Analysis for the investor

Investors have different motives such as safety, liquidity and profitability. When buying shares, an investor would keep in mind the purpose of investment and degree of risk involved. An investment may be used for enhancing current income or future income or blend of the two. High risk, high return is the cardinal rule. If someone is seeking safe investment, “blue chips” are quite safe with comparatively assured income and less volatility. But such blue chips would available at a high price which would adversely affect ratios like price earnings ratio and dividend yield etc.

It is obvious that certain types of analysis is of interest to potential investors. This is subject matter of this hub.

There are many words for describing an investor. It can be called entrepreneur or risk-taker or simply owner. But it is different from a gambler or a speculator or an adventurer. An investor takes a calculated risk and avoid pure risk or speculative risk. By nature, an investor is risk-averse.

In order to help an investor to take a sound decision, there are many techniques such as risk analysis, project appraisal, SWOT analysis, Decision Tree, law of probability, experiments and market surveys. While these techniques does not replace human judgment, it strengthens decision making process and give warning signals if anything is going wrong.

An investor can learn a lot by studying stock exchange operation and analysing stock behavior with economic conditions. It can take prudent decisions such as when to buy and when to sell. There are number of ways for risk reduction and ensuring a steady flow of income from investment.

View point of an investor would differ from those of lenders or managers even if they are looking at the same company. An investor is more interested in profitability ratios derived from income statement and future outlook. An investor gets its reward by way of dividend income, capital gain and derivatives.

In particular, an investor would watch the following ratios:

• Dividend Yield
• Earning Per Share
• Price Earning Ratio
• Book Value Per Share
• Return on Equity
• Dividend Payout Ratio

The aim is to manage investment. It would involve buying decisions, selling decisions and holding decisions. For example, dividend payout ratio shows aggressiveness of the company. It is a short-term ratio. A company cannot survive much longer by distributing all its earnings by way of dividends and borrowing from the market at a much higher rate if there is a cash need for expansion or modernization.

It shows relationship of dividend and price. In simple words, it is ROI per share. It takes a conservative view and ignores possible capital gains. It is a way to work out how much cash an investor is getting for each rupee invested. It shows a bang for the buck.

In case of Packages Ltd, the yield is very low as the company is not paying dividend but re-investing. It is increasing its earning potentials and thereby market value of its share. The investors would compensate themselves from capital gains.

Investors seeking minimum cash flows should invest in stock paying high and stable dividends. In order to meet expectation of the share-holders, some companies maintain dividend equalization reserves.

Also known as “earnings multiple” or “price multiple” or simply "multiple". It is comparison of price of a share in the market and its earnings per share. For example, a share is presently trading at Rs.66 and earnings per share of the company were Rs.3, the P/E ratio would be 66 divided by 3 or 22. It shows how expensive the stock is. Obviously, if there is a slump in the market and the price dwindles down to Rs.18, the P/E ratio would accordingly fall to 3 as against 22 before market crash. If someone buys it at 18 while earnings remain Rs.3 per share, one would have a windfall profit from the deal.

There are some variations about earnings. If earnings are taken from the last four quarters results, it would be called trailing P/E, if next four quarters, it is known as forward P/E. Sometimes, a combination is used i.e. two past and two future quarters.

High P/E ratios are considered risky as it signifies high expectations.

EPS is profitability ratio showing how much profit has been earned per share. Naturally, if a company increases its share capital, EPS is affected for the time being. Later, it may go up if the additional funds were used for a high earning project.

In simple terms, total earnings are divided by total outstanding number of shares. There are some variations whereby weighted average technique is used for working out outstanding shares. Also, some analysts may include shares of convertibles bonds in the outstanding shares number.

EPS is a very significant ratio throwing light on the profitability of a company. EPS is a component of another ratio P/E which is equally important.

Ratios differ from industry to industry but ROE is a ratio which does not vary much.  It has a common denominator i.e. one rupee of shareholders’ equity.  It tells how much an investor is getting from each rupee invested or retained in the business. Naturally, if one industry is returning low profit, the investor would shift to other sectors.  As a result, there would be lesser investment in a losing industry.  Eventually, the entire industry would be wiped out by imports.  If there is an import ban, the scarcity would drive profit up and there would be chances of re-investment.

ROE calculation is simple: Net profit after tax divided by equity and expressed as a percentage.

If a company is not distributing dividends but retaining the profit in business, the retained earnings or reserves and surplus would go up. This would boost up book value per share which in turn would have a good effect on market price of the shares. The ratio is calculated by dividing total equity with number of shares outstanding. T

he ratio is compared with market value. Suppose a share is selling at Rs.35 where as its book value per share is Rs.55. Potential investors would be keen to buy such share as it gives a good hope of future dividends in the form of cash or bonus.

An investors studies the financial statements to get some information of the industry in general and the company in particular. Such information alone does not help form a good decision and must be augmented with other sources such as stock-exchange quotationsf, economic indicators, industrial prospects and profession advise.

Financial analysis helps the investors to get the ground realities such as Return on Equity (ROE). This indicator can be compared with market rate, desired rate of return or cost of capital. Sometimes, opportunity cost is used as a bench mark. The idea is to grasp whether an investment would prove fruitful or be avoided.

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