dividing the net income of the company with the number of outstanding shares as on any particular date.The formula for EPS is,
EPS = Net Income/ Number of outstanding shares of the company.
How can a person invest in stocks?
Any individual can invest in stocks by opening a Demat account and then investing in shares through a broker or by themselves.
What are the two market trends that influence the pieces of the stocks?
The market trends that influence the prices of the stocks are the bullish trend and bearish trend. A bullish trend leads to increase in prices of stocks whereas a bearish trend leads to decrease in stock prices.
How is Return On Equity calculated?
ROE is calculated through the following formula,
ROE = Net Income/ total shareholder equity