Stocks, or shares, are fractions of ownership of public listed companies
Contrary to public perception, picking stocks successfully is not as difficult as Wall Street or Hollywood would like you to know. Sometimes, it takes just a little more than common sense to do it. We can assure you, it will feel like cheating, literally.
First of all, if you're into stocks investing for the money, you'll really have to pick the companies that have solid track record of profit. A good example would be a company having made profit for every one of the last five years, which includes times of recession.
Numerically, we are interested in the earnings per share (EPS) and return on investment (ROI), which is the earnings per share divided by the share price. However, the reciprocal of ROI, known as price to earnings ratio (P/E) is more commonly in use.
EPS = Net profit / number of shares
ROI = EPS / share price
P/E = Share price / EPS = 1/ ROI
To look for undervalued stocks, pay attention to stocks with P/E ratio less than 10.
However, one should bear in mind that the rate of growth of a company makes a huge difference in the long term.
The growth of a company can be attributed to prudent management, products being well received by the market (usually highly differentiated or have competitive advantage), and public infrastructure among many other factors.
The rate of growth of a company without taking on additional financial leverage, assuming there's no dividend paid can be represented by return on equity (ROE) which is usually used to represent the efficiency of a company.
ROE = Net profit/ equity
Whereas equity is the net worth of the company, shown by the accounting equation:
Assets = Equities + Liabilities
Equities = Assets - Liabilities
Fundamental investors usually look for at least 15% of ROE in the past three to five years, on top of having healthy level of borrowing. Shares of companies with rapid rate of growth usually come at a much higher price tag.
A rule of thumb to ensure that a growth stock isn't overvalued is to look at the ratio between its price to earnings ratio and the growth of its earnings per share, otherwise known as PEG ratio.
PEG ratio = (P/E ratio) / (Growth rate)
As a rule of thumb, PEG ratio of equal or less than 1 is a value buy.
Takeaway
Stock investing isn’t as tough as it seems/ as risky as people portray it to be. All you need is emotional intelligence, some math, patience, the ability to learn from failure and most importantly, education!
From us in the BYIC R&E team, we wish you all the best in your current/future endeavours in the stock market!
Terence
Research & Education Team
Bursa Young Investor Club
