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Sunday, August 24, 2014

Beginners guide to Stock market Investing

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The most important factor where beginners feel difficulty is to deduce a formula for finding the correct price of the stock. One should refrain for purchasing overpriced stock, but the question to answer here is : How a beginner find correct value of a stock?

Following important ratios of various stocks help in finding the correct price of the stock. Once an investor knows the correct value of a stock and purchasing it is in his/her budget, only then he should purchase a particular stock.

First of the most important value which an investor should know is that of PE Ratio which is ratio of Share Price/EPS(earning per share).

The price-to-earnings ratio is the most commonly used valuation parameter. A lower PE indicates either an attractively valued stock or one whose prospects are poor. You may compare the current PE of a stock with its own historical valuations (say, 5-year average), the industry average PE ratio value should be compared to PE of SENSEX or NIFTY. While calculating PE ratio there are two approaches:
1. Calculating PE ratio using TTM (trailing 12 months) data. Calculating PE ratio using TTM data or Forward PE is based on the earnings estimates provided by analysts. The advantage of using it is that stocks respond to the prospects of a stock. But the risk remains that earnings estimates might go wrong. It is based on past four quarters' earnings, Hence it is always correct but it is backward looking and if the particular sector is on decline then investor would incur losses for sure.

Second most important value to know while purchasing a share is the PB ratio of a stock, PB ratio is ratio of stock value to the Book value of it's IPO, The price to book value compares the price of a stock with its book value (value of shares originally issued, plus retained earnings). The book value is a proxy for the liquidation value of the company. It is a good measure for judging the valuations of asset-heavy companies. It is also well suited for banking and other financial services companies. However Investors should refrain from using this ratio while purchasing stock of service firms.

Third most important ratio which a newbie investor must calculate it's EV/EBITDA value.

This particular ratio compares the enterprise value of a stock with its EBITDA (earnings before interest, tax, depreciation and amortisation), a measure of a stock's operating profits. The EPS gets affected by 'other income', which is income not derived from the company's operations, but from, say, sale of an asset. This can artificially inflate the EPS and bring down the PE. This doesn't happen with EBITDA. The latter is, hence, a better reflection of a company's earnings capability. EV or enterprise value measures a company's value. It is the sum of the market value of the firm and its longterm debt, minus its cash.

Fourth ratio which a investor must understand and calculate before finalizing a stock is the PEG RATIO which is ratio of PE and (earning per share growth rate) Here you compare a company's PE ratio with its 3- or 5-year EPS growth rate. Sometimes, a company's PE may appear high compared to its own historical valuation or the industry average. This usually happens with high-growth companies. If you wait for its PE ratio to fall, it may never happen. The PEG ratio, by comparing the PE with the EPS growth rate, offers a justification for investing in such a stock. The PEG ratio should be be below 1. If it is less than 0.5, it is very attractive stock to invest into.
Apart from calculation of all the above valuations of a stock there are various behavioural inputs needed in investors. First and most important of them all is that investors should never think that stock market investing is a route to quick riches. Those who think in similar ways are sure to lose their money over a period of time. Stock market investing needs deep understanding of the company in which one wants to invest his money. Second most important behavioural input needed while investing in stocks is that one should be ready to invest lot of time in understanding working of stock markets and should educate themselves about the very basics of investing by following LiveBombayStockExchange blog. Third most important behavioural input needed in stock market investors is that, they should never purchase a stock keeping selling in mind, stocks purchased by keeping selling in mind is way to short-sightedness and does-not give any returns at all. One should do fundamental analysis of the stock and should follow the principle of 'buy-and-hold' rather then 'purchase-for-sell' approach in stock markets.

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