To Pick a Winning Stock you have to think like a investor and not like a trader
Introduction
The objective of buying stocks shall be to accumulate wealth. If you want to make money in stocks then you shall start thinking like an investor and not as a day trader. Day traders are not investors. Investors are the like owners of the house and traders are like guests. Guests may come to your house for fun, and excitement and goes eventually go back. It is for investors to clean the mess they have created and develop strategies for future development and growth of their household. Think like an investor / owner if you really want to make money in long run. Stock market is the most accessible option when it comes to investing. With the development of online trading made possible, common people are more involved in the process of investment in stock market. When it comes to stock picking there is no one fool proof method which can guarantee growth. Rather stocks are as vulnerable as the business itself. So developing a mind of an investor allows you to think like a business man and see future more clearly. Stock picked by an eye that can see future is ideal. Suppose you had an eye of Bill Gate and invested your money in Microsoft in 80’s. By 21st Century your money would have grown astronomically to few thousand percentage (35000%). So picking correct stocks at best times is crucial for wealth building. There are many strategies for evaluating a stock, all are different and complex, but one thing is common among all of them, all of them try to evaluate the ‘worth of a company’ in their own ways.
Step-1, Stock Picking after Fundamental Analysis of stock
Invest in companies with strong fundamentals. This phrase is commonly heard in the world of stock market. But do we know what factors decide the fundamentals of a company / stock? Fundamental analysis of stock shall be a starting point for selection of all stocks. Here we will try to explain how fundamental analysis is done for a stock. When a stock is traded in stock exchange the price of that stock is called market price. When we will do the fundamental analysis of a stock we will actually calculate the “intrinsic value” of the stock. Intrinsic Value of stock is the name given to the actual worth of a stock. Generally the market value of stock is higher than its intrinsic value. If a market value of a good company is equal to its intrinsic value, it is the best time to buy and hold that stock. Let’s try to calculate the intrinsic value of a company. To calculate the intrinsic value of a company you shall be able to predict the cash flows (Net profit) of the company for net five years as discussed.
| Company Name : XYZ | 2009 | 2010 | 2011 | 2012 | 2013 |
| Previous Year Cash Flow (Profit $10mn)* | 5,201 | 5,096 | 5,860 | 6,446 | 7,090 |
| Growth Rate ** | 10% | -2% | 15% | 10% | 10% |
| This Year Cash Flow (Profit $10mn) | 5,096 | 5,860 | 6,446 | 7,090 | 7,799 |
* Total Profit that we can expect to carry home at the end of the financial year
** Rate of growth of profit in each year.
After you have forecasted the future profits (cash flows) of the company, you will have to discount these future profits to its present value. Means, you will apply the time value of money to calculate the value of future money as on today. You know that the strength of a dollar reduces with time. Suppose you can buy a movie ticket today by paying $5, but after one year the same $5 will not be strong enough to buy that ticket. In other words the movie ticket will become costlier and can be bought at $6. Means $6 of tomorrow is equivalent of $5 of today. The discounting factor is 0.833. To calculate the present value of future cash flows you will have to multiply the discounting factor with future profits.
| Company Name : XYZ | 2009-10 | 2010-11 | 2011-12 | 2012-13 | 2013-14 |
| Previous Year Cash Flow (Profit $10mn) | 5,201 | 5,096 | 5,860 | 6,446 | 7,090 |
| Growth Rate | 10% | -2% | 15% | 10% | 10% |
| This Year Cash Flow (Profit $10mn) | 5,096 | 5,860 | 6,446 | 7,090 | 7,799 |
| Discount factor | 0.93 | 0.86 | 0.80 | 0.75 | 0.69 |
| Discounted value (PV) | 4,739 | 5,039 | 5,156 | 5,317 | 5,381 |
| Sum of PV of cash flow | 25,632 |
After you have calculated the sum of PV of future profits the next step is to calculate the worth of the company (intrinsic value) in the fifth year in terms of present value (PV). To find the intrinsic value, calculate the “value of the company’ added with the ’sum of PV of cash flow’.
| Value of Company | |
| Cash flow in after five years | $7,090 |
| Growth rate after 5 years | 5% |
| Cash flow in sixth year | $7,444 |
| Capitalization rate ++ | 10% (say) |
| Value of company | $7,444 / 10% = $74,440 |
| Discount factor (5 years) | 0.69 |
| PV of company | $51,363 |
| Intrinsic Value | $51,363+$25,632 = $76,995 |
++ Capitalization rate = Present Gross Income / Present Market Capitalization
If the Present Market Capitalization is less than intrinsic value it means the stock is a good buy.
Step-2, Stock Picking after Qualitative Analysis of stock
The qualitative analysis of a stock asks for answering the following question like, who is managing the business. What is the product of the company? Who are their competitors? And does the company have any brand name established?
Step-3, Stock Picking after Value Analysis of stock
Value investing is all about buying the stocks of a fantastic company at a reasonable price rather than buying an average company at a fantastic price. The focus is to acquire and accumulate the stocks of good companies. It is always observed that good companies stocks are always overpriced. A value investor tracks the price of all great companies and on every dip is prompt to put his money in the same. Few values important for a value investors are:
- Price of stock shall be equal or less than 0.66 times its intrinsic value
- P/E ration of the company shall be in the lowest 10% all equities.
- PEG < 1 means stock in undervalued. (PEG = [P/E] / [annual growth in EPS] )
- Price of stock shall be more than its tangible book value
- Debt Equity ratio (D/E) ratio shall be less than one (<1)
- Current Assets / Current Liabilities = 2
- Dividend yield shall be at least 0.66 times of AAA bond yield.
- Growth of earning (Net Profit) at least 7% for last 10 years compounded annually.
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