5 Important Things To Check Before Buying a Stock

The company's Business growth, Business quality, debt position, promoter analysis, Valuation and the health of its industry are all metrics you should consider prior to making an investment.

   1) Business growth

More revenue from sales does not always mean more profit. Revenue is only part of the story. Revenue minus expenses equals profit. A business must keep its costs as low as possible to make sure it is maximizing its profits.

 

2) Business quality

"Quality is about meeting the needs and expectations of customers" Customers want quality that is appropriate to the price that they are prepared to pay and the level of competition in the market.

2.a) ROCE

What is ROCE?

ROCE is a financial ratio used for assessing the profitability as well as the capital efficiency of a company. It helps to know how a company is performing and is raising its profits from its capital.

How to Calculate ROCE - ROCE Formula

Here is the Return on Capital Employed Formula:

ROCE= EBIT/Capital Employed

EBIT = Earnings Before Interest and Tax
Capital Employed = Total Assets – Current Liabilities

EBIT: -It is also known as operating income and indicates how much a firm generates from its operations alone, excluding interest and taxes. EBIT is determined by deducting revenue from the cost of goods sold and operating expenditures.

Capital Employed: -It is quite like the invested capital utilized in the ROIC calculation.

Return on Capital Employed (ROCE):-Return on capital employed (ROCE) is a financial statistic that may be used to analyze the profitability and capital efficiency of a firm.

In other words, this ROCE ratio can assist in determining how successfully a firm generates profits from its capital when it is used. When evaluating a firm for investment, financial managers, stakeholders, and potential investors may utilize the ROCE ratio as one of the numerous profitability ratios.

How to Calculate ROCE - ROCE Formula

Here is the Return on Capital Employed Formula:

ROCE= EBIT/Capital Employed

EBIT = Earnings Before Interest and Tax

Capital Employed = Total Assets – Current Liabilities

ROCE is a measure for assessing profitability and possibly comparing capital profitability levels across firms. Return on capital employed is calculated using two components: earnings before interest and tax and capital employed.

EBIT: It is also known as operating income and indicates how much a firm generates from its operations alone, excluding interest and taxes. EBIT is determined by deducting revenue from the cost of goods sold and operating expenditures.

Capital Employed: It is quite like the invested capital utilized in the ROIC calculation.

Capital employed is calculated by deducting current obligations from total assets, yielding shareholders’ equity plus long-term loans. Instead of utilizing capital used at an arbitrary moment in time, some analysts and investors may prefer to compute ROCE using the average capital employed, which is the average of opening and closing capital utilized for the time period under consideration.

Examples of the Capital Employed Formula

Understand the application of ROCE Formula through the below given examples-
According to the most recent annual report, the firm generated earnings before interest and tax ₹12 cr. total assets and total current liabilities of ₹60cr. and ₹5 cr., respectively, as of the balance sheet date. Based on the facts provided, compute the company’s ROCE for the year.


Solution –

2.b) ROE:-

What is ROE in the stock market?

ROE in share market is a financial performance metric that is determined by dividing net income by shareholders' equity. ROE is defined as the return on net assets since shareholders' equity equals a company's assets less its debt.

What happens if ROE is negative?

A negative ROE indicates that an organization is having issues with debt, asset retention, or both.

What causes high ROE?

All else being equal, ROE will rise as net income rises. Another method for increasing ROE is to diminish the value of shareholders' equity.

Why is ROE important?

ROE is regarded as a measure of a company's profitability and efficiency in generating profits. The higher the ROE, the more effective management is at generating income and growth from equity financing.

Formula to Calculate ROE

Here is the ROE Formula-

Return on Equity (ROE) = Net profit / average Shareholders equity.

3) Debt position

What Is the Debt Ratio?

The term debt ratio refers to a financial ratio that measures the extent of a company’s leverage. The debt ratio is defined as the ratio of total debt to total assets, expressed as a decimal or percentage. It can be interpreted as the proportion of a company’s assets that are financed by debt.

A ratio greater than 1 show that a considerable amount of a company's assets is funded by debt, which means the company has more liabilities than assets. A high ratio indicates that a company may be at risk of default on its loans if interest rates suddenly rise. A ratio below 1 means that a greater portion of a company's assets is funded by equity.

3 a) Debt to Equity (DE) Ratio

The debt-to-equity ratio (D/E ratio) depicts how much debt a company has compared to its assets.

It is calculated by dividing a company's total debt by total shareholder equity.
Note a higher debt-to-equity ratio states the company may have a more difficult time covering its liabilities.

DE Ratio= Total Liabilities / Shareholder’s Equity

Liabilities: Here, all the liabilities that a company owes are taken into consideration.

Shareholder’s equity: Shareholder’s equity represents the net assets that a company owns.

High DE Ratio

A high DE ratio is a sign of high risk. It means that the company is using more borrowing to finance its operations because the company lacks finances. In other words, it means that it is engaging in debt financing as its own finances run under deficit.

Low DE Ratio

This means that the company’s shareholder’s equity is in excess, and it does not need to tap its debts to finance its operations and business. The company has more owned capital than borrowed capital and this speaks highly of the company.

3 b) Interest coverage ratio

What is Interest Coverage Ratio?

In simple words, the interest coverage ratio is a metric that enables to determine how efficiently a firm can pay off its share of interest expenses on debt. This ratio is also known as ‘times interest earned’.

How to Calculate Interest Coverage Ratio

Interest Coverage Ratio = Earnings before Interest and Taxes or EBIT/ Interest Expense

Here, EBIT =company operating profit.
Interest expense=interest paid on borrowing like loans, lines of credit, bonds etc.

How to Interpret Interest Coverage Ratios

Interest Coverage Ratios (1 or less):-  Interpretation =>The company might be facing challenges in fulfilling interest obligations and may become a defaulter

Interest Coverage Ratios(1.5 to 2):- Interpretation =>The company is financially sound and has ample funds to fulfil its obligations

Interest Coverage Ratio(2 or More):-Interpretation =>The company is extremely financially sound and can easily fulfil its interest obligations.

4) promoter analysis

Promoters play a significant role in the success of a start-up organization and are usually paid in terms of equity shares of respective holding companies in proportion to the total capital raised. Apart from market strategies implemented to incentivize investment in a particular company, the holdings of a stock promoter also influence the total trade volume of its equity shares in both primary and secondary markets.

Types of Promoters

Depending upon the nature of an issuing company/authoritative body, stock promoters can be classified into the following categories.

Penny promoter: -One of the most popular types of promoters, such individuals/company is in charge of creating awareness regarding a start-up business among residents. Such promotion can cater to both resident and non-resident individuals, depending upon the requirements and guidelines pre-set by issuing companies.

Penny stocks are often considered a dubious form of investment, as no adequate knowledge regarding the issuing companies and services provided are available to individuals. In India, all stocks trading below Rs. 10 can be labeled as penny stocks. Such securities are highly speculative as no public information is available, and they often have large bid-ask spreads and consequently, a lower trading volume.

Promoter specializing in government securities:-

Debt tools issued by the central government and the RBI are initially traded through auctions and subsequently resold in the secondary market. A promoter often purchases a substantial chunk of such securities and trades it over the counter in major stock exchanges to facilitate investment in government securities by retail individuals not having a Subsidiary General Ledger (SLR) or Current Account (CA) with the RBI.

Institutional promoter:-

Gradually, over time, all equity shareholders act as institutional promoters of a company as they advise their friends/relatives over purchasing corresponding stocks. Such a promoter increases a company’s market reputation without imposing any financial strain and can only be developed based on past performance. High annual turnover and sales, timely declaration of profits and dividend pay-outs, etc. can create an institutional promoter, inducing huge trade purchase volume, which, in turn, drives up the market prices of such shares (through higher demand) in the market.

5)Valuation

Valuation is the process of determining the theoretically correct value of a company, investment, or asset, as opposed to its cost or current market value.

5 a) PE Ratio – Price to Earnings Ratio

PE Ratio Meaning

P/E Ratio or Price to Earnings Ratio is the ratio of the current price of a company’s share in relation to its earnings per share (EPS). Analysts and investors can consider earnings from different periods for the calculation of this ratio; however, the most used variable is the earnings of a company from the last 12 months or one year. It is also referred to as price multiple of earnings multiple.

What is P/E Ratio Formula

P/E Ratio = (Current Market Price of a Share / Earnings per Share)

Price to Earnings Ratio is one of the most widely used metrics by analysts and investors across the world. It signifies the amount of money an investor is willing to invest in a single share of a company for Re. 1 of its earnings. For instance, if a company has a P/E Ratio of 20, investors are willing to pay Rs. 20 in its stocks for Re. 1 of their current earnings.

What is a good PE ratio in India?

A good P/E ratio isn't always a high or low ratio on its own. The market average P/E ratio is currently between 20 and 25. Therefore a higher PE ratio above that may be deemed negative, while a lower PE ratio may be considered better.

What does the PE ratio indicate?

Price to Earnings Ratio The multiple is the ratio of a stock's share price to its earnings per share (EPS). One of the most often-used stock valuation metrics is the PE ratio. It indicates whether a stock is costly or inexpensive at its present market price.

What does a negative PE ratio mean?

A negative P/E ratio indicates that the company is losing money or has negative earnings. Even the most established businesses face downtime, which may be caused by environmental variables outside the company's control.

5 b) PEG Ratio – Price/Earnings-to-Growth

What is a PEG Ratio?

A PEG ratio, or Price/earnings-to-growth ratio, draws the relationship between a stock’s P/E ratio and projected earnings growth rate over a specific period.

This metric can provide a much more informed view of a stock in relation to its earning potential.
In other words, it allows investors an idea about a stock’s actual value like a P/E ratio does while also factoring in its growth potential. Therefore, for more fundamental analysis, the PEG ratio is crucial.

How to Calculate PEG Ratio?

PEG = PE Ratio / Earnings per share growth rate.

PEG Ratio vs P/E Ratio

The primary points of distinction between the PEG ratio and P/E ratio are discussed in the table below.

Parameters	Price Earnings to growth ratio	Price-to-earnings ratio
Definition	It is the ratio between a stock’s P/E ratio and projected EPS growth rate of that company.	The market price-to-earnings ratio of a stock is determined by dividing the stock's market price by its earnings per share.
Nature	It is part objective or historical and part forward-looking.	It can be both historical, forward-looking, or a hybrid.
Types	There is only one type of PEG ratio.	There are two types of P/E ratio – trailing and forward.