In order to choose good stocks for inclusion in ones investment portfolio one must analyze the stocks properly. Good stocks are not visible superficially. In fact it is impossible to identify goods stocks if we are not analyzing its fundamentals deeply. If one really wants to choose good stocks, then one must learn to analyze stocks fundamentals in the right way. In this article I will propose how to choose good stocks for building investment portfolio. In fact choosing good stocks for investment is not so difficult either. Only if we know how to comprehend companies earnings, we can identify good stocks with much ease.
How to Choose Good Stocks 1 - Know the Source of Earnings of Company
A company’s main source of income is from sales of its products and services. If we talk about Tata Steel we know that it generates its earnings by selling steel. If we talk about Maruti Suzuki we know that it makes money by selling cars. If we are talking about ITC we know that its major earnings are generated from FMCG products and hotel business. So before choosing any stock for inclusion in investment portfolio one must know that what are its major products or services.
How to Choose Good Stocks 2 – Quantify the Earnings of Company
Once we know the source of earning, we must also quantify it. The idea behind this exercise is to make safe predictions about future earnings. Suppose a company which sells steel has generated EPS of Rs 10. In last five years the company was able to grow its EPS at rate of 10% per annum. With this we can assume that the company will maintain the same EPS growth rate in next five years of its operation. So it means that in next five years the company will have its EPS appreciated from Rs 10 to Rs 16. EPS of company directly influence the market price and dividend. Both these parameters (market price of stock and dividend earning) most crucial parameters for any investors. Hence quantifying earning and its growth rate is essential.
How to Choose Good Stocks 3 – Ensure Predictability of Future Earnings of Company
No matter how well the company has generated earnings in the past, if that trend cannot be maintained in future, its of no use for present investors. In old days Government controlled telecom companies. These public owned companies (MTNL, VSNL, BSNL etc) used to provide STD and ISD facilities to citizens on India. In those times these companies was like blue chip stocks. These companies enjoyed monopoly marker as it was under strict control of government on India. But those days are now gone and major players like Bharti, Idea, Reliance, Tata etc has now taken over. These companies are now the market leaders. So, in the process of choosing good stocks for long term holding, scrutiny of future-demand of companies products is necessary. If you have any doubts that companies products or services are going to be less required in future always avoid such stocks. There are also instances where, though the demand for the product has only gone, but still company did not do well. This happens when company faces stiff competition. Excessive competition eats into the companies profit margin. Investors musts be very careful in choosing stocks of sectors which has extreme competition. Aviation, telecom etc such sectors which faces stiff competition. This is one reason why earning levels of such sectors are so hard to predict. Predictability of future earnings is of paramount importance for value investors
How to Choose Good Stocks 4 – Investing in most Profitable Company
A company which requires less fund to generate $1 of earnings can be said to be more profitable. Lets take Example of three companies and try to understand which company is more profitable.
|Net Worth/Share||Rs 130.16||Rs 116.16||Rs 96.74|
|Earning/Share||Rs 15.09||Rs 20.32||Rs 24.82|
|Fund Required to generate Rs1 of Earnings||Rs 8.6||Rs 5.7||Rs 3.89|
|Net Worth/Share||Rs 537.64||Rs 505.05||Rs 418.94|
|Earning/Share||Rs 68.95||Rs 71.58||Rs 56.37|
|Fund Required to generate Rs1 of Earnings||Rs 7.80||Rs 7.06||Rs 7.43|
|Net Worth/Share||Rs 24.04||Rs 20.62||Rs 36.84|
|Earning/Share||Rs 7.88||Rs 6.45||Rs 10.64|
|Fund Required to generate Rs1 of Earnings||Rs 3.05||Rs 3.20||Rs 3.46|
From the above three comparison it is very clear that ITC is most profitable company. So if given a choice, investors must select ITC stock over Airtel and Tata Steel.
How to Choose Good Stocks 5 – Buying Undervalued Stocks is a must
Investors must know whether the current market prices are overvalued or undervalued. Stocks of fundamentally most strong company can be bad if it is trading at overvalued price levels. The price at which investors choose to buys stocks can make it good or bad. Lets take another example to know how an investor will know it first hand if the company is overvalued or undervalued.
|Bharti Airtel||Rs 309||Rs 15.09||4.88%|
|Tata Steel||Rs 428||Rs 68.95||16.1%|
|ITC||Rs 287||Rs 7.88||2.75%|
Compare the earning yield of companies with risk free rates (of bank deposits). Presently on 3 years deposits banks provide interest of 8.5% per annum. Valuation of Tata Steel is by the best among ITC and Bharti Airtel. ITC yield is the lowest, trading far below risk free interest rates.