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For last six month I was trying to attempt to buy stocks but each time I ended up buying mutual funds instead.
Why? because I don’t know how to choose a profitable stock.
But there are people who are making profits daily. Not only this they have been making profits from the markets all time and so I started following traders, investors on-line. Furthermore, I switched to reading books on stock investments and was deeply looking for a guidance to build a very simple trading system. After many days I eventually found three gems which basically decides your investment road map i.e.
- Entry Point: You are entering in the market with capital for Short, Medium or Long term.
- Stop Loss (Exit Point): How much loss you can take? or your risk appetite.
- Profit Taking: When to sell the stocks and make money?
Once you have answered above three, it is far easier to enter the market. For Example, If I want to go for long term, then I can use a slight deviated version of Magic Formula. Similarly for short term, I can use trends coupled with calculated exit points. I was already investing in the mutual funds which is for long term and so for me it was short term (1 week or a months) in which I was interested. I will say, I am still not ready with the intra-day trading.
Ok, Now what? There are thousands of company listed on a stock exchange which one should I pick. I lived with this question for year and everyday I was looking for an answer. Genuinely, I still don’t know because market is driven by information sentiments and sentiments are not 100% deterministic but you can be ahead of many if you apply a bit of mathematics. I will say, investors has come up with so many mathematical concepts and I am going to explain six concepts which will be relevant for all the entry points. These are part of fundamental analysis of a company and we know if fundamentals are strong then it will be good company.
Note: fundamentals doesn’t effects much on daily trade or high frequency trade because in both the cases they are driven by information sentiments
P/E Ratio is most commonly use ratio to find cheaper stocks relatively. It stands for Price of a share divided by last year profit earned on each share.
P/E = Price of a share/ Earning Per Share
What it tell? If P/E is 10 then it means it will take 10 years for the firm to make profits equivalent to its market capitalization. So, A high growth firm with lower P/E will be consider cheap.
Why? Higher growth firm will easily do break-even.
Example: Let’s take the example of two private sector banks in India.
HDFC: P/E = 178.07
ICICI: P/E = 45.85
Now which one you will choose? At first glance, you will say HDFC is no-no because it will take 178.07 years for it to be profitable which is a insane number but as said above P/E should not be looked without the growth rate. HDFC has a annualized growth rate of 46% where as ICICI have 11%. Now which one to choose? As the growth rate for HDFC is high so its earning and it is expected to produce better revenue and expand really fast but it is a gamble, maybe the growth rate might not be the same next year but it is I will make huge profit here. Again, its a high risk investment.
Rule of thumb: The lower the P/E ratio the cheaper it is and I will go for the ICICI.
It is improvement for the P/E ratio because P/E ratio is about last year earnings and it doesn’t give any idea about what will be the earning for the current year. So PEG ratio consider basic value while taking earnings growth into account.
PEG = (P/E Ratio) / Earning Growth Rate
It is based on the future earning. For Example, A house is worth of what rental income you can squeeze till it’s life time. A average house life is 20 years and if the rental income per month is $ 2000 then the worth of house is 20 * 2000 * 20 = $800000 (excluding inflation).
The lower a PEG the better, as it means a stock is cheap relative to its potential earnings growth.
|HDFC||178.09||46%||178.09/46 = 3.87|
|ICICI||45.85||12%||45.85/12 = 3.82|
Again ICICI have lower PEG, it means it is cheaper.
Rule of thumb: The lower a PEG the better a stock is.
Dividend is a part of profit percentage a company gives to it’s share holder. Let me ask you a question? you just need to think about it.
Dividend Yield = (Part given to holder/Price of Share) * 100
Q: If a company is paying high dividend yield, doesn’t it means it is making great profit?
A: Maybe or Maybe Not
Most of the times the companies which gives lesser dividends are profitable and have high growth rate. Why? because they are paying less to the investor saying you will have more profit in future. On other side if a company is paying high dividend it means it is trying to please the holders by giving back the money.
Example: HDFC: Dividend yield = 1.24% ICICI: Dividend yield = 1.81%
As in above case ICICI have more dividend yield and it is reflected to what I was saying. ICICI growth is almost stagnant i.e. 12-14% for last 7 years where as HDFC have very bumpy rides i.e. growth ranging from 10-50%. It want to keep the profit for expansion or for further investment.
Here HDFC wins.
Rule of thumb: The lower a Dividend Yield the better a stock is.
I will be writing about new acronyms soon. if you like it, please share your feedbacks in the comments.