Chapter 5- Analysis of Stocks – How to check on what to buy?
Analysis of Stocks
There are 2 primary ways in which people look at companies to evaluate which ones would be good ones to invest in.
Fundamental Analysis revolves around studying a company’s earnings history, balance sheet, management, product line and other factors that affect the Company’s profitability and growth to be able to decide which Companies look good for investment. Fundamental analysts search for intrinsic value of the company and hence the stock. In short Fundamental Analysis is based on Business Fundamentals studied through the Company’s Books of Accounts. Usually Fundamental Analysts tend to be Long Term investors.
Technical Analysis is stock analysis that seeks to detect and interpret patterns in past prices to be able to predict future movements.
Technical analysis dwells on charts of stock price movements and trading volume, as opposed to a company’s business, earnings, and competition. Investors who use technical analysis focus on the psychology of the market, scrutinizing investor behaviour. They try to determine where the big, institutional money is going so they can put their cash in the same places. Technical Analysis does not have too much meaning in the long run and is hence used in Medium term and Short Term investments.
We have explained some of the terms most widely used in Fundamental and Technical Analysis of shares. The attempt is to make sure that you are aware of what these are, understand what analysts are saying when they are discussing any particular company, and slowly begin to put your learning to use to do some analysis and predictions of your own. The terms discussed in this chapter will cover only the basics, discussing Fundamental and Technical Analysis would be beyond the scope of this book – apart from being an Information overload at this point J
EPS (Earnings Per Share)
One of the most important indicators about how a company is doing is to check for its Earnings Per Share (EPS). It is defined as the Net earning of the company (Profit After Tax) divided by the number of shares of the company. So, hypothetically, if a company made a Profit of Rs.100 for a year, and the company had 20 shares, the EPS would be Rs.5/share – So if you watch where a company’s EPS is and compare it to previous year’s EPS, you should get an idea of how well the company is growing. It is important to keep in mind while making this comparison that the company might have allocated additional shares in between, in which case these shares would need to be considered in the calculation.
EPS can be calculated for the previous year (“trailing EPS”), for the current year (“current EPS”), or for the coming year (“forward EPS”). Note that last year’s EPS would be actual, while current year and forward year EPS would be estimates.
P/E (Price to Earnings) Ratio
The Price Earnings Ratio of a share is the ratio of its Market Value (currently traded market price) to its Earnings Per Share (EPS). To extrapolate on the previous example, if the same share with the EPS of Rs. 5/share had a market value of Rs. 50, it would be said to have a P/E = 50/10 = 10.
Just to set the perspective, at the time of writing this book, all the shares trading on the Indian Stock Exchange together have an average P/E of 14-15. However, this is not constant across all sectors. E.g. most companies in the Metal Sector are currently trading at a P/E of 5-7, whereas most companies in the IT Sector would be trading at a P/E in excess of 20-30.
The Price Earnings Ratio is usually the quickest measure of how costly the share is based on its current performance. The numbers are also an indicator of how soon the market expects that particular company or sector to grow. The normal market sentiment is – Higher the P/E, the greater would be the expectation that the company’s earnings would grow fast.
The last year’s price/earnings ratio (P/E ratio) would be actual, while current year and forward year price/earnings ratio (P/E ratio) would be estimates, but in each case, the “P” in the equation is the current price. Companies that are not currently profitable (that is, ones which have negative earnings) don’t have a P/E ratio at all.
PEG Ratio is defined as a stock’s P/E ratio divided by the forecasted growth rate of its Earnings Per Share (“forward EPS”). As a general rule of thumb, a stock has a PEG value less than 0.5 is considered a very attractive buy, one between 0.5 and 1 is supposed to be a possibly good buy, one between 1.0 and 1.5 is an opportunity to hold on to the share if you are already invested in, and a PEG value of 2 is an opportunity to sell. What is very important, however, is that all this should be based on a realistic and fairly reasonable value of “forward EPS”.
Support & Resistance
Support and Resistance are very important Technical Analysis elements and probably the best day trading option if you want to be on the right side of the market.
Support is a price level at which a stock or other security stops falling (at least temporarily), hence the name. Resistance is a level at which price stops rising, at least temporarily.
Disclosure in Market terms means exactly what it does in normal usage. Disclosure is letting people know about certain details about yourself or your company. To reduce fraud SEBI has made it compulsory for many people to disclose their holdings, e.g. a Stock Analyst who is recommending a stock might also be holding the same stock himself and would hence gain from extra buying into the stock – hence the Analyst is supposed to disclose any personal or business interest he might have in the Stock he is discussing. Similarly companies going in for an IPO would be needed to disclose potential risks to business so that people who are thinking about investing would be aware of what the risks are and can then take an educated decision.