10 things you must understand before buying stocks

In the stock market, we have different types of stocks. You have to select those that fit your financial goals. Remember, good stock picking means doing your homework right and then buying the stock at the right price.

Before investing into any stocks you should ask yourself following questions;

  • Will the company make more profit in the future that it did last year or year before?
  • Are the company’s sales growth higher in comparison to the industry standards?
  • Is the company going to make higher sales than it was a year before?
  • Is the company working on innovating new products or business deals?

Answers to all these questions will be possible if you have knowledge and sufficient information to take a decision.

Without these two, if you enter into the stock market jungle, then chances are that you will end up losing money.

Opportunities to make money in the stock market will always be there irrespective of market conditions. Therefore, it’s better to get knowledge and information before getting into the stock market.

The first and foremost thing is you need to completely get familiar with all the basics of stock investing

In this article we will tell you how you can acquire knowledge, what type of information is relevant for stock investing and from where you can get information to use for your stock investing strategy.

Understand how macro analysis works

You need to understand how major forces are affecting the economy and what will be its impact on the stock.

For instance, if the economy is performing poorly, then avoid high valued stocks and diversify your portfolio to protect it from any downfall in the stock market.

Here are some of the most important macro indicators;

  • Gross domestic products – GDP
  • Consumer price indices – CPI
  • Unemployment rate
  • Interest rates
  • inflation

Understanding these key indicators and its impact will help you to find out in which direction the economy is moving. 

For example, the total value of output goods and services for a particular nation is known as GDP.  A rising GDP will have a positive impact on the stock market. These data can be obtained from government sites.

Many individual and institutional investors buy stock when they think that the economy will do well and sell when they think that it will deteriorate.

Understand how Stock exchange works

Stock exchanges will help you find lots of information and corporate filings.

Main stock exchanges in India are Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).

In the USA, we have New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) and NASDAQ, from where you can get lots of information.

Stock market is full of confusing financial jargons. You need to learn all these basics to have a sound understanding of the stock market. The best place to get information is to visit their websites.

Learn fundamental analysis to pick stocks

Fundamental analysis can help you to choose stocks that are really worth buying. It helps to find the correct value of the stock. Fundamental analysis used to analyse the company’s financial health before investing. Different financial tools are used to assess the company from an investing point of view.

You can compare the intrinsic value with the market price to find out whether the stock is valued higher than the current price or less than the current price.

Here are certain parameters used to evaluate a company’s performance:

  • Growth in sales and earnings
  • Return on equity or ROE
  • Volume
  • Size of the company
  • Earnings Per Share – EPS
  • Price to earnings ratio – P/E – We have covered it at a later part of this article

Growth in sales and earnings

Growth in sales and earnings will tell you how the company is growing its market share and how well its managing cost. 

In general, a comparison of 5-6 years of income statement will tell you the growth story of sales and earnings. 

When earnings move at a higher rate in comparison to the growth rate of sales, it means that the management is able to manage its cost more efficiently to generate higher return.

Return on equity or ROE

Return on equity is a factor which allows you to know how much return the company has earned on stockholders equity. It’s a different way to analyse profitability.

ROE tells you how much the company has earned in the past with the money invested by shareholders. By knowing this particular ratio, you can assess the return the company will offer in future based on your investment. 

For example, if the company’s ROE is 20%, then the company is giving 20% return on the amount invested by shareholders. To compare, if you find company A’s ROE is 15% and company B’s ROE is 20% in the same industry, then company B is a clear winner to invest.

We have not taken other fundamentals into account. However, you should take all other fundamentals before making an investment call. 

Volume

Volume tells you the number of shares traded in the stock market for a particular day.

If 1,00,000 numbers of shares are traded in the stock market, then volume of that particular stock is 1,00,000. Large-cap stocks have typically large volumes. 

If the volume is far in excess of the normal range, then it’s a sign that something is going on with that stock. Impact can be positive or negative, but something which didn’t happen on a normal trading day. 

Here are certain important reasons when trading volume can be high with increase in share price: announcement of earning results, business deal, launch of new product or services and success on certain innovation. 

Here are certain negative reasons that can also increase the trading volume with decrease in share price: poor earning results, adverse impact of government decision, debt repayment issues and problems in financial health.

Size of the company 

When we talk about the size of the company, it means we are talking about total market value. We want to know whether the company is a small-cap, mid-cap or large-cap stock. 

If the stock is falling under the small-cap category, then investing into it can give you higher return as the company is in a growing stage, but it comes with high risk. 

Economic downturn can wipe out the entire business of the company. 

Large-cap companies are less risky but offer lesser return compared to small cap. In between these two, you have mid-cap stock. Based on your risk appetite, you must decide in which type of stocks you want to invest.

Earnings Per Share – EPS

Earnings per share is calculated by dividing earnings by total outstanding number of shares.

EPS or earnings per share tells you how much money the company is making per share. Money to calculate EPS should be the earnings that are left out after taking all expenses, taxes out of gross receipts or revenue. 

You can get earnings details and EPS from the company’s audited financial statements in the annual report.

Apart from above indicators you are also required to analyse company’s debt to equity ratio, growth in company’s net-worth, EBITDA – Earnings before interest depreciation, tax and amortization and Free cash flows.

To understand these tools and applications, you have to acquire knowledge to analyse a company’s financial statements. It consists of followings;

Remember the company’s profitability and future growth in earnings is the main reason why people are investing in stock. Company’s valuation will depend on how profitable it will be in the future.

You can know the company’s earnings from its income statement.

Before selecting a company for investment, you should do a comparative analysis. Which means, you take other companies from the same industry and start comparing financial details and other things to know which company is performing well and will perform better in future.

Understand the demand and supply concept

In order to build wealth through stock investing, you need to have a good understanding of the general markets and their major directional trend in addition to choosing the right stock.

Demand and supply is the most important factor that determines whether stock will go up or down.

Demand is what people want or are willing to pay for.

Supply is what is available.

When a company has stock which no one wants to buy, the stock price will go down as there is no demand but availability is huge as many people are willing to sell it.

Similarly, when everyone wants to buy a company’s stock, the demand goes up and no one is willing to sell, supply goes down, hence the stock price moves up.

Cause and effect analysis

Market reacts to certain types of news. Experts say that when you are seeing a stock price keeps increasing, you have to first understand the reason behind it. 

Here are certain events when stock price in general goes up;

  • Positive news report about a company.
  • Any positive news about the industry where the company has a leading position.
  • News about company’s revenue growth.

Similarly a negative news about the company will bring down the stock price.

Many online news agencies, websites and applications, are covering the financial world. You need to keep yourself up to date by knowing what is happening in the financial world and how the economy is moving.

You will come to know followings;

  • What’s going on in the industry? If the industry is not doing well, then your stock will obviously underperform. Remember, the opposite is also true. 
  • What’s happening in society and  culture? 

As a beginner you need to understand the cause and effect properly before investing.

Understand the impact of government decisions on stocks

Taxes, laws and regulations can affect the company’s fundamentals which in turn reflect in a company’s stock price. Government decisions can go against one industry where you have investments or planning to invest.

War or threat of war is another factor which affects the stock market.

The opposite can be true as well. For instance, if the government has decided to give tax credits to electric vehicles, then it will have a positive impact on all those companies that manufacture or sell electric vehicles. 

Therefore, you need to gather information on government decisions and try to understand how it impacts your company’s stock price.

Dividend payment

If you are investing for a regular income and your main objective is not to get much growth in stock value, then look for company’s following parameters;

  • Dividend yield – it tells you the return on the money you invested. Calculated by dividing annual dividend by the stock’s current market price. It changes on a daily basis as the stock price changes.
  • Payout ratio
  • DPS
  • Dividend dates – You need to remember all dividend dates with special importance to the ex-dividend date

A good dividend paying stock can help you get regular income in order to take care of your living expenses post retirement.

Stocks Beta

Beta is an indicator which tells you how volatile the stock’s price is in comparison to the stock market as a whole. 

You will get the Beta of a stock from stock exchanges.

If Beta of a stock is 1, it means that the stock moves up and down at the same pace as the market moves.

When stock beta is 1, it means market price moves up or down faster than the stock market as a whole. Similarly, when beta is below 1, stock price movement is smaller than the market as a whole.

In general, experts suggest avoiding stocks with high beta as they are more volatile.

Price to earnings ratio – P/E

P/E ratio is calculated to understand the relationship between the stock’s current market price and its reported annual earnings. It indicates how expensive a stock is. P/E ratio is also referred to as earnings multiple or multiple.

If the P/E ratio is 70, it means you have to pay 70 times the company’s earnings per share to buy one stock of the company. 

Can your investment be based on the P/E ratio. No, it’s one of the criteria you must look at but before investing you should take other fundamentals of the company to have a better picture in mind. 

If the price of the stock rises based on market situation, then P/E ratio goes up as demand picks up. If there is no demand for the stock, then ultimately stock price comes down and stock starts trading at a low P/E ratio. Therefore, a lower P/E ratio should not be blindly taken as an investment factor.

Low P/E or high P/E should not be the only criteria for investment. You need to look at other financial parameters before investing.

Industry strength

One of the key things you should analyse as an investor is how the company is growing and how the company is managing the rise in prices of raw materials. In addition to existing products growth, you should also understand the new products launch and its price tag in comparison to products of competitors.

All publicly traded companies publish their financial statements in comparison to last quarter of the year. From it you can easily know whether the company’s revenue is growing or shrinking. Management will also tell you how its existing and new products have performed. It will tell you the demand of the company’s product.

By checking company revenue in comparison to competitors, you can measure the company’s size. Almost all companies will provide revenue details that they brought in from all business units. This breakdown in business will help you understand the core revenue generating or the most important business unit of the company.

To analyse the company’s revenue growth,we suggest you download the historical revenue data for several years and start calculating the year on year growth.

Value investors always base their investment strategy on long-term growth in stock value, known as capital appreciation. If you are a new investor, buy stocks that are good values at the time of purchase and expected to grow at an above average rate in future.

To know the right valuation of a stock, these value investors first try to understand the fundamentals and factors that influence performance of the company. 

Before investing, value investors asks following questions to find the best stocks for investment:

  • How much is the company earning? 
  • Can the company produce satisfactory returns over the years compared to the market?
  • Will the earnings be upward in future?
  • Can the company maintain the growth rate in future?
  • How is the company funded? What is the company’s debt-to-equity ratios?
  • What types of risks are associated with the company? And, how can they influence the company’s sales and earnings in future?
  • Is this a company to invest for the long run?
  • How the company has performed quarter to quarter and year on year?
  • How is the management?

These and other key fundamental questions can be answered only when you have done in-depth research on the company’s fundamentals.

 You should do your own research before investing in the stock market. Never invest on the basis of a recommendation or tips.

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.