“You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
- Warren Buffett
One key point you can take from the above quote is that, unlike popular belief, the stock market is no rocket science! You do not have to be a financial expert or a well-researched person. All you need to acquire is a basic understanding of what you are doing and how things work in the stock market?
So if you are a know-nothing investor or just getting started, naturally, the first question that comes to your mind is how do I know which is a profitable stock? In today's article, we will discuss the four things that will make the stock selection process easy for you.
Understanding the company and its products
“Never invest in a business you cannot understand.”
- Warren Buffett
Buying a stock necessarily, mean owning a part of the company. And surely, you would not want to put money into a business you do not understand. Therefore, the first and foremost important thing is to know the fundamentals of the company you are interested in.
It could involve answering basic questions like, what are the types of products produced by the company? What is the long-term vision of the company? As a consumer, do you believe that the product has long-term viability? How is the company's top management? Does the company have any pending legal cases on it?
Answering these basic questions will serve as a foundation for your research.
Trends in earnings growth
Once you acquire the basic understanding, the next crucial thing is a company's earnings growth. In other words, it is like studying the increase in its profits over time. A positive earnings growth implies financial and operational stability within a company. Similarly, a negative trend shows mismanagement and losses.
However, looking at the overtime rise in profits along with the actual capital growth (value addition to the company's assets) will give you a better picture.
One can get this information from; the financial reports, earnings call transcripts, and other investors related information provided on the companies website or other online investment research platforms (like Captwist).
The more common word for an economic moat is a competitive advantage. Just how in ancient times, the Moat would protect the castle from its invaders, in the stock market, it is a term for inputs or tactics used by a company that gives it protection from its rival companies.
Take the example of IRCTC. IRCTC is a state-owned entity and the only player in the railway sector in India. So, the consumers do not have any alternative in this sector.
This monopolization gives a competitive advantage to IRCTC since there cannot be any competition in the first place.
Like, earnings growth, such information can also be obtained from; the earnings call transcripts or detailed financial reports of a company.
Looking at the various profitability ratios
Below are the necessary profitability ratios that help you understand the position of a company in the market (within its sector and in comparison with other players).
1. Debt-to-equity ratio: It is a measurement to look at a company's debt levels and whether the equity funds are enough to cover the debts in case the company tumbles.
The higher the D/E ratio, the riskier the stock, and vice versa.
2. Price-to-earning ratio: It is merely a measurement to understand if a company is overvalued or undervalued in the market. In other words, it tells you how much the market is willing to pay for a particular stock today, depending on the past (trailing P/E ratio) and the future (forward P/E ratio) earnings of the company.
The higher the P/E ratio, the more overvalued a company is, and vice versa.
3. Return-on-equity ratio: It is a measurement to check a company's ability in generating profits from the shareholder equity. However, sometimes companies purposely take debt to increase RoE figures to attract investors, in such a case, it is wise to consider the D/E ratio along with the RoE ratio.
The higher the RoE ratio, the more profitable the company is, and vice versa.
4. Return on Capital Employed: It is also a measure to check a company's ability to generate profits by putting its capital to use. ROCE is a better profitability ratio because, unlike RoE, it considers both debt and equity.
EBIT = Earnings before interest and tax
Capital Employed = Total assets − Current liabilities
The higher the ROCE, the higher the profitability of the company, and vice versa.
Needless to say, the stock market is extremely volatile, which makes it an uncertain playfield. If you look at historical data, every company, once in a while, has experienced a drop in market value because of either internal or external factors. However, wisely picking up a stock you understand and believe in will help you keep faith in your choice selection. It, in turn, will eventually let you achieve your underlying investment goals.