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Spot a good stock. Win big!

By Sulagna Chakravarty
February 08, 2005 13:05 IST
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Between MTV and Channel [V], you might have sometimes come across, say, CNBC.

You might have noticed a band that runs at the bottom of the screen containing the stock prices.

This is called the ticker.

Watch this ticker for some time, and you will find that stock prices are constantly going up or down. Rarely do they stay put.

Which brings you to the common question: when should you buy stocks?

Pose this question to any stock market guru (even someone who falsely professes to be one), and you will get this answer: Buy Low. Sell High.

That means you should buy stocks at a low price and sell them at a high price.

Easier said than actually done, of course.

Which brings us to the next question: 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 we¡¦ve 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.

Please watch out for ratios and how to calculate shares in the coming pieces.

• Growth stocks can make you rich!
• Sensex? What's that?
• Here's why the Sensex rises
• How the stock exchange protects your money
• Make money with shares
• What's in a share? Money!
• Make money with shares

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Sulagna Chakravarty