Investing in stocks: five steps to assess which stock to bet on

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Since the price investors pay today is for the future performance of the business, investors need to be confident that the business they are investing in is moving in the right direction.

By P Saravanan and Sumit Banerjee
In recent times, Indian stock indices have been hitting lifetime highs on a daily basis. However, some people are still sitting on the fence; either because they are wary of the market or because they don’t quite know how to decipher the numbers before investing their hard-earned money. While we can’t influence the former very much, we can help the latter by emphasizing how to use numbers to their advantage while investing.
Industry averages

Academic standards for ratios don’t help here. A current ratio of 2: 1 or a cash ratio of 1: 1 should be relegated to the books. When investing, an investor should look at the target company’s numbers and compare them to their peers as well as industry averages. For example, the liquidity of a food delivery company can be very high and that of a construction company very low. Always compare ratios with peers and understand performance and ratios cannot be interpreted independently.

Cash balance
A company’s cash position can be used as a “cash back” offer when buying shares in a company. For example, a cash balance of Rs 3 per share of a company whose shares are currently trading at a price of Rs 10 per share effectively results in a net price of Rs 7 per share. Thus, investors pay a much lower price for that company than an identical company with no cash balance.

Debt position
The debt position of the business is the opposite of the cash position. Higher debt on the books indicates that foreigners have a higher burden on the assets of the business. Lenders may also have strict covenants (called covenants) that may not allow management to take advantage of riskier opportunities. It also means that more of its profits go to interest on the debt. So generally lower debt indicates a good signal.

Proportion of promoters
A crucial indicator that helps investors understand which direction the business is going is looking at the number from the promoter. Promoters have access to information about the company’s prospects, which is not available to the general public.

Thus, if the share of promoters increases, it is a weak signal that the company is on the way up and constitutes a good investment opportunity.

Cash flow
Profits are the first indicator to consider in order to understand the performance of the company. But, they are accumulated in nature. Management can manage the profit position through its discretionary actions, presenting an inflated picture of performance. Investors should look at cash flow to see if management actions are supported by cash inflows. A careful study of the cash flow statement helps to understand where the money comes from and where it has gone.

Investors should consider the above factors as they invariably have an impact on the performance of the company. Since the price investors pay today is for the future performance of the business, investors need to be confident that the business they are investing in is moving in the right direction.

P Saravanan is professor of finance and Banerjee is a doctoral candidate at the Indian Institute of Management, Tiruchirappalli

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