How to know if a stock is worth buying?

How to know if a stock is worth buying or not?

How a beginner can decide if a stock is worth buying or not? This question is simple but unfortunately there are no thumb rules that can solve this puzzle.

Yes, stock investing is not less than solving a puzzle. A careful investor must approach stock investing as if they are attempting to solve a puzzle.

Every step taken to solve a puzzle is essential. In a similar way, a beginner cannot afford to be complacent in stock investing.

I also offer a detailed worksheet on stock analysis for my readers. But in this post I will present a short-cut way to know if a stock is worth buying or not.

Before proceeding ahead, I would like to reiterate a theory that I often quote on my blog posts.

Market price of a stock  will grow fast only when “sales” and “profits” of its underlying business is also growing at a similar rate over a period of time”

Coming back to our important question, how to know if a stock is worth buying or not? To give a meaningful answer to this question one need to dig into financial reports of companies.

But don’t worry, I will not make the answer too complicated.

I will ask few simple questions about companies, whose answers will eventually help us to know if a stock is worth buying or not.

Stock is worth buying

#A. Stock is worth buying?

Ask following questions and check its business fundamentals first.

Question 1. Does companies operations produce enough cash to pay for its cost of doing business?

Answer : YES or NO

One will find the answer to this question in companies cash flow report. Open moneycontrol and check the company’s cash flow report. Just for example I have provided here the cash flow report of Hindustan Zinc. If net cash flow from operating activity is positive, it means that cash produced by companies operations is sufficient to cover its operating expense.

If net cash flow from operating activity is negative, it means that enough cash is not produced by the companies operations.

In case companies oprations is not generating enough “cash”, then company will have to borrow money from banks etc. Some company also issue more stocks to raise capital. Both are not considered good from from point of view of existing shareholders.

In case of Hindustan zinc, YES the company is producing positive cash flow.

Stock is worth buying_Cash Flow Report

Question 2. Has the company posted solid profit growth in last 5 years?

Answer : YES or NO

One will find the answer to this question in companies profit and loss accounts. Again, open profit and loss accounts of the company in moneycontrol. Note down last five years “net profit after tax“ figure. Observe closely if the profit has been growing consistently or the pattern is haphazard.

A good company will surely exhibit consistent net profit growth over time.

It is also important to know the growth rate of net profit. To calculate the growth rate, use the CAGR formula. As a rule of thumb, company must be able to grow its profits at the rate of inflation.

In case of Hindustan zinc, YES the company was able to grow its profits almost consistently in last 5 years.
Stock is worth buying_Profit & Loss Ac

Question 3. Has company been able to increase its sales turnover in last 5 years?

Answer : YES or NO

One will find the answer to this question in companies profit and loss accounts. Again, open profit and loss accounts of the company in moneycontrol. Note down last five years “revenue from operations“ figure. Observe closely if the revenue has been growing consistently or the pattern is wavering.

A good company will surely exhibit consistent revenue growth over time.

It is also important to know the growth rate of revenue. To calculate the growth rate, use the CAGR formula. As a rule of thumb, company must be able to grow its sales turnover (revenue) at the rate of inflation.

But why it is important to check companies revenue growth?

Revenue growth means that the companies product and services are growing in demand. A company whose products are in high demand is sure to give good profits to its shareholders.
In case of Hindustan zinc, YES the company was able to grow its sales turnover in last 5 years.
Stock is worth buying_Profit & Loss Ac2

Question 4. Is the companies profitability high?

Answer : YES or NO

One will find the answer to this question in companies finantial ratios. Again, open ratio report of the company in moneycontrol. Note down last five years “return on net worth” and “return on capital employed” figure. Observe closely if the profitability has been growing consistently or the pattern is erratic.

A company which has high profitability, it talks a lot about the “competitive advantage” it enjoys. A company which enjoys a monopoly market will have a high profitability figures.

In case of Hindustan zinc, YES the companies profitability is good.
Stock is worth buying_ratios

Question 5. Is Return on Asset (ROA) of the company is more than 10% per annum?

Answer : YES or NO

For a non financial company, ROA of more than 10% is considered good. ROA is total profit divided by total asset. ROA highlights the efficiency of companies asset to generate profits.

Company which has accumulated too much assets will have lower ROA. Idea should be generate maximum profit per unit asset. Such companies are best for shareholders.

For a financial company (like banks, insurance companies), ROA can be 2-3% per annum.

In case a company has ROA less than 10% (3% for finance companies), just observe that if the ROA has been improving in last 5 years or not.

In case of Hindustan zinc, YES it’s ROA is above 10%.
Stock is worth buying_ratios2
In order to conclude that if a stock is worth buying or not, answer to all the above question must be YES.

Once you get all YES’s for a stock, the next step is to check companies market price valuation.

#B. Stock is worth buying?

Check if the stock price is undervalued or overvalued.

In order to understand if the market price of stock is undervalued or not, note the following information.

Hindustan Zinc:

Current Market Price per share (P) : Rs.254

Earning Per share (E) : Rs. 19.68

Price Earning Ratio (P/E) : 254/19.68 = 12.91

Earning Per Share growth rate (EPSG) in last 5 years :
EPSG = { [ (19.33/13.08) ^ (1/ 5 years) ] – 1 } = 8.1%

PEG Ratio (PE/EPSG)

PEG = PE / EPSG = 12.91 / 8.1 = 1.59

If the value in step e (PEG) above is less than one (1), stock is considered undervalued.

In case of Hindustan Zinc, it’s PEG is 1.59. Hence we can conclude that, though it has strong business fundamentals, but it’s market price is currently overvalued. Hence buying it’s stock at present price levels must be avoided.

Conclusion

In order to know if a stock is worth buying or not, first evaluate its business fundamentals. I have provided here 5 questions that will answer if the stock has strong underlying business fundamentals or not.

Once you have identified a stock with strong business fundamentals, DO NOT go ahead and buy it’s shares.

One more step remains.

Identify its PEG ratio to know if the stock’s market price is undervalued or not.

Have a happy investing.



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Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.

About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

6 Comments on "How to know if a stock is worth buying?"

  1. please tell me if this is the right way to do:
    Subtract the beginning EPS from the ending EPS to calculate the change in EPS. For example, if you are measuring the EPS growth rate from year one to year two, subtract the EPS from year one from the EPS for year two. If the EPS grew from $1.20 to $1.50, subtract $1.20 from $1.50 to get 30 cents.
    Divide the change in EPS by the beginning EPS to calculate the growth rate as a decimal. In this example, divide 30 cents by $1.20 to get 0.25.
    Multiply the EPS growth rate as a decimal by 100 to convert the growth rate to a percentage. In this example, multiply 0.25 by 100 to find the EPS growth rate: 25 percent.

  2. hello sir I didn’t understand EPSG calculation
    1. (19.33/13.08) how do come with this figure.
    2. ^ what is this sign mean
    please let me know

  3. Hii it was nice explanation, I have one question, do we have buy stocks only when the stock price is undervalued?

  4. Hi ur explanation to identify good stocks is very good. thanx for publishing a nice post.

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