Start Investing in Stock Markets
Now that you are aware of all the crux to get started with your investment in shares. So let us begin.
How to start investing in Stock Markets?
As a beginner, it is important to learn how to evaluate the stocks and pick the right one for you. Not all stocks are a good investment. Some are overvalued or some may have weak fundamentals or poor corporate governance or whatsoever.
Hence, it is important that you identify the shares that can help you earn some profits either in terms of dividend or capital appreciation. For this purpose, it is essential for you to learn stock analysis. It is not rocket science; just a little bit of knowledge and practice will make things easier for you.
Firstly, you need to learn how to read the financial statements of a company. The objective here is to invest in only fundamentally or financially strong companies.
Ideally, the investors will be more interested in investing in companies with higher profits since higher profits mean higher profit-sharing in terms of dividends. But, some of the companies instead of sharing profits as dividends might retain it for future expansion and growth. This, eventually helps the company to earn even higher profits in the coming years.
Also, higher retained earnings will reduce the dependence of the company on external debt thus reducing the interest expenses and increasing profitability. And higher profitability in turn has a positive rub off on the market prices of the share.
You should look at the past Earning Per Share (EPS) for the company for the past few years to understand the improvement in the market prices of the share.
Also, try avoiding the shares that are overvalued even if the company has strong fundamentals. The best way to check the reasonability of the market price of a stock is by using the Price Earnings Ratio (P/E Ratio) which is obtained by dividing market price of the share with the EPS. There is no standard rule to identify if a company is expensive or not, however, you can set your own rule, for example, if the P/E ratio comes out to be more than 15 then the stock is overvalued and hence, should be avoided.
These are just the two indicators, there are other tools such as dividend yield, current ratios, long term debt ratios, etc. that can help you in making an informed decision. Also, you should keep yourself updated with the current market news and look out for internal and external indicators that can affect the stock prices such as changes in government policies, political changes, company’s management changes, etc.
Here are the various financial ratios that shall help you in making an informed and analysed decision while investing in the stock market:
1.Earnings per share (EPS)
It is the most basic and important financial ratio that you need to know before making an investment in shares. It basically indicates the profits that the company made in the last year divided by the number of shares issued in the market. Preferred shares are not included in the total number of shares while calculating EPS.
Hence, EPS = Net profits (after deducting the dividends paid to preference shareholder)/ total number of outstanding equity shares
So, while deciding whether to invest in a stock or not, a higher EPS is considered good. It shows the company has the capability to generate higher profits. Also, you should check the EPS for the last five years. So, if the EPS was growing in the past years, then it is a good sign, but if the EPS has been falling for the past few years, then you should avoid such stocks.
2.Price to earnings ratio (P/E)
It is yet another important financial ratio while analysing a stock before investment. It helps in ensuring that the stock is not overvalued. A high P/E ratio shows that the stock is overvalued i.e. it is selling for more than its value. Hence, a stock with a lower P/E ratio is considered good.
Price to earnings ratio= Price per share/ earnings per share
You can use the closing price of the previous day and calculate the EPS by the above-mentioned formula to arrive at the P/E ratio for a stock. Usually, a P/E ratio lesser than 15 is considered good. Also, the definition of a higher or lower P/E ratio differs from industry to industry. Hence, you cannot compare the P/E ratio of one company from one industry to another.
3.Price to book ratio
This is calculated by dividing the current market price of the share by the book value of the share from the last quarter. It helps in determining how much the investor needs to pay for the net assets of the company. The lower P/B ratio indicates that the stock is undervalued, but again like the P/E ratio this definition varies from one industry to another.
Price to book ratio= Price per share/ Book value per share
4.Debt to equity ratio
This helps in measuring the relationship between the borrowed capital (debt) and the shareholder’s capital (equity) in a company. Usually, the lower debt-equity ratio which is less than 1 is considered favourable since it indicates that the company has a stronger equity position and relies least on the outside debt. Whereas the companies with the higher debt to equity ratio (i.e. more than 1) are considered risky.
Debt to equity ratio: Total liabilities/ Shareholder’s equity
5.Return on equity
This financial ratio calculates the amount of net income that is returned to the equity shareholders. The return on equity ratio helps in measuring the profitability of the company in terms of profit generated by the company by investing the shareholder’s money. It basically determines how good is a company at rewarding the equity shareholders. Usually, the ROE i.e. more than 20% for the past three years is considered good.
Return on Equity = Net Income/Average Shareholder Equity.
6.Price to sales ratio (P/S)
The price to sales ratio helps in measuring the prices of a company’s share in respect of the annual sales. It is very similar to the P/E ratio. It is a more reliable tool than other financial ratios since the sales figure cannot be easily manipulated in comparison to the profits, earnings, or income figures by using various accounting rules.
Price to sales ratio: Price per share/ Annual sales per share
Click here to check out Price to Sales ratio of Reliance Industries Ltd. (Note: Market Cap to Sales is referred to as Price to sales ratio)
Current ratio is the critical financial ratio to measure the liquidity of the company. It helps in determining how many current assets does the company owe to cover the current liabilities. A current ratio greater than 1 is generally considered good since the company has more current assets than the current liabilities.
Current ratio = Current assets/ Current liabilities
This financial ratio helps in calculating the dividend that a share can yield in comparison to the current market price of the share. It is calculated on a percentage basis.
Dividend yield= Dividend per share/ Price per share.
Usually, higher dividend yield signifies that the company is out of investment avenues and wants to distribute the retained earnings to its shareholders.
Besides this, you can also check out our ELM School module on 'Financial Statement Analysis' to get a better understanding of stock analysis for your investments.