Wouldn’t it be wonderful if you knew how to make money in the stock market? Contrary to popular beliefs, making money in the stock market is not a herculean task. Neither is stock market wealth reserved for elite investors like Rakesh Jhunjhunwala or Vijay Kedia. Anyone can make money in the stock market provided they do one key thing right – Analyse and invest in the right stocks. If you excel at this one step, then you will surely make money in the stock market.
We have all played cricket at least once in our lives. And honestly, the adrenaline rush on hitting a six is no less than the one felt by Yuvraj Singh! But does this mean that we can play in the world cup? Sadly, No.
So, what makes us different from professional cricketers? It’s the knowledge and the skills they apply to consistently win matches.
The stock market is also like this. Skills and knowledge in choosing the right stock is what makes great investors stand out from normal ones.
So, when you think about how to make money in stocks or how to make money in the stock market, the answer is fairly simple. You need to master the art of choosing the right stocks. If you excel at this one step, then you will surely make money in the stock market.
Now the question arises, how do you pick the right stock?
To pick the right stocks, you must conduct thorough research about the company. This is like conducting research before buying a car. You would first compare various models, research about the brand and a lot more to decide which car is the best.
Similarly, when you are researching the right stock to invest in, you must look for these five things.
It may look daunting for many but I have even listed an easier way to make money from stocks in the end. So do forget to read the whole article.
1. Analyse the sector and the industry
We have all heard about the top-down approach, right? If not, then let’s quickly understand it. The top-down approach focuses on the broader picture first. So, we first look at the performance of the overall economy, then a specific sector, then comes the industry and finally the company.
There are various sectors in our economy. Some of the major ones include financial services, information and technology (IT), consumer goods, oil and gas, and pharma.
But why should you analyse the sector instead of the company in the first place? This is because understanding the sector in which the company operates helps you understand how the company might perform in the future.
When a sector is booming, most of the companies which belong to the sector will also grow. For example IT sector after Covid-19. Most of the IT companies gave stupendous returns post the Covid-19 pandemic.
Whereas, even if you invest in any well-known company but the sector has been underperforming. There are high chances that your stock might underperform too. For example, aviation sector is known to be a difficult sector to operate.
So, when you think about how could you make money in the stock market, the first thing to look for is the right sector.
Next, you need to look for the booming industry in a particular sector. You might be wondering what is the difference between the sector and the industry.
Well, the sector refers to the larger segment of the economy. Industries are the structured group of businesses of a particular sector.
For example, the financial services sector is diversified into a broad range of businesses such as mutual fund industry, banking businesses, non banking financial companies (NBFCs), Insurance companies and a lot more. So you must look for booming industries from a particular sector.
2. The business model of the company
Once you select a booming sector and an industry, you then need to compare stocks and analyse the business models of different companies. You must choose a company that is constantly upgrading its technology and adopting innovative practices to improve its efficiency. Such companies have higher chances of long-term sustainability.
Let’s take the example of Jio Fiber. It provides broadband and high speed internet. Hence it is known to be the best one among its competitors in the telecom sector.
So, to select the most promising company you can simply look for a company’s unique selling points (USPs). You can also do a strength, weakness, opportunity and threat (SWOT) analysis.
3. The management of a company
This is one of the most overlooked areas while analysing a stock. Investors rarely pay attention to the quality of people who are running the business. This is a huge mistake.
Management is the backbone of a successful business. A company’s management is responsible to provide value to its shareholders. The decisions taken by the management will affect the company and eventually the share price.
Hence, you must check the management commentary or Management Discussion and Analysis section in the annual report of the company to know their views about industry and business. Here the management also provides insights into their future goals, opinions, challenges and a lot more.
4. Financial statements of the company
The next important thing to check in a company is their financial statements. This data is readily available to us these days. All you need to do is refer the investors section on the company’s website. You must check consolidated financial statements and not standalone statements. This way you have a wholesome view of the entire group companies.
While studying a company’s financial statements, evaluate the following:
- Balance sheet – This shows the total assets and liabilities of a company.
- Income statement – This shows aspects such as revenue, expenses, taxes etc.
- Cash flow statement – This is a reflection of the cash flow required for day to day survival and liquidity of a company.
You must also check the annual reports which describes the important activities undertaken in the financial year.
5. Financial ratios of the company
This is a shortcut for studying the detailed financial statements of a company. Financial ratios help you analyse and compare key parameters of a company.
Here are a few important ratios to consider while selecting the right stock.
1. Profitability ratio
Profitability ratio helps you analyse how much profit the company is able to earn on its capital. Profitability ratios include:
a. Return on Equity (ROE)
Return on equity = Net Income / Shareholder’s Equity
It measures the ability to generate returns on equity capital. Here, you must compare the average industry ROE with the ROE of the company. Ideally, the company which provides consistency and growth in ROE is the ideal investment option.
b. Return on Asset (ROA)
Return on Assets = Net Profit / Total Assets
It measures how efficiently the company is using its asset to generate returns. You must look for stocks with high ROA. Higher the ROA, the more efficient the company is.
c. Return on capital employed (ROCE)
ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
ROCE determines the returns generated on the entire capital i.e. equity + debt capital.
2. Liquidity Ratios
Do you ever go out shopping for groceries without money? No, right. Similarly, for smooth day to day operations, the company must have enough liquidity. Liquidity ratios measure the company’s ability to meet its short-term obligations.
Recommended watch: What is liquidity ratio?
a. Current ratio
Current Ratio = Current Asset / Current Liabilities
The current ratio is used to evaluate a company’s ability to pay its short-term obligations due within 12 months. These payments include interest payable, salaries, wages etc. Ideally, a current ratio of less than one indicates that the company might not be able to meet its short-term obligations and may default. So, always look for a current ratio of more than one.
b. Quick ratio
Quick ratio = Quick asset / Current liabilities
Quick ratio measures a company’s ability to pay bills due in the next three months. It does
not consider inventory. This is because inventory can take longer than three months to be sold and converted to cash.
3. Solvency ratios
Solvency ratios compares the debt levels of the company to its assets. While quick ratio measures a company’s short-term obligations, solvency ratios measure a company’s long-term obligations.
a. Debt to equity (DE ratio)
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
Debt to equity ratio shows how much debt a company has compared to its equity capital. A company with high debt will have to spend its earnings on repayment of interest and principal. So, equity shareholders might get very little share of a company’s earnings.
Recommended watch: What is DE ratio?
b. Interest coverage ratio
Interest Coverage Ratio = EBITDA / Interest Expense
Interest coverage ratio measures a company’s ability to honour its debt payments. Ideally, the interest coverage ratio should be high as it denotes that the company has the ability to pay its interest on time.
These are a few of the most important points to consider while finding the right stock. But while you analyse stocks you must check if the returns generated by the stocks and the risk involved align with your investment goals. If not, then the stock might not be the right one for you.
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