How to Spot a Good Stock

#1
How do you know if a stock is worth buying?

One, look at the 'fundamentals' of the stock: check the underlying factors behind the stock price.

In other words, find out what it is about this stock that makes it hot.

Let me introduce you to three ways by which you can figure that out.

1. Earnings per Share (EPS): How well the company is doing

Company XYZ Ltd.

Capital: Rs 100 crore (Rs 1 billion).

Capital is the amount the owner has in the business.

As the business grows and makes profits, it adds to its capital.

This capital is subdivided into shares (or stocks).

For a clearer understanding of capital, read What's in a share? Money!

The capital is divided into 100 million shares of Rs 10 each.

Net Profit in 2003-04: Rs 20 crore (Rs 200 million).

EPS is the net profit divided by the total number of shares.

EPS = net profit/ number of shares
EPS = Rs 20 crore (Rs 200 million)/ 10 crore (100 million) shares = Rs 2 per share

Lesson to be learnt

If a company's EPS has grown over the years, it means the company is doing well, and the price of the share will go up. If the EPS declines, that's a bad sign, and the stock price falls.
Companies are required to publish their quarterly results. Keep an eye out for these results; check for the trend in their EPS.
2. Price earnings ratio (PE ratio): How other investors view this share

Two stocks may have the same EPS. But they may have different market prices.

That's because, for some reason, the market places a greater value on that stock.

PE ratio is the market price of the stock divided by its EPS.

PE = market price/ EPS

Let's take an example of two companies.

Company XYZ Ltd
Market price = Rs 100
EPS = Rs 2
PE ratio = 100/ 2 = 50

Company ABC Ltd
Market price = Rs 200
EPS = Rs 2
PE ratio = 200/ 2 = 100

In the above cases, both companies have the same EPS.

But because their market price is different, the PE ratio is different.

Lesson to be learnt

In the case of EPS, it is not so much a high or low EPS that matters as the growth in the EPS. The company's PE reflects investors' expectations of future growth in the EPS. A high PE company is one where investors have hopes that earnings will rise, which is why they buy the share.

3. Forward PE: Looking ahead

The stock market is not nostalgic. It is forward looking.

For instance, it sometimes happens that a sick company, that has made losses for several years, gets a rehabilitation package from its bank and a new CEO.

As a consequence, the company's stock shoots up.

Why? Because investors think the company will do better in the future because of the package and new leadership, and its earnings will go up.

And they think it is a good time to buy the shares of the company now.

Suddenly, the demand for the shares have gone up.

Because stock prices are based on expectations of future earnings, analysts usually estimate the future earnings per share of a company. This is known as the forward PE.

Forward PE is the current market price divided by the estimated EPS, usually for the next financial year.
Forward PE = Current market price/ estimate EPS for the next financial year.


To illustrate what weve been talking about, let's take the example of Infosys Technologies.

Trailing 12-month EPS = Rs 56.82 (EPS of the last four quarters)
Closing price on January 6 = Rs 2043.15
PE = Price/EPS = 2043.15/ 56.82 = 35.95
The PE of Infosys as on January 6 = 35.95

Clear? Now be alert:

Estimated EPS for 2004-05 = Rs 67
Estimated EPS for 2005-06 = Rs 90
These figures are according to brokers' consensus estimates (you can find those in the business daily, Economic Times).

Forward PE = current market price/ esimated EPS for next financial year
Forward PE for 2004-05 = 2043.15/ 67 = 30.49
Forward PE for 2005-06 = 2043.15/ 90 = 22.70

With an EPS growth of over 30%, a forward PE of 22.7 is not high, indicating that there is scope to be optimistic about the stock's price.

Lesson to be learnt

Sometimes, investors look out for a low PE stock, expecting that its price will rise in the future. But sometimes, low PE stocks may remain low PE stocks for ages, because the market doesn't fancy them.
Keep tab on the business news to check out the company's prospects in the future.
That was the basics of fundamental analysis. Not too mind boggling, is it?

Next time you want to buy the shares of a company, at least do this groundwork.

:)
 
#3
anubak said:
How do you know if a stock is worth buying?

One, look at the 'fundamentals' of the stock: check the underlying factors behind the stock price.

In other words, find out what it is about this stock that makes it hot.

Let me introduce you to three ways by which you can figure that out.

1. Earnings per Share (EPS): How well the company is doing

Company XYZ Ltd.

Capital: Rs 100 crore (Rs 1 billion).

Capital is the amount the owner has in the business.

As the business grows and makes profits, it adds to its capital.

This capital is subdivided into shares (or stocks).

For a clearer understanding of capital, read What's in a share? Money!

The capital is divided into 100 million shares of Rs 10 each.

Net Profit in 2003-04: Rs 20 crore (Rs 200 million).

EPS is the net profit divided by the total number of shares.

EPS = net profit/ number of shares
EPS = Rs 20 crore (Rs 200 million)/ 10 crore (100 million) shares = Rs 2 per share

Lesson to be learnt

If a company's EPS has grown over the years, it means the company is doing well, and the price of the share will go up. If the EPS declines, that's a bad sign, and the stock price falls.
Companies are required to publish their quarterly results. Keep an eye out for these results; check for the trend in their EPS.
2. Price earnings ratio (PE ratio): How other investors view this share

Two stocks may have the same EPS. But they may have different market prices.

That's because, for some reason, the market places a greater value on that stock.

PE ratio is the market price of the stock divided by its EPS.

PE = market price/ EPS

Let's take an example of two companies.

Company XYZ Ltd
Market price = Rs 100
EPS = Rs 2
PE ratio = 100/ 2 = 50

Company ABC Ltd
Market price = Rs 200
EPS = Rs 2
PE ratio = 200/ 2 = 100

In the above cases, both companies have the same EPS.

But because their market price is different, the PE ratio is different.

Lesson to be learnt

In the case of EPS, it is not so much a high or low EPS that matters as the growth in the EPS. The company's PE reflects investors' expectations of future growth in the EPS. A high PE company is one where investors have hopes that earnings will rise, which is why they buy the share.

3. Forward PE: Looking ahead

The stock market is not nostalgic. It is forward looking.

For instance, it sometimes happens that a sick company, that has made losses for several years, gets a rehabilitation package from its bank and a new CEO.

As a consequence, the company's stock shoots up.

Why? Because investors think the company will do better in the future because of the package and new leadership, and its earnings will go up.

And they think it is a good time to buy the shares of the company now.

Suddenly, the demand for the shares have gone up.

Because stock prices are based on expectations of future earnings, analysts usually estimate the future earnings per share of a company. This is known as the forward PE.

Forward PE is the current market price divided by the estimated EPS, usually for the next financial year.
Forward PE = Current market price/ estimate EPS for the next financial year.


To illustrate what weve been talking about, let's take the example of Infosys Technologies.

Trailing 12-month EPS = Rs 56.82 (EPS of the last four quarters)
Closing price on January 6 = Rs 2043.15
PE = Price/EPS = 2043.15/ 56.82 = 35.95
The PE of Infosys as on January 6 = 35.95

Clear? Now be alert:

Estimated EPS for 2004-05 = Rs 67
Estimated EPS for 2005-06 = Rs 90
These figures are according to brokers' consensus estimates (you can find those in the business daily, Economic Times).

Forward PE = current market price/ esimated EPS for next financial year
Forward PE for 2004-05 = 2043.15/ 67 = 30.49
Forward PE for 2005-06 = 2043.15/ 90 = 22.70

With an EPS growth of over 30%, a forward PE of 22.7 is not high, indicating that there is scope to be optimistic about the stock's price.

Lesson to be learnt

Sometimes, investors look out for a low PE stock, expecting that its price will rise in the future. But sometimes, low PE stocks may remain low PE stocks for ages, because the market doesn't fancy them.
Keep tab on the business news to check out the company's prospects in the future.
That was the basics of fundamental analysis. Not too mind boggling, is it?

Next time you want to buy the shares of a company, at least do this groundwork.

:)
Thanx Anubak!! :)
 

Prabhan

Well-Known Member
#8
How do you know if a stock is worth buying?
Hi Anubak,
simply superb explanation !!! no doubt fundamental analysis is the best way to earn profits in long term.
But one question remain unanswered. How Do we identify the best stock out of thousands of odd stocks?? Is it like we keep on searching about the companies which satisfies these ratios/criterias or do we have any specific or preliminary criteria to filter out 100s out of thousands and do further analysis.
Seeking your valuable point of view on this !!!
Once again..thanks alot for the wonderful post...

Regards,
Prabhanshu
 

rvm123

Active Member
#9
Dear Shri Prabhan,

u can see any business newspaper like Economic times, Business Line, etc., where alongwith the quotation, p/e ratio also will be displayed. among them u can select companies with lesser p/e ratio and verify the correctness of the same thro' some sites. That way u can select companies which are quoting less with reference to their eps
 

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