Equity - 5 STOCK SELECTION GUIDELINES

1. Know the business

Warren Buffett, one of the world’s most successful investors, follows the philosophy of buying stocks of only those businesses that he understands. Select companies in businesses that you already have an idea of and find interesting. One of the businesses that could be of interest to you would be the one, which you are affiliated to because of your employment. For instance, if you are working in a pharma company, you may understand this business well.

2. Assess the past performance

All companies present details of their financial performance in their Annual Reports[A1] . In case of a company having its Initial Public Offering – IPO (when a company offers its shares to the public for the first time, it is called Initial Public Offering), it is required to publish its past performance in its IPO offer document[A2] . There are also a vast number of research reports published by research and brokerage houses, and company analysis done by the media, which is worth reading, to assess a company’s past performance and future potential. ‘Ratio Analysis’ is widely used to assess a company’s past performance.

3. Know the promoters

The promoters and management team of a company are the key people who drive its business. Their integrity dictates whether the business benefits or they benefit personally. Also, their experience and business competence is crucial for business growth. Evaluate the company’s promoters and management on the basis of four Cs: Competence, Credibility, Corporate governance and Concern for shareholders.

4. Assess the future prospects of the company

Although a company may have performed well in the past, it is not necessary that it will continue performing well in the future. All companies go through business cycles of ups and downs. It is important that you form a view on the future trends of the business the company is a player in. This can be done by reading views of experts in that business/industry and forming your own view by reading and understanding economic trends and the impact of these trends on the company’s business.

5. Assess the stock price

As mentioned earlier, the share price of all companies continuously fluctuate on the stock markets with investors buying and selling the shares. The price at which an investor is willing to buy or sell a share of a company is the perceived value of the share of the company taking into consideration the company’s present business and future business growth. In addition to this, investor sentiment plays a large role in pricing of stocks. It is important that before you buy a company’s share, you assess whether the price of the share at which it is available for purchase, is adequately valued i.e. it is not over-priced. Similarly, when you sell, you need to make sure that you are not selling too cheap. To help you assess this, you could use a popular stock market ratio called the Price/Earning ratio (P/E ratio). The P/E ratio is based on the following formula:

P/E ratio = Market price of the share
Earning per share (EPS)*

*EPS = Profit After Tax (PAT)
Total number of shares issued by the company

You can obtain information on the EPS, PAT and total number of shares issued by the company from its annual report.

Let’s understand how the P/E ratio is used with an example:

Company XYZ Ltd. has issued a total of 10 lakh equity shares and has earned a net profit of Rs 10 lakh. The EPS of the company is Re 1. The current market price of the company is Rs 15 per share. The P/E ratio of Company XYZ Ltd will be 15 (Rs 15 / Re 1).

The P/E ratio helps judge by how many times the company’s share is traded based on its earnings. In this case, the company’s stock is available at a multiple of 15 times its earnings. The higher the P/E ratio, the higher is the stock’s valuation. Usually market prices of well-established companies with a good past track record and reputed promoters command a high P/E ratio.

To use the P/E ratio correctly, keep the following aspects in perspective:

• Compare the P/E ratio of a company with that of other companies in the same business.
• Compare it with P/E ratios of the benchmark indices such as the P/E ratio of the BSE Sensex, the NSE Nifty, etc.
• Compare the P/E ratio with the growth potential of the company and the industry it is a part of. There could be a situation that even if the P/E ratio of a company is high, it would be worthwhile to buy the stock if the growth potential is significant.

To conclude, just because a company’s P/E ratio is high, it does not mean that it is over-priced. Consider this ratio along with other factors such as past performance, business potential, promoters, the company’s order book position, etc.

Income from equity investing

Capital appreciation
Equity shares of companies are listed and traded on a stock exchange (the Bombay Stock Exchange or the National Stock Exchange). The market prices of these shares are continuously moving up or down depending on the interest in the company’s stock, it’s business potential, etc. As an equity shareholder, you can profit/lose from the market price rise/fall. For instance, if you have purchased the equity shares of Company ABC at Rs 25 per share and the market price of the share rises to Rs 30, you can sell the shares at this price to make a profit. This is called ‘capital appreciation’. However, if the market price falls to below Rs 25, you would lose. This loss would be notional till you actually sell at this price and book the loss.

Bonus shares
When you purchase shares of a company, you become a shareholder of the company. When the company is doing well, it may declare a ‘bonus issue’. This means that the company will issue fresh equity shares to its existing shareholders, for free. As a shareholder, you will be entitled to receive bonus shares in proportion to your holding in the company. For instance, if the company declares a bonus in the ratio of 1:2 (this means it will issue one share for every two shares you hold) and if you hold 100 shares, you will be entitled to 50 shares as a bonus. When you sell your bonus shares in the stock market, the market price at which you sell your bonus, minus brokerage charges and necessary taxes (Service Tax, Securities Transaction Tax, etc.), will be your profit i.e. capital appreciation. In this case, there will be no cost of purchase since you have received the bonus for free. For instance, if the company declares a ‘bonus issue’ in the ratio of 1:2 (this means it will issue one bonus share for every two shares you hold) and if you hold 100 shares, you will be entitled to 50 shares as a ‘bonus shares’. The cost of these shares will be nil. In this case, if you sell your bonus shares in the market at say, Rs 35, your capital appreciation will be the entire Rs 35 per share minus brokerage, taxes, etc.

Rights shares
Another way a company offers benefits to its shareholders is by offering ‘rights shares’. This means that the company will offer fresh equity shares to its existing shareholders at a price, which is lower than the current market price of the share. For instance, if the current market price of the company’s share is Rs 35, it will offer shares at below this price, say Rs 25. As a shareholder, you will be entitled to receive ‘rights shares’ in proportion to your holding in the company. For instance, if the company declares a ‘rights issue’ in the ratio of 1:2 (this means it will issue one share for every two shares you hold) and if you hold 100 shares, you will be entitled to 50 shares as a ‘rights shares’. This implies that to obtain the ‘rights shares’, you will have to pay Rs 1,250 (50 shares you are entitled to x Rs 25 per share). In this case, if you sell your rights shares in the market at say, Rs 35, your capital appreciation will be Rs 10 per share minus incidental selling costs.

However, if you don’t want to subscribe to the rights offered to you, you can sell your rights entitlements. The price that you receive to sell your rights entitlements will depend on the rights offer price, the current market price and the demand for the company’s shares. For instance, taking the above example forward, if you decide to sell your rights entitlements of 50 shares and you receive Rs 2.50 per share, you will get a total of Rs 125. This will be your profit after deducting incidental selling expenses.

Dividend income
Companies report their profits earned on a quarterly basis. Based on the quantum of profits, companies declare dividends to distribute a portion of these profits to their shareholders. Dividends are declared as a percentage of the share’s face value. For instance, if a company declares a dividend of 10 per cent and its share has a face value of Rs 10, it implies that it will pay Re 1 per share as dividend (Rs 10 x 10 per cent). As a shareholder, you will be entitled to dividend to the extent of your share holding. For instance, in this case if you hold 500 shares, you will get a dividend of Rs 500 (500 shares x Re 1 per share). However, dividend income is uncertain. Companies don’t declare dividends regularly. Dividends are declared only when there are profits available for distribution.

Characteristics of equity

Equity is unsecured and a high risk-return investment
When you invest your money in a debt investment such as a bank deposit, bonds, etc., you are promised a fixed amount of interest on your investment and return of capital. This isn't the case with an equity investment. By becoming an owner, you bear the risk of the company not being successful. However, the rewards for bearing this risk are high. You, as an equity shareholder, are entitled to a share in the profits of the company’s business as well as any appreciation in the perceived value of the shares.

The risks and rewards of investing in equity are clearly apparent from the Bombay Stock Exchange Sensitive Index (BSE Sensex), which is a popular stock market index. This index reflects the movement of the share prices on the stock markets. The Sensex rises and/or falls continuously during trading hours. Rises indicate gains and falls indicate losses. True equity money is unsecured and directly reflects the faith of the investor in the business, its management and the commitment of its principals to it.

Equity remains in perpetual existence
The perpetual existence of a company implies that the death, disability, retirement or termination of a shareholder, director or officer, will not affect the existence of the company. For an equity shareholder, this is convenient since he does not need to renew/renegotiate the terms of his investment (like in the case of a fixed tenure debt investment). He also has the option to sell his equity holding through the stock exchange if he no longer wants to remain invested in the company.

Limited liability
Another extremely important feature of equity is its limited liability, which means that, as a part-owner of the company, you are not personally liable if the company is not able to pay its debts. In case of other entities such as partnerships, if the partnership goes bankrupt, the partners are personally liable towards the creditors/lenders and they may have to sell off their personal assets like their house, car, furniture, etc., to make good the loss. In case of holding equity shares, the maximum value you can lose is the value of your investment. Even if a company of which you are a shareholder goes bankrupt, you can never lose your personal assets.

Need for a Systematic, planned approach to money management

Whilst beginning our financial journey, we need to inculcate a meticulous saving habit. “But I do save for the future and also invest my money in various investment avenues, such as NSC, PPF, mutual funds, insurance and equity, along with some tax-saving products,” is what most of us say. And it’s true. However, it’s also a fact that very few of us adopt a systematic and planned approach to managing our finances.

This leads to an ad-hoc, casual and haphazard attitude to handling of finances. Such an approach could result in erosion in the amount of capital that is invested and, instead of a wealth build-up, it can lead to a deterioration in financial health. Worse still, an unplanned method of investing could culminate in having to cut back on aspirations leaving some or most dreams unrealised.

A financial plan

To be able to successfully fulfil your financial aspirations and live a financially secure life, constructing a “Financial Plan” is helpful. This plan analyses your short-term and long-term financial goals and sustenance needs in order to help you decide how much you should save to meet these requirements. It also times cash flows based on when financial aspirations come up for fulfilment. Not only this, the plan addresses managing of personal risks using insurance, and reducing your tax burden through proper tax planning. Lastly, in order to help you judge the level of risk you are able to cope with where investing is concerned, the plan helps you profile your risk personality and risk-taking capacity.

All this may sound extremely complicated on the surface, but financial planning simply boils down to effectively managing your financial resources to meet your desired needs and ambitions in life. A good financial plan serves as a ‘road-map’ for efficient money management. It gives a meaning to the entire gamut of financial actions that you undertake, including earning, spending, saving, investing, paying taxes, etc. So, begin with a financial plan and see how well begun is half done.