Demystifying StocksHow to evaluate a stock?

Investing in a stock or selected stocks is easy when you're equipped with the right facts coupled with focused analysis. This would not only save you a lot of time and unnecessary worry, but also turn you into a smart investor!

Introduction

While the markets may be chaotic, your approach doesn't have to be so as well. As a novice investor, there are many things to consider before you plunge into the volatile sea of equities. One may even feel that equity investment is daunting for the not-so-experienced, or that it is confusing given the multiple views and so called 'tips' doing the rounds.

Introduction

To begin with you need to understand yourself and your risk tolerance - how much risk are you willing to take and what level of risk can you handle. Also, instead of the common practice of chasing stocks based on trends, it is better to understand that you're actually investing in the company's net worth, and not just its stocks. Therefore, looking at a company's history and performance is key. Here are some insights that will help you evaluate a stock and make the right choice.

Company History

It's very important to understand the performance of the company over a length of time. You can look up the reports of the company and study the same to know whether it is in a healthy financial position. This will indicate whether the company will generate relatively good cash flows in the future and whether it has the muscle to tide over a crisis.

Market Cap:

This is a simple calculation that refers to the total value of the tradable shares of a publicly traded company. It is found by multiplying the per-share price times the total number of outstanding shares.

For instance, Stock price: $50Outstanding shares: 50 millionMarket cap: $50 x 50,000,000 = $2.5 billion

Cash Flow

Cash flow is one of the most important measurements in evaluating a stock. It refers to the amount of cash a company brings in and uses after the deductions and expenses.

EBITDA Margin: Simply put, this is how one can measure a company's operating profitability. It is equal to earnings before interest, tax, depreciation and amortization (EBITDA) divided by total revenue. Since EBITDA excludes depreciation and amortization, EBITDA margin can provide investors with an insight into a company's core profitability

P/E Ratio

The Price-Earnings (PE) Ratio is a key indicator in valuing a stock. It looks at the relationship between the share price and the company's earnings.

It is calculated as: Market Value per Share / Earnings Per Share (EPS)

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS, is calculated as: Net Income / Number of Outstanding Shares

While the P/E Ratio does not tell the whole story, and it's not advisable to base an investment decision solely on this number, it does help in comparing this with other stocks in the same sector. Typically, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

Return on Equity

This refers to the amount of net income returned as a percentage of shareholders' equity.

It is calculated as: Net Income / Shareholders' Equity

For instance, if XYZ Bank generated $10,000,000 in net income last year, and it's shareholders' equity equaled $20,000,000 last year, then ROE = $10,000,000/$20,000,000 = 50%

This means that XYZ bank generated $0.50 of profit for every $1 of shareholders' equity last year, giving the stock an ROE of 50%.

ROE is a measure of efficiency; it indicates how the Management of the company is deploying its shareholders' capital. It is important to note, that comparisons of ROE should be made of companies within the same industry.

ROE is a measure of efficiency; it indicates how the Management of the company is deploying its shareholders' capital. It is important to note, that comparisons of ROE should be made of companies within the same industry.

So, now, you've run the numbers and done a fair bit of analysis. Armed with this information and basic stock fundamentals, you can get objective about your investments. Keeping all these factors in mind is important vis-à-vis your portfolio. Next time around, don't get tempted by the rumours you hear around the water cooler, focus on the facts instead. The age old maxim may say "buy low, sell high", but you know, that it's only wishful thinking. Follow these steps, as this knowledge will help you become a more responsible self-directed investor.

Conclusion

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