Stocks Market Made Easy
Price of each share is determined by laws of demand and supply. Higher the demand, greater the share price and vice versa.
Exchanges play a very important role in the economic growth of the country. Economy grows when new jobs are created, new jobs are created when companies open new factories, new factories are opened when firms have sufficient funds required to make these investments and exchanges help these firms raise funds for investment.
Types of orders
Limit Order: In a limit order, the order will get executed at your desired price or at a better price — i.e. at the limit price or a lower price in case of a buy order, and conversely, at the limit price or a higher price in case of a sell order.
Market Order: In this case you key in an order to buy/sell the shares immediately at the current market price.
Stop Loss order: Let’s assume you do not want to lose more than Rs.5 on your purchase (Rs 100), a stop loss order can be put in at Rs.95.
Duration order: This order variety allows you to specify the time till when the order you placed stays open. “Good for the day” and “Good until cancelled”
Shares Outstanding = Total number of shares issued by the company
Market Cap = Current Price * Shares Outstanding
(This tells me what is the current value of a company)
The important takeaway from this example is that when we create an index or buy a basket, number of shares of each stock remains constant, however weightage of each stock does not. Weightage represents the portion of total value represented by a single stock and as the stock price changes everyday, weights do too.
Stock weightage = Value of investment in the stock / total value of all investment.
1. Price Weighted : stocks in the index are weighted based on their prices, stock with the highest price will have the highest weight
2. Market Cap Weighted : stocks in the index are weighted based on their market capitalization, stock with highest market cap has the highest weight
3. Equal Weighted : stocks in the index are equally weighted.
Sectoral Indices
Tracking these tailor-made, easy to use indices enables an individual to quickly ascertain a sector’s health, its historical performance compared to other sectors, and helps him make a better investment decision.
Benchmarking
Point of reference matters — Einstein
In finance and investment world, performances are generally measured in relative terms and compared to a benchmark. The benchmark is generally an index, relative to which an an individual stock or basket of stocks performance is measured. Let’s say I define Nifty as my benchmark and invest in a basket of 5 stocks, called “my basket”. Suppose after a month, Nifty has generated a return of 5% whereas my basket has appreciated by 7%, then one can conclude that my basket outperformed Nifty by 2% (7% — 5%).
Understanding Financial Statements
Balance sheet
Balance sheet gives us an idea about the assets and liabilities of a company, as of a specific date.
Assets are obtained by using funds and liabilities represent sources of funds. Hence assets are always equal to liabilities.
We further classified assets into fixed & immovable asset and current assets.
Liabilities were classified as shareholder’s equity and long term bank liability.
Debt is a liability and refers to the the amount of loans raised by the company on which it is has to pay interest every financial year.
Equity refers to the initial investment put in by different investors/shareholders. Company can raise more funds through equity route by issuing new shares. In such a scenario equity will increase by a proportionate amount.
Leverage = debt /(debt+equity).
In ABC’s case leverage is 50% (=50000/100000). Hence ABC is 50% levered.
The debt/equity ratio of 1:1 or 50%:50% in this case, is also known as the capital structure of the firm.
Income statement
Items covered in the income statement give details about what has happened over a specific period of time.
Key Financial Ratios
ROE = PAT (income statement) / Total shareholder’s equity (balance sheet)
It is usually expressed as a percentage. In case of ABC Inc, it would be 24% (ROE = 12000/50000 = 0.24)
It is the income generated per unit of equity invested, i.e. how much returns shareholders/investors are getting on the money invested by them in the company. Please note that not all returns will be credited to the investor’s account. The company might decide to return only some amount as dividend and retain the rest for future investment purpose.
Past performance doesn’t guarantee any future performance and that the company might not generate high returns next year. But suppose ABC Inc. has continuously generated ROE of 24% over the previous 5 years, then there is a good chance that company might do this in the future as well. One should always look at the ROE history of a company to understand how much returns can be expected in the future. ROE also helps in comparing two different companies. However please make sure that only apples are compared to apples, i.e. similar companies from same sectors should be compared to each other.
Dividend Yield
Dividend yield is defined as the ratio of dividend per share to price per share (commonly expressed as %).
Div. yield (%) = DPS / Price
where DPS is total dividend declared by the company/total number of shares
In case of ABC Inc, DPS = 2000/500 = 4. Hence dividend yield of ABC Inc = 4/100 = 4%.
It’s very important to understand that when you invest in shares, your total return is not just the price return, but price plus dividend return. Dividend yield is a measure of the second type of return. It is an indication how much dividend can be expected on the investment.
As discussed earlier, an early stage company might not pay dividends and might retain its profit for future investment purpose. So in this case, dividend yield will be zero. But we know that dividend is just one part of the return. Stock prices of growth companies grow fast in response to company’s higher growth rate, thereby generating substantial capital gains. One should always consider dividend yield when investing in a company’s stock, as it can be significant part of the return that might be generated. High dividend yield stocks are a good investment avenue to supplement your income needs.
Net Profit Margin
It is defined as the ratio of net income generated in a year to total sales / revenue.
NPM = PAT / Sales
The NPM ratio tells us how efficiently a company is converting its sales to profit. Better management of taxes, raw materials, inventory and operational efficiency can lead to substantial profits. Thus in case of two different companies of same size which operate in the same sector, the company which has higher NPM is more efficient, as it can generate more profits by selling the same amount of goods.
Dividend Payout Ratio
This ratio tells us how much of profit is distributed to shareholders/investors in the form of dividends.
Payout Ratio = Total dividends / PAT
early stage companies tend to pay less dividends and reinvest more as they have more opportunity to grow. On the other hand, mature companies pay more dividends out of their profits as they have fewer growth opportunities.
Key Investment Ratios
PE Ratio
Price-Earnings Ratio
PE ratio is the price paid per unit of earnings and is calculated by dividing current market price by earnings per share. In our example, PE ratio would be X as X/1 = X.
You might have read that PE ratio of a stock is 25 or Nifty is trading at a PE ratio of 16. You might naturally wonder why anybody would pay that much to buy Rs.1 earnings. So it is important to understand that when you pay money and invest in a company, you are eligible to receive a part of the earnings generated by the company, every year, as long as you hold the share.
A has a PE ratio of 18 and B has a PE ratio of 20. We can easily say that A is undervalued compared to B as it has lower PE ratio. It would be prudent to buy shares of A as we have to pay lesser amount per unit of earnings compared to shares of B.
One can also compare the current PE ratio of the company with its historical PE to deduce whether the stocks is currently undervalued/overvalued.
PB Ratio
Price-to-Book Ratio
Book value broadly represents the amount that a shareholder can recover from a company if the company decides to shut its business today.
In XYZ Inc.’s case price to book value ratio would be 1.5. This means that you need to pay more to buy a stock, than what will accrue to you if the company decides to shut down its business today. Investors will buy at this price only if they believe that in future, value of net assets will grow as company progresses. If the value is below 1, then it usually means that investors do not believe that the company will be able to recover the book value.
Price to book value ratio of less than 1 could indicate that the stock is undervalued and it is a good investment opportunity. The ratio could also be less than 1 because investors believe that the company will not do very well in the future and might not be able to recover the amount represented by the book value. Hence it is prudent not to base investment decision on just PB ratio. And just like in the case of PE ratio, PB ratio of 2 different companies can be compared only if they operate in the same sector. A company’s current PB ratio can also be compared with its historical ratio.
Correlation
When it rains in Mumbai, India defeats Pakistan
Correlation represents how any two variables move together.So when we say that correlation between Stock A and Stock B is 80%, it means that out of 100 times when stock price of A increases, stock price of B will increase 80 times.The reverse can also be true that out of 100 times when stock price of A decreases, stock price of B will decrease 80 times.
Beta
Beta is a measure of market risk. If the beta of a stock is more than 1, it means stock moves along with market in the same direction and is more volatile than the market. So if market is expected to increase by 10%, a stock with a beta of more than 1 is expected to generate more returns than 10%. Generally, in a bull market we invest in high beta stocks, to enhance returns. If the beta is less than 1, it means that stock is less volatile and not related to the market. These stocks are best bet in a bear market, to protect against sharp price drops.
Example: Suppose there is a political party called CNG headed by a very weak politician. The party is generally viewed as non-progressive and against modern reforms, required to bring in rapid economic growth. If such a party gets elected, then obviously prices of all the stocks will go down. This is not a company specific risk, but the general market risk. Irrespective of the fact that whether I have invested my money just in Maruti or have a big portfolio of unrelated stock, I would have experienced a significant loss. That is why we say it’s not possible to avoid market risk by investing in a portfolio of unrelated stocks, as all will be impacted by market events.
