Most of us have heard of the stock market crashing and the amount of money that was lost in these crashes from our near and loved ones. The past news has led us to believe that the stock market is like gambling or like a casino. But in reality investing in the stock market is not gambling. In order to know about the myths of the stock market one should have the appropriate knowledge of the stock market.
Now let us start understanding some of the basic things of the stock market:
Stocks are also called as share in a part of the company. When you buy a stock, you become a part owner of the company. This means that you will be a part of all the risks and responsibilities of the company. In other words, if the company does well and makes a profit then you will get a share of the profit too and vice versa.
Stock is one of the riskiest of all asset classes. In past we have seen people lose their entire savings because of one wrong decision to invest. In other investments like gold, land or cash, there are various safeguards built into these investment products to ensure the safety of the initial capital. But in the stock market there is no such barrier to the downside risk.
Most of the people invest in the stock market because of greed and ignorance. Most of them want their money to give quick returns, so they look at stocks which offer “quick” returns ultimately resulting into heavy losses.
The second part is ignorance.
Most of the people who invest in the stock market know nothing about the companies in which they have invested money. Most of them make decisions depending upon the advice of fund managers who gladly take their commission but not the risk. They are lured by the graphs and projections of mutual fund companies. While the market is good and things are going great, they make money, but when things start going down, they are in for huge losses. It is important to know the rules of the game. If you keep playing the game whose rules you are not aware about then even if you win a couple of times, you are bound to lose in long run.
Some of the important points to be kept in mind are:
1. Do not believe in generic statements like “Stocks always go up in the long run”.
Most of the market analysts and financial planners will tell you that if you stay committed and invest in a particular company for the long run, you are bound to make money. They will provide you with different statistic figures and data to make their point. Our investment decisions should not be based on financial data only. You need to take into consideration and analyse all macro factors including the US markets, impact of the global markets and other monetary decisions that will impact the domestic stock market.
2. Which stocks to be invested in?
There are thousands of companies listed on the NSE and BSE. As an investor you need to study the companies that you wish to invest in. Some are overpriced above their fair price value while some are lower priced. So the main goal is to find a fair value of the stock that you are interested in. To find a fair price value of a stock, you need to understand the financial statements of the company, information of their new projects, funding from banks and other important information. After making the decision to buy the stock at a particular fair price value, you need to wait for the market to price it fairly and only then buy the stock. In short, a good investor will buy a stock cheap. So let’s look how we can evaluate stocks as to whether they are cheap or expensive.
a) Price to Earnings ratio:
To calculate the price to earnings ratio, you need to know the total revenue of the company in the latest financial year, also called as total earnings and the total number of shares publicly available. For e.g., a company has total earnings of Rs.1000 and there are 10 shares publicly traded on the exchange. If you divide the first by the second, you get Earnings per Share (EPS). And if you divide the price of the company by the EPS, you will get the price earnings ratio. For e.g., If a company is trading in BSE at a price of Rs 500 and the EPS is Rs 10 then the PE ratio is 500/10= 50.
This means that the share of the company you bought today for Rs 500 has earned only Rs.10 last year. In short it will take 50 years (500/10) at the current earnings level to get your initial investment back.
Why do people pay such a high amount for the stock today? The reason is that they believe that the EPS will go up further in the future. Speculation in the market also leads to making profit. EPS is the starting point to make a quick judgement whether a company is cheap or expensive. Average PE is different for different industries. For e.g. PE for the paints industries is around 40 while the average PE for infrastructure will be below 10.
b) Price to Book Ratio:
The book value of the company is the value of its total tangible assets minus its liabilities. The book value per share is the measure of the company’s book value that each share carries within it. Divide the current share price by the book value and you get a fair estimate of how leveraged the company is. For e.g. if the company is liquidated today, then how much of share price will be paid back to the shareholder. The general rule is that the lower the price to book ratio, the lower is the risk that an investor takes by buying into the company. It must also be noted that the book value calculates only the tangible assets. Intangible assets such as patents, brand value and good will are not measured.
c) Dividend yield:
A dividend yield is a portion of a company’s earnings distributed at regular intervals to its shareholders. The dividend yield is a measure of a percentage of annual return for holding the stock. For e.g., if you have stocks worth Rs.100 and the dividend yield is 2% then you get Rs.2. The higher the dividend yield the better it is.
These are some of the important aspects that need to be kept in mind while investing in the stock market. A proper and a careful study of stocks will lead you to make a better decision in investing in proper stocks.
Please read our article Financial Planning for the family
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Tags: dividend yeild, price to book ratio, price to earning ratio, Stocks, Stocks as Investment options