Most new investors make the mistake of buying stocks based on recommendations or following a famous investor’s portfolio.
While this approach might work for a few people, this is generally not encouraged. Why? Because each investor has a unique profile and risk tolerance. This makes it essential to analyze and invest in companies you know.
Read on to learn how to evaluate a stock before buying.
How to Start Evaluating Stocks?
The evaluation of a stock involves finding answers to some vital questions. Consider your evaluation successful if you have concrete solutions to the questions below by the end of your analysis.
These include:
- What do I know about the company- why has it captured my attention or occupied my mind space?
- Who are the competitors, and how are they different?
- Who are the promoters? Other details about the top management and their history of conduct
- How has the company performed financially over the past years? How are the debt levels?
- Has the company ever faced corporate government issues or scandals?
- How is the industry segment the company belongs to performing as a whole?
- Do the company’s prospects look promising?
A deep dive into these questions will be required to evaluate a stock before buying.
There are two levels of analysis that you are required to do – company-level analysis and industry-level analysis.
Company-level Analysis
1. Management Quality
A company is as good as the people running it. Checking management quality means conducting a background check on those running the company.
What should you look for?
- Experience of the upper management and promoters in the field
- Executive compensation
- Promoter shareholding pattern
- Has there been any negative news regarding the management
- Decision-making approach
Such factors enable you to run a quality check on the management. This is not difficult at all. A simple internet search will help you check all the related news.
2. Corporate Governance
Corporate governance means all the rules and practices put in place to run the company. Corporate Governance is one of the top tools for understanding a company's management quality. For many experienced shareholders, it is not enough that a company is churning profits.
Corporate governance involves checking-
- How well the company can balance the interests of the shareholders, employees, customers, investors, and likewise.
- If principles of honesty, ethics and integrity are being followed.
- Any fraud or malpractices that may have happened in the past.
If you want to evaluate a stock in India or anywhere else, an ethics check is required at all costs before you get to the financials.
3. Financials
Once your base is set, look at the financials of the company. Let’s see the main things to look for when I say financials-
- Pay heed if the company has been running under severe debt and is inching towards insolvency proceedings. Debt is not always bad, so looking at debt alone on a final note will be wrong. You also need to look at the debt servicing history of the company. If the company shows a good track record here, then it is likely that it will also be able to service its debt in the future.
- Consider ratios such as debt-to-equity ratio or interest coverage ratio.
- Check the earnings history and if there has been a history of profitability and fewer patches of losses.
- Check the price-to-earnings ratio (PE Ratio), which will tell you if a stock is undervalued or overvalued.
- Take note of the sales growth (revenue from operations) to know if the business has done well in the past.
- Check return on equity, as it will inform you about the returns a stock can generate.
- You can look at things like the dividend-paying history of the company.
4. Growth Prospects
Where is the company headed? Is it expected to grow on a consistent note? For future growth prospects, you will have to assess all the parameters above historically and make a projection into the future.
Even if there is a deviation, if the management is strong and financials have been good over a long period, the company will probably perform well in the future (no guarantee, though).
Industry-level Analysis
You should also look at what the future of the larger industry looks like. Say you want to invest in ICICI Bank. Your analysis should not stop with analyzing just ICICI Bank Ltd but the banking sector as a whole.
Industry-level information is also easily available. You can see if your chosen company is over-performing or underperforming its industry consistently. Here is how:
1. Peer-to-Peer Comparison
It’s important to compare a company's performance with peers from the same industry. You cannot reach the debt level of a bank to an IT company and then arrive at a decision.
All industries perform differently. Therefore, remember that parameters and financials should compare with industry peers only.
2. Highs and Lows
It would be best to look at how the management tackled the highs and lows of the economy. And how did the company perform during the lows, was it able to weather macroeconomic storms.
You need to also look at how the company performed during its highs; did it splurge or spend judiciously on growth parameters.
Analyzing historical performance during extremes is important to understand how efficiently the company tackles economic and industrial booms and busts.
Where Can I Find This Information?
Most of these ratios can be calculated with the help of information available on company balance sheets. The Securities Exchange Board of India (SEBI), the markets regulator, the stock exchanges, the Bombay Stock Exchange (BSE), National Stock Exchange (NSE) mostly have all the resources on the financials.
Insolvency and Bankruptcy Board of India will have all the details on bankruptcy proceedings, if any. A general news check will also give what has been happening around the company. Financials are also available on the company’s website.
Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.
