Most new investors make the mistake of buying stocks based on recommendations or following a famous investor’s portfolio. While this approach might work out 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 do your analysis and invest in companies that you know. But where do you start? What are the aspects that you need to consider? Answers to such questions and more are covered ahead. Read on to know how to evaluate a stock before buying.
In this article
The evaluation of a stock involves finding answers to some vital questions. If by the end of your analysis you have concrete answers to the questions stated below – consider your evaluation successful. Let’s see what these questions are:-
- What do I know about the company- why has it captured my attention or occupied my mind space?
- What are the products/services the company offers?
- Have they been offering the same products/services for a long time or do they diversify their offerings from time to time?
- 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? Is it consistent or erratic? How are the debt levels?
- Has the company ever faced corporate government issues or scandals?
- How is the industry segment the company belongs performing as a whole currently?
- Do the company’s future prospects look promising?
This is just the tip of the iceberg. 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. Let’s see the components of both in detail.
1. Management Quality
A company is as good as the people running it. Checking management quality means conducting a background check on those who are running the company.
What should you look for?
- Experience of the upper management and promoters in the field
- Executive compensation
- Promoter shareholding pattern
- Whether the management has a customer-focused vision
- Has there been any negative news regarding the management
- Decision-making approach
- Whether the management believes in inclusiveness and involves all necessary parties/employees in decision making
Such factors enable you to run a quality check on the management. This is not difficult at all. A simple search on the internet will help you to check all the related news and if there has been any bad-mouthing.
2. Corporate Governance
By definition corporate governance means all the rules and practices that are put in place to run the company. Corporate Governance, in fact, is one of the top tools to understand the management quality of a company. 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, running an ethics check is required at all costs before you get to the financials.
Once your base is set to 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 an absolute 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 the company will also be able to service its debt in the future as well.
- Check the earnings history and if there has been a history of profitability and fewer patches of losses. The debt to equity ratio is one measure to look at.
- 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
- Assets that the company owns and liabilities that the company owes
- Check return on equity as it will inform you about the returns a stock is capable of generating
- You can look at things like the dividend-paying history of the company. If it has been erratic or there has been some consistency. This is not the best parameter but it can certainly be looked at. A lot of times dividend-paying companies falter too because of wrong management practices or faulty financials. Hence get your basics right first.
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 aforementioned parameters 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, chances are that the company will perform well in the future as well (no guarantee though).
You will have to look at the profile of the customers the company is targeting and whether the association between the company and customers appear strong. You don’t have to look at short term pricing but at factors that help you build a long term picture of the company.
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 on the whole.
Industry-level information is also easily available. You can look at if the company which you have picked is over-performing or under-performing its industry consistently. Use industry-level analysis to map trends.
1. Peer to Peer Comparison
It’s important to compare the performance of a company with peers from the same industry. You cannot compare the debt level of a bank to an IT company and then arrive at a decision. All industries perform differently. Therefore, when you are wondering how to evaluate the stock price, remember that parameters and financials should compare with industry peers only.
2. Highs and Lows
The larger economy, the industry the company is in or individually the company itself will be going through many highs and lows. What you need to look at is how did the management tackle the highs and lows, 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 did it spend judiciously in growth parameters, did it value its shareholders during its highs and protect them during its lows.
Analyzing historical performance during extremes is important to get an idea of how efficient the company is in tackling 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 in company balance sheets. 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 all has been happening around the company. Financials are also available on the company’s website.