How to find shares for Investment?
There are plenty of opportunities available in the share market for investment. Finding a good share for long term investment is the main task. There are many shares you could have seen in the past which showed very good growth in the share price but after sometime the shares are falling like anything. Investors must be skeptical in selecting a share for investment. Investment, as we mentioned earlier, must be for a fair period of time. The word long term normally refers to three to five years. Hence choosing an appropriate share is very important. The company must have strong fundamental which the investor must consider.
- Sales Growth: Annual sales growth must be minimum 15% continuously for last three years at least. Sales growth is the sign the company can market it shares properly and it is able to improve the sales year by year.
- Net Profit Growth: Net Profit must also be increasing year by year. Minimum 15% increase in Net Profit every year makes the share attractive for investment.
- Dividend: A good company will take care of its shareholders. A company pays dividend regularly means it is taking care of its shareholders. If the company pays dividend regularly then it is the indication that the company has positive cash flow and it can afford paying divided to its shareholders.
- Return on Net Worth (RONW): How the company using its money is an important factor to consider when thinking about investment. It shows how much profit a company generates with the money the equity shareholders invested. RONW shows the increase of shareholders wealth. Higher RONW indicates the value grows and the same will be reflected in the share price of the company. RONW of a company must be compared with other companies in the same industry so that the position of the company can be found out. 15% – 20% RONW is desirable for choosing the company for investment. This is calculated by dividing the Net Profit available for equity shareholders over the Net Worth excluding preference capital (if any).
- Price Earning (P/E) Ratio: P/E ratio is the current market price of the share divided by its Earning Per Share. This shows how many times you are paying to get the earnings back. P/E Ratio of a company must be compared with its industry P/E. It is the general tendency of people to say low P/E shares are good for investment i.e., if P/E Ratio of a company is lower than its industry average P/E then the share is good for investment. This is not true all the time. If a company is unable to give sustainable growth the investors may not be interested in the share, in such a case the price of the share will be low compared to its peers. Hence low P/E share is not always value buy. Contrary to this, there may be some shares which are trading n high P/E compared to its industry and peers. It is not advisable to avoid such shares, since the investors are ready to pay high price for that share expecting the company’s future growth. So P/E alone is not a deciding factor. Generally, low P/E shares have the potential to grow subject to other factors mentioned above.
- Debt Equity Ratio (D/E): Debt Equity ratio is calculated as Long Term Debit divided by Net Worth. This provides an insight in to the company’s capital structure. A company can operate with its own money or own money and borrowed money (debt). Debt is available at low cost compared to the equity investors’ expectation on their equity contribution. A good combination of debt and equity will optimize the profit available to shareholders. But if the debt is too high say more than the equity then the company is subject to risk because of its interest burden. Hence the ratio between debt and equity must be looked in to. There is no specific formulae or rule for debt equity ratio but if the total debt is less than 40% (or 0.40) of the net worth it is considered as safe level. You could have come across with many companies due to its debt burden the company is unable to pay interest which leads to restructure / liquidation of the company and the share price will be falling. Such debt ridden companies are not for investment.
- Price to Book Value (PBV): Book value is the value of an equity share. This is calculated as Net Worth divided by number of equity shares in the company. This is the value of an equity share based on the latest balance sheet i.e., historical value or value based on past performance whereas the market price of a share is increasing or decreasing based on the expectation of future performance of the company. If a share is trading below its book value, the share is undervalued. From investment perspective, undervalued shares can be considered for investment. Subject to other parameters undervalued share is a good buying opportunity. This is called as Value Investing.
Conclusion: Having seen all the parameters above, how to choose a share for investment? There is no single method or formulae or technique to find share for investment. Benjamin Graham has a simple magic formula to select share – Multiply P/E and PBV of the stock. Before doing this make sure the P/E Ratio of the share is not exceeding 15 and the Price Book Value is maximum 1.5. So the upper limit of this formula is 22.50 and any share having multiplying value less than or equal to 22.50 is the one you can invest in as a value buy. As mentioned repeatedly, again this is not the sole deciding factor, you need to consider other parameters mentioned in this article.
In addition to the numbers explained above Industry outlook, quality of the management, future plan & business prospects, Marketing network of the company, etc. to be considered before taking investment decision.