5 key factors to look for while investing in Stock market

5 key factors to look for while investing in Stock market

1. Earnings

The key element all investors look after is earnings. Before investing in a company you want to know how much the company is making in profits. Future earnings are a key factor as the future prospects of the company's business and potential growth opportunities are determinants of the stock price.

Factors determining earnings of the company are such as sales, costs, assets and liabilities. A simplified view of the earnings is earnings per share (EPS). This is a figure of the earnings which denotes the amount of earnings for each outstanding share.

 

2. Profit Margins

Amount of earnings do not tell the full story, increasing earnings are good but if the cost increases more than revenues then the profit margin is not improving. The profit margin measures how much the company keeps in earnings out of every dollar of their revenues. This measure is therefore very useful for comparing similar companies, within the same industry.

 

Higher profit margin indicates that the company has better control over its costs than its competitors. Profit margin is displayed in percentages and a 10 percent profit margin denotes that the company has a net income of 10 cents for each dollar of their revenues.

To get better understanding of profit margins it is good to compare two companies with alternative margins, see table below.

3. Return on Equity (ROE)

Return of equity (ROE) is a financial ratio that does not account for the stock price. Since it ignores the price entirely it is by many thought of as THE most important financial measure. It can basically be thought of as the parent ratio that always needs to be considered.

This ratio is a measure of how efficient a company is in generating its profits. It is a ratio of revenue and profits to owners' equity (shareholders are the owners). Specifically it is: 

 

An easy example of this is that if company A and company B both generate net profits of $1 Million but company A has equity of $10 Million but company B has equity of $100 Million. Their ROE would be 10% and 1% respectively meaning that company A is more efficient as it was able to produce the same amount of earnings with 10 times less equity. 

 

 

The reason for why this measure is so important is because it contains information about several factors, such as:

• Leverage (which is the debt of the company)

• Revenue, profits and margins

• Returning values to shareholders

Good approximation is that ROE should be 10-40% greater than its peer.

4. Price-to-Earnings (P/E)

When taking the current market price into consideration, the most popular ratio is the Price-to-Earnings (P/E) ratio. As the name suggest it is the current market price divided by its earnings per share (EPS). It is an easy way to get a quick look of a stock's value.

A high P/E indicates that the stock is priced relatively high to its earnings, and companies with higher P/E therefore seem more expensive. However, this measure, as well as other financial ratios, needs to be compared to similar companies within the same sector or to its own historical P/E. This is due to different characteristics in different sectors and changing markets conditions.

This ratio does not tell the full story since it does not account for growth. Normally, companies with high earnings growth are traded at higher P/E values than companies with more moderate growth rate. Accordingly, if the company is growing rapidly and is expected to maintain its growth in the future this current market price might not seem so expensive.  This is the reasoning for the existence of different investment styles; Value vs. Growth stocks.  

Example 

While some sectors normally have low P/E measures, other sectors commonly have higher ratios. For example, utilities commonly have P/E ranging from 5 to 10 while technology companies commonly have a P/E ratio ranging from 15 to 20 or above. This is due to expectations in the market about the sector and its earnings-growth possibilities. The utility sector has stable earnings and is not expected to grow rapidly while technology companies are expected to grow faster and tend to need less capital for its growth. 

In order to simplify, the following table illustrates four companies in two sectors  with alternative figures.

 

It is not very appropriate to compare Apple with GDF Suez as Apple has a growth rate of 11 times more than GDF. It is more appropriate to compare Apple with Google. In that relation, Apple seems cheaper than Google by the look of the P/E. Now you should ask why that could be? -is this bargain or are some other reason why Apple is priced lower than Google. One suggestion might be that the market expects Google to have more earnings-growth in the coming future and Apple's previous earnings growth is not expected to grow much further. 

 

In order to account for growth, the P/E ratio can be modified into the Price/Earnings to Growth (PEG) ratio. A PEG ratio is calculated by dividing the stock's P/E ratio by its expected 12 month growth rate. A common rule of thumb is that the growth rate ought to be roughly equal to the P/E ratio and thus the PEG ratio should be around 1. A relatively low PEG ratio indicates an undervalued stock and a PEG ratio much greater than 1 indicates an overvalued stock.

The PEG ratio can be very informative figure, especially for fast growing and cyclical companies. In this one ratio you get an understanding of the company's earnings, growth expectations and whether it is trading at a reasonable price relative to its fundamentals.

 

5. Price-to-Book (P/B)

A price-to-book (P/B) ratio is used to compare a stock's market value to its book value. It can be calculated as the current share price divided to the book value per share, according to previous financial statement. In a broader sense, it can also be calculated as the total market capitalization of the company divided by all the shareholders equity.

This ratio gives certain idea of whether you are paying too high price for the stock as it denotes what would be the residual value if the company went bankrupt today.

A higher P/B ratio than 1 denotes that the share price is higher than what the company's assed would be sold for. The difference indicates what investors think about the future growth potential of the company.