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Simple Mathematics Behind Stock Analysis and Selection

Updated on February 7, 2019
Babu Mohan profile image

I am a marketing professional from India holding a post-graduate degree in Management.

Understanding Stock Markets

Long Term Orientation

Stock markets may not appear to be driven by logic and reason at a given point of time. But over a longer period of time, the market movement could be explained by logic and reason.

I have personally lost some money with a short term approach and my good investment decisions have always been associated with a long term approach. Stock market returns would be attractive only if one stays invested in good companies for long term, say ten years at the minimum.

Trading room in action
Trading room in action | Source

Key Metrics to Analyze Stocks

Stock analysis is not rocket science. The following simple metrics are more than enough to evaluate a stock.

1) Sales

2) Profitability

3) Key ratios like PE, P /B & debt equity ratios

4) Dividend yield

5) Historic trends

I would focus primarily on the techniques involved in evaluating stocks in an attempt to demystify the process of stock analysis and stock selection.

Sales

Sales is the most important factor one should look at. The patronage of loyal customers and good sales are indicators of a company's health. We may know of many good companies doing well in market place in visible industries like FMCG, pharma and automobiles. In unfamiliar categories like certain industrial products, we can get the sales numbers easily through a net search.

The company's sales should also be compared with its competitors to see its relative strength. If a company has good sales numbers, then it clears the first test.

Sales is the most important factor one should look at. The patronage of loyal customers and good sales are indicators of a company's health.

Profitability

Some companies report good sales but they may not be profitable. It is possible that such companies do not have a sustainable business model to survive in the long run. On the contrary, it is also possible that the company is in the initial investment phase and would start making profits later.

There are so many companies that are already profitable with good sales numbers. Instead of breaking our heads about whether a loss making company would become profitable later, we can stick to companies that are already profitable.

Net profit margin = net profits / sales

Higher the net profit margin, better is the financial health. So profitability is the next step in evaluating stocks.

Stock Comparison Table - An Illustration

 
Company A
Company B
Company C
Sales
$ 14.5 million
$ 14.5 million
$ 100 million
Net profit margin
8%
7%
2%
PE ratio
14
16
42
Dividend yield
3%
2.5%
0.5%
Clearly Company A & B have better value compared to Company C on all parameters except total sales.

Key Financial Ratios

A company with good sales and profitability may not be attractive if its share price is very high. Buying such an expensive scrip would not give us great returns. There are also good companies at reasonable or bargain rates. These scrips have a better potential to grow. Would we buy a new Mini at $ 1 billion even though most of us may love the car? Same logic applies to stocks also. We should buy good stocks at the right price.

The financial ratios like PE, P / B and debt equity ratio would help us understand if the share is priced right or not.

Price earnings ratio (PE) = share price / earnings per share

Lesser PE ratio for a stock compared to the index PE would mean that the stock is undervalued. A higher PE ratio for a stock would mean that it is overvalued. Lesser the PE, better would be the prospects of returns. The Dow Jones Industrial had a PE of around 19 on 17th January 2019 and the Indian Nifty had a PE of around 26.

Price to book ratio (P / B) = share price / book value per share

Herein, a lesser P / B ratio would be preferable. For instance, a P/B ratio of 100 would mean that the stocks are overpriced by 100 times over the book value. This would mean that the stock is way too expensive compared to its asset value.

Debt equity ratio = Total debt / equity capital

This again is a critical metric as more debt exposure would mean a risky business model. A lower debt equity ratio is always a healthy sign. A company's debt equity ratio should be preferably less than the average debt equity ratio of the industry. Ideally, one should opt for companies with debt equity ratio of 1 or less.

Dividend is a sign that the company's profits are real. Dividend is also a great source of passive income that can grow over time.

Dividend Yield

Dividend is a portion of the company's profits that gets distributed to shareholders. Dividend is a sign that the company's profits are real. Dividend is also a great source of passive income that has the potential to grow over time.

Dividend yield = dividend per share / share price

Dividend yield for Dow Jones Industrial is 2.33% and Indian Nifty is 1.24℅. One can easily find stocks with higher dividend yield than the respective indices. A dividend income is also handy even as we enjoy the benefits of long term capital appreciation when the share price goes up.

After applying these 4 metrics, our list of good stocks would shrink but we would be left with gems. There is still one final test to clear, namely the past history.

Illustration of Historic Sales Trends

 
Company A
Company B
Company C
Year 0
$ 10.0 milllion
$ 16.0 million
$ 98.0 million
Year 1
$ 11.0 million
$ 15.0 million
$ 98.0 million
Year 2
$ 11.5 million
$ 15.5 million
$ 102..0 million
Year 3
$ 12.5 million
$ 14.5 million
$ 101.0 million
Year 4
$ 14.0 million
$ 14.5 million
$ 99.0 million
Year 5
$ 14.5 million
$ 14.5 million
$ 100.0 million
Company A seems to be on a better growth path with a CAGR of 7.7%. All things considered, Company A is the best scrip with a good PE ratio, dividend yield and sales growth.

Historical Trends

After looking at the above 4 metrics, one should not forget to look at the historical performance of the company. One should look at the history of a stock for the last 5 or 10 years.

One should identify stocks where sales, profits and dividends are growing over the years. A consistent dividend payout coupled with a growing sales is a very healthy sign. Once we look at a number of companies using all these 5 metrics, we can select the good investment options.

CAGR for a 5 year period = (Year 5 sales / Year 0 sales)^(1/5)-1

Compound annual growth rate (CAGR) of sales, profits and dividends would give an idea of how well the company has fared.

Apart from the numerical analysis, one should also look at the qualitative aspects. The online retail is threatening to take huge shares from organized retail. The younger generation is increasingly becoming conscious of their looks and this would mean growth opportunities for personal care products and services. Internet has become an integral part of our lives and there is a growing need for better online security. We can expect companies specializing in online security to do well. Such qualitative insights are useful as well.

Can we go wrong when we find growing companies with a dividend yield that beats bond yield or deposit rates? As greedy as this requirement may seem, such hidden gems can be found in every market. If we stick to fundamentals and stay invested for long, we can see the best possible returns from stock markets..

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

Please leave your valuable comments.

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    • Babu Mohan profile imageAUTHOR

      Mohan Babu 

      2 weeks ago from Chennai, India

      I agree with you Eurofile. Long term perspective is a main if not the only requirement to be a successful investor.

    • Eurofile profile image

      Liz Westwood 

      3 weeks ago from UK

      Your article echoes the impression that I have picked up about stocks. Namely that you have to be in the market long term to make the big overall gains.

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