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Things to learn before you invest in stocks

April 15, 2010 17:02 IST
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Investing in the stock markets is both risky and profitable venture. On one hand, the returns on investment are usually higher than traditional investments, while on the other, the risk of loss is also higher. A detailed analysis of the company's financial statements is important for two reasons:

1. Minimize the risk of investing in non-profitable stocks
2. Keeping track of stocks you already hold

A very important aspect of financial analysis of a company is verifying its key ratios. They can be calculated using information from the financial statements of a company and they reflect its financial health. To begin with you should have the latest annual report of the company. You can also get information from the stock exchanges where these stocks are traded, especially, if you need information for a quarter period. It is a good idea to have annual reports for few previous years.

This will be helpful in comparing current period's statistics with prior periods.  It is also important to compare a company's ratios with those of its competitors or similar industries and with the market ratios in general. Hence, it is important that you have reliable data on competitor's financials too. You will get data on markets as a whole from trade magazines or stock exchanges.

How should you analyze financial statements? For example, you hold equity stock in ABC Ltd. You would like to evaluate the financial ratios of the company.

    ABC Ltd. Financial Statement Excerpts

Revenue: Rs 5,00,000

Average Equity: Rs 200,000 (2,000 shares of Rs. 100 each)

Net Income: Rs 50,000

Market price of Stock:  Rs 50

Dividend to Preference stockholders: Rs. 5,000.00

Purchase Price of Stock: Rs  40

Assets: Rs  450,000

Dividend paid on Equity Shares: Rs  10

Total Liabilities: Rs  150,000

i. Earnings per share: This ratio is given in the Income Statement of companies and hence there is no real need to compute it. However, if you wish to calculate:

EPS =     Net Income after Interest and Taxes and dividend to preferred stockholders       

Average number of equity shares outstanding

             =   45,000.00     = 22.50


i.e. a single share invested generates Rs. 22.50 in net earnings.

A high EPS in comparison to competitors EPS or a steadily increasing ratio are encouraging factors to invest in a company's stocks.

ii. Return on Equity: This is calculated to verify if a company is using its capital efficiently to generate earnings. A growing return on equity ratio is a good sign.

Return on Equity = Net Income after Interest and Taxes     = 50,000.00       = 0.25 or 25%

                                 Average Common Equity                     2,00,000.00

i.e., every rupee of equity capital invested in the company generates Rs.0.25 in earnings

iii. P/E or Price Earnings ratio: The ratio indicates the amount an investor will pay in return for a rupee's earnings in the company. A higher P/E ratio indicates that the stock is in more demand as compared to competitor's stock.

P/E =  Market price of Stock     =          50.00        = 2.22

                        EPS                               22.50

iv. Dividend Payout Ratio: It compares the dividend paid by the company to the net earnings for the period.

Dividend Payout Ratio =  Cash dividend per equity share    =      10.00       =  0.44 or 44%

                                                             EPS                                  22.50      

An increasing dividend payout ratio over the years is an indicator of organization's growth. While deciding between stocks of different companies, it is advisable to buy stock of a company having a higher dividend payout ratio, if other factors affecting stocks are same.

v. Total return on stock: Although not a ratio, it is important to know the total returns on your investments. This number incorporates changes in stock prices since it was purchased.

Total Return   =      Dividend + changes in stock prices / purchase price of stock.

                        =      10  + 10   = Rs 20

vi. Debt Equity Ratio: This shows the total debt of a company in relation to the amount of equity of stockholders. This ratio will help you understand the financial leverage of a company. How much debt does ABC Ltd. have for every rupee of equity?

Debt Equity Ratio =   Total Liabilities    =      150,000    =  0.75 or  75%

                                      Total Equity             200,000

A high debt equity ratio implies that the company uses large amounts of loans / borrowings in its business. This can affect the company's ability to raise further debt and increase the cost of borrowing funds in the future. A ratio higher than 50% may also suggest liquidity crunch in a company.

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