The stock market does not always perform under viable conditions. However, equity trading is known to generate good returns. In this article, we have tried to explain the process of analyzing companies.
Any fair valuation of a stock is the actual value at which the stock should be trading at according to your analysis. This value can be compared with its market price to determine whether it is overpriced, underpriced, or moderately priced.
You should buy underpriced stocks, as its value will be appreciated to your estimated cost. This way, you are bound to make some profits. In case you own an overpriced stock, you can sell it; whereas when it comes to moderately priced stocks, it is better to let them be.
Generally, the valuation of equity shares is done using either one of the three techniques.
1. Present Value Models
The principal on which these models are based states that since shareholders are also joint-owners of the company, the future profits made by the company belongs to them. Hence, the combined price of these profits (concerning today’s currency value) is said to be the value of the equity shares.
2. Relative Value Models
An organization can be evaluated based on other similar organizations. In this situation, the market price of the competitors will be compared with the said company’s fundamentals (like sales, book value of the equity or income). The ratio is then used to estimate the value of the company.
3. Asset-based Valuation
Here, the value of the company is based on the market value of the assets it owns. The market value of the assets (excluding the equity) is then subtracted from the market value of the assets to arrive at the cost of the investment. However, this model is rarely used for valuation.
The financial performance of the company is recorded in the form of financial statements. There are three types of financial statements that are used to present the annual and quarterly reports of the company.
I. The Income Statement
It consists of the income and the expenses of the company during a particular financial year.
II. The Cash-flow Statement
As the name suggests, this statement is basically about the cash position of the company. In simpler words, it gives a brief about the cash inflow and outflow of the business.
III. The Balance Sheet
This includes the assets and liabilities of the company. Generally, it reflects the state of the assets and liabilities at a particular time and not over a period.
When it comes to fundamental analysis, it is a 6-step process that involves –
i. Using Financial Ratio for Initial Screening
Screening all the listed companies in the stock exchange is quite impossible. Hence, use financial ratios like
a. PE Ratio
Price-Earnings Ratio determines the future growth of the stock
b. P/B Ratio
Price-to-Book Ratio is used to compare the company’s current market price to its book value
Return on Equity determines the profitability of a business in relation to its equity
Compound Annual Growth Rate provides the constant return rate over the time period.
e. Current Ratio
It determines whether a firm has enough resources to meet the short-term obligations.
f. Dividend Yield
It is the company’s total annual dividend payments divided by its market capitalization.
ii. Understanding the company
It is essential that you have a complete understanding of the company in which you are planning to invest. You can gain information on companies by visiting their official website.
iii. Studying the financial report of the company
Once you understand the company that you are planning to invest in, check its financials (like the balance sheet, profit loss statements, and cash flow statements).
iv. Checking the debt
Make sure that the company you are investing in is not under severe obligations as it will not perform well in the market. Invest in companies that have a debt to equity ratio less than 1.
v. Check Company’s Competitors
It is highly recommended to even check the competitor of your chosen company before investing. This will help you make a well-informed decision.
vi. Analyze prospects
Plan to invest in a company that has a long prospect. Choose companies with products and services that will still be in use 20 years from now.
Stock market trading can be complex to understand. However, with share market software applications available in the market, you can continue trading on the go. Moreover, they provide live-updates on financial markets across the globe. Hence, downloading a share market trading application is worthy for anyone planning to invest in the Indian share market.