Are you hunting high and low for quality stocks that will deliver fruitful returns in the long run? You may have received a lot of ‘Jackpot Calls’, or ‘Multibagger Stock Recommendation’ on your Smartphone or your email. but afraid to invest in stocks since 90% people lose money in the stock market.
If you belong to those types of investors who want to select a stock after proper scrutiny to earn a consistent return, you are in the right place. Here you will learn how to pick best stocks in India that will yield fruitful returns in the long run.
So, stick to the post. Within 15 minutes you will learn how to select a stock to invest in the Indian stock market.
How to pick best stocks in India
Many an Investor is at sixes and sevens when it’s high time to start investing in the stock market. They are at sea to figure out which stocks are the best stocks to buy in India for the long term and which ones aren’t. When it comes to stock market investing for consistent returns, in the long run, you not only watch out certain parameters but also stay invested in the long run.
Check out the company’s Fundamentals
Before investing in any stock check out the fundamentals of the company to decide whether the stock will deliver better returns in the long run. These factors will help you to find financially healthy companies that will yield better returns. If the fundamentals are not intact then it becomes a futile work to investigate the products or services the company offers, management of the company, competitive moat, etc.
Parameter #1. Debt to Equity Ratio
A company can raise capital by two ways one is debt financing and other one is equity financing. When a company takes loan from banks or non-banking financial institutions then it is referred as debt financing. Contrary to that, a company raises capital by issuing equity that is traded in the stock market. It is referred as Equity Financing.
The Debt to Equity Ratio reveals how much debt or liability the company has relative to its total equity capital.
Suppose, Titan Company’s total debt or liabilities is 3 and total equity is Rs. 100. Using the above-mentioned formula the Debt Equity Ratio of Titan Company is 0.03.
It’s the best investment decision to pick a stock that has a zero debt or marginal debt ratio of less than 0.25.
Why should you invest in debt-free companies?
It’s no wonder that the companies with zero debt will deliver better Dividend Yield and higher Return on Equity, since the companies have no obligation to repay the loan to banks or non-banking financial institutions.
Parameter #2. Revenue Growth
When you pick a company that has delivered a consistent revenue growth year on year owing to robust sales, the chances are higher that the stock price will rise consistently. When it’s time to pick a winning stock that will yield better returns, in the long run, choose a stock that has delivered a double-digit growth [at least 10%] during the past 3 consecutive years.
Parameter #3. Profit Growth
Don’t invest in a company that has delivered double-digit revenue growth, but owing to the poor management the company has failed to deliver double-digit profit growth. Invest in such companies that have delivered a profit growth of 15% for the past 5 years.
Parameter #4. Free Cash Flow
Unlike Revenue Growth and Profit Growth that are prone to manipulation, Free Cash Flow will give a clear signal to the investors about the profitability of a company. Free Cash Flow helps an investor to find what a company pays its shareholders through dividends and share buybacks after funding operating expenses.
A consistent growth in the Free Cash Flow of a company is a good sign for its shareholders. After operating expenses are covered the remaining amount is allotted for business expansion, share buyback, dividend payments, or reducing debt obligations. When there is a constant rise in the company’s Free Cash Flow, there are higher chances that the share price will move upwards.
Let’s make it clear with an example. Suppose, you run a household and earn a decent five-figure monthly income. If you are not able to manage your expenses and fail to save a dime then your financial future will suffer a lot in the near future. When you need urgent cash to meet the expenses you will need to borrow from banks or relatives etc. From the next month, along with your monthly expenses you will need to repay the loan within a predefined period. To repay the loan you are unable to save for the future.
The same scenario is applicable to the companies too.
If the company fails to deliver a positive free cash flow, the company is prone to take loans from banks or non-banking financial institutions that will lead to a decrease in its profitability and increase bankruptcy risks. When the company raises funds from equity financing, this will lead to dilution of ownership of the existing shareholders.
From the above example, an investor must pick a company that has a positive free cash flow so that the company is able to deliver dividend payments and fruitful returns in the long run.
Parameter #5. Earnings per Share
Investing in those stocks that have delivered dividend but also have witnessed a growth of dividend per share is quite rewarding. These stocks will deliver fruitful returns in the long run.
Suppose, Lupin has a net income of $100 a year and pays $50 as dividend last financial year. Lupin has 50 shares outstanding.
From the above calculation, Earnings per Share of Lupin = $1 per share.
Before investing in any stock make sure that the earnings per share witness double-digit growth during the past 5 years.
Steer clear of companies that frequently dilutes the ownership
A company raises capital via Initial Public Offering to retail investors for expansion or drive growth. You must steer clear of those companies that constantly issue new shares diluting the existing shareholders’ ownership. Let’ make it clear with an example.
Suppose, a company issues one million shares via IPO to one million shareholders. Hence, each shareholder has a 1% stake in that company. Now after a year, the company issues additional one million shares to one million new shareholders. This eventually brings down the shareholders’ stake to 0.5%. Additionally, the market price of the company will decrease eventually.
Parameter #6. Dividend Payout
Whenever the company is making a profit from its operations there are three possibilities that the company uses this profit.
- First, the company uses the capital to expand its business by acquiring a new property, or starting a new plant, etc.
- Second, the company distributes the profit among its shareholders.
- Third, the company allots some portion for dividend payments and the remaining part is allotted for expansion purposes.
A Dividend refers to a cash reward or an additional stock or other properties to the shareholders of a company that a company allots from some of its earnings as determined by the company’s board of directors. A majority of the companies that are listed on the BSE and NSE announce a dividend each year to its shareholders.
A dividend is quite rewarding for long-term investors who have been investing in a company for 20-25 years. Suppose, you own a stock that doesn’t give any dividends to its shareholders then you won’t make money until you sell the stocks. Contrary to that, if a company gives a dividend regularly, say 5% a year, then as a shareholder, you not only receive monetary benefits in your bank account but also your investment grows, since you haven’t sold your stocks.
When a company gives dividends regularly to its shareholders for the past 10 years, it is a clear signal that the company is financially healthy. On the contrary, when a company is irregular in paying dividends to its shareholders, it can be assumed that the company is not financially healthy. Therefore it is a good decision to invest in those companies that have delivered consistent dividend payments regularly.
Parameter #7. Return on Equity
Return on Equity can be calculated by dividing the net profit a company makes from its operations with the company’s shareholder equity.
Suppose, two companies X and Y are in the Consumer Durables industry. Both the companies have made a profit of 100 for the financial year 2020-21. Now let’s look at a glance at the Balance sheet of both the companies. The total shareholder’s capital for Company X is 1000 and Company Y is 2000.
The ROE for company X is 0.1 and for company Y is 0.05.
From the results, it is clear though both the companies have delivered the same net profit, but the management of the company X is more efficient in converting the capital employed in its operations into profits. Hence, it’s a wise decision to invest in company X.
Parameter #8. Return on Capital Employed
The Return on Capital Employed can be calculated by dividing a company’s Earnings before Interest and Tax i.e. operating income with the Capital Employed.
Suppose two companies X and Y are in the Consumer Durables industry. Both the companies have made a profit of 100 for the financial year 2020-21. Now let’s look at a glance at the Balance sheet of both the companies. The total shareholder’s capital for Company X is 1000 and Company Y is 2000. But the debt obligations of company X and Company Y are 100 and 250 respectively.
The RoCE for company X is 0.09 and for company Y is 0.04.
From the results, it is clear that though both the companies have delivered the same net profit, but investment in company X is more profitable.
While calculating the RoCE we take an account of Net profit, Taxes payable, and Interest payable on debts. When EBIT increases steadily year on year, the company will pay more taxes to the Government. The Company will repay the debt to its lenders, and a shareholder will witness a hike in Dividend payments.
Parameter #9. Price to Sales Ratio
The Price to Sales Ratio can be calculated by dividing the total market capitalization of a company with the total sales in the financial year.
Pick a stock that has a lower Price to Sales ratio. For non-cyclical stocks, a price to Sales Ratio of 0.75 is deemed fit, and for cyclical stocks, the ideal Price to Sales Ratio is 0.4.
Parameter #10. Price to Earnings Ratio
To determine whether a stock is undervalued or overvalued Price to Earnings Ratio is one of the key matrices used by analysts.
The price-to-earnings ratio can be calculated by dividing the company’s share price with its earnings per share in a financial year.
The Price to Earnings Ratio reveals what the market is willing to pay today for a stock for its future earnings growth. The increase in earnings leads to an increase in dividend payments. The higher earnings and higher dividend payments will skyrocket the stock price.
Do remember P/E Ratio reveals what investors are willing to pay today for future earnings growth. That’s why the P/E ratio varies from sector to sector.
Take the example of the Banking sector. When inflation tends to rise banks earn more income in the near future by charging higher interest rates while offering credit cards and mortgages.
Contrary to that, at the end of the economic recession consumer durables sector will deliver robust performance since consumers will buy more consumer products on credit when the interest rates are low.
Finally, as an intelligent investor, take a glance at the economic cycle and the sector accordingly to pick the best stocks that are undervalued.
Parameter #11. Price to Book Ratio
The Price to Book Ratio can be calculated by dividing a Stock’s Market Price with its Book Value per Share.
Although the Price to Book ratio varies from industry to industry, any stock with a P/B ratio of less than 1 is undervalued and it is a good bet for the long term horizon.
Parameter #11. Beta
To calculate the risk while investing in stock, Beta is a widely used key matrices used by the analysts. Beta is quite handy to determine the volatility of a stock in comparison to the overall market. If a stock has a beta of 1 or higher, then it is a clear signal that the stock is more volatile than the market and is able to deliver better returns than the overall market. When a stock’s beta is less than one, then the stock is less volatile than the market and yield lower returns.
Parameter #13. Current Ratio
The Current Ratio gives a snapshot of the Current Assets and Current Liabilities of a company.
The current Ratio reveals the financial health of a company. It indicates whether it will repay the debt [short term and long term debts] and liabilities or obligations [Taxes, Dividends] by liquidating its current assets. Investing in companies with Current Ratio 2 is deemed fit.
Parameter #14. Liquidity Ratio
The liquidity ratio reveals a debtor’s ability to pay off current debt obligations without pumping external capital. In other words, the Liquidity Ratio discloses the company’s ability to sell its assets at full tilt to raise cash to meet short-term debt obligations. Liquidity Ratio gives a snapshot of the financial position of a company to calculate whether the company is able to repay the debt without making default on a loan.
Parameter #15. Solvency Ratio
Unlike Liquidity Ratio that gives a snapshot of pay off short-term debt obligations, Solvency ratio measures a company’s ability to meet its long-term debt obligations without any default. In other words, the Solvency Ratio reveals the probability of whether a company will default on its long term debt obligations.
Check out the Qualitative Factors
Fundamental Analysis emphasizes on earnings, valuation, and other key matrices. On the contrary, Qualitative Analysis of Stock involves a detailed analysis of intangible factors namely, Business Model, Competitive Moat, Management, and Corporate Governance of the company. Qualitative Analysis allows a retail investor to understand how the businesses generate revenue, whether the company has a sustainable competitive advantage, how management is efficiently deploying the capital to generate profit, and most importantly whether the company is poised to grow.
Parameter #16. Business Model
When you are the first time in Dalal Street, it’s a crucial decision. You need to understand a business model of a company. The Business Model refers to the company’s strategy to make a profit from its operations. It’s interesting to investigate what products or services the company sells, who is the target audience, and how they manage the finances to generate profit. There are various simple businesses that you may find as clear as mud. There’s no single person who understands all the sectors and their business model in the world. The important point is to think about what businesses you understand and what businesses are hard to interpret.
Let’s illustrate what is a simple business with an example.
A simple business is one where you can easily evaluate whether the company will be still in operation in the business that is doing now after 20 years. The chances are high that GSK Consumer will continue to sell Horlicks, ITC is likely to sell Cigarette, and Asian Paints will sell paints and pigments. Find these types of businesses where there is some degree of certainty of what they are doing today will continue to do the same business even after 3 decades.
By applying the same technique, ace investor Warren Buffet avoids huge losses during the dot-com bubble burst. Warren Buffet doesn’t make an investment if the company’s business model is hazy. This haziness makes it a difficult call to predict the performance and returns in the long run.
Parameter #17. Management of the Company
Efficient and transparent management is the backbone of the company that will deliver better earnings to its shareholders. It’s important to research management before investing in any company. It’s worth seeing whether the management of the company is making an innovative strategic decision that will lead to a rise in earnings consistently and the shareholders will get a sweet share in the form of a dividend.
Apart from the above, as a smart investor watch out who are sitting on the key positions i.e.CEO, CFO, CIO, along with their qualifications and past performance. You should hunt high and low for what tenure they have been sitting on these key positions. A management team that handles the operations for a long time is a sign of a healthy company. Contrary to that, a frequent change in management is a red signal that signifies that the management is not efficient enough to deliver robust performance.
To determine the future prospect of the company, watch out whether the promoters of the company increase their stake in the company. The promoters of the company have the best knowledge about the earnings and future prospects. When they increase their stake, it’s a clear signal that the promoters believe that the company will outperform in the long run. You should invest in those companies that have offered share buybacks in the past. In essence, Share buybacks and increase in promoters’ stake are the strong signals that the company has delivered a robust performance.
Finally, you should investigate the transparency of the management. It’s the management call to disclose the earnings before the shareholders and investors. Search for companies with ‘Transparent Management’ that disclose earnings results not only when the company has delivered a robust performance but also when it witnesses a decline in earnings and the reasons behind the deteriorating earnings.
Parameter #18. Competitive Moat
Competitive Moat allows a company to stay ahead of peer companies thus dominating in any specific industry. To find out the competitive advantage of a company first evaluate how the company is operating and how a company has an advantage over its peer companies. Before searching for quality companies, analyze whether the company has a competitive moat within the industry.
Let’s make it clear with an example. Coalgate is the first preference when anyone goes to the market to buy a toothpaste. It gives Coalgate a sustainable competitive moat. When you like the product then theoretically other consumers will also prefer Coalgate. Another example is Fevicol – an adhesive brand of Pidilite Industries.
Apart from that, you should investigate whether the company has a large and diverse consumer base. When a company targets a specific portion of demographics, there are higher chances of devastation when the target consumer’s preferences take a shift.
Parameter #19. Corporate Governance
Corporate Governance refers to a set of rules, objectives, and practices set by the board of directors by which a company is directed and controlled. It’s worth seeing whether the company follows the principles of transparency that allows an insider or outsider to gauge the company’s goals, actions, etc.
Additionally, one of the important matrices of corporate governance is security. It’s the company’s responsibility to ensure the shareholders’ or clients’ personal information is not leaked or unauthorized users don’t get any access to these vital pieces of information. A data breach may weaken the trust of the public in the company leading to a decline in the company’s stock price.
Parameter #20. Shareholding Pattern
The Shareholding Pattern discloses the ownership pattern that comprises the entities namely, The promoter’s Stake, FII’s Stake, DII’s Stake, and Retail Investors Stake.
Promoter’s Stake – They are with the company since inception and they are the owners of the company. Usually, the promoters hold a majority of the stake of the company.
Foreign Institutional Investors – Foreign Institutional Investors belong to other countries who invest in Indian companies that have a growth opportunity.
Domestic Institutional Investors – Domestic Institutional Investors are the Indian entities namely Mutual funds, Insurance companies, etc. that buy a stake in a company that trade in the domestic stock market which will yield better returns.
Retail Investors – Like, you and I are retail investors that own a stake in any company.
When in a company there is a high stake of the promoters, it is a positive sign that the promoters of the company are confident that the company will outperform the market in the long run. Contrary to that, a low stake of the promoters in a company signals that the promoters aren’t confident enough about the company’s performance. Additionally, when promoters increase their stake, it’s a good indication that they are optimistic about the potential of the company and that’s why they increase their stake.
The same scenario is applicable to FII’s stake. When FII’s stake in a company is high or FII’s increase their stake year on year, it means that FII’s are optimistic about the future growth of the company.
7 Questions you should ask yourself before investing in the stock market
After analyzing the above-mentioned fundamentals and qualitative factors of a company here are a few points you should consider before investing in the stock market.
Are you investing money for the long run to say 30 years?
“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” – Benjamin Graham.
Stay invested for the long run to witness the power of compounding. Suppose you have invested a lump sum amount of Rs. 1 lakh. When you stay invested for 10 years, 20 years, and 30 years, your investment will be 4 lakh, 16 lakh, and 66 lakh assuming 15% CAGR.
Do you have a clear picture of what product or services the company offers?
Before investing in any stock you must understand the underlying business. There are ample numbers of companies operating in the consumer durables, automobiles, banking sector, non-banking financial sector, or pharmaceuticals. Investigate the company behind the product before investing in it. Don’t invest in the ‘Petroleum’ sector without any idea what products or services it offers and whether it is capable to tackle peer competition and the scope for the company in the long run.
Whether the products or services the company is offering will be relevant after 20 years?
This will give you a clear signal about the future prospects of the company. Watch out the services and products that a company is offering now. Investing in such companies that will exist 20 years from now has a huge growth potential. It is because you will witness the power of compounding. For example, do you think that people will use toothpaste for 30 years from now? The answer is yes. The industry has been existed for over 100 years and will definitely continue for the future to come. Maybe the flavours will change, but the toothpaste will be there. Long story in short, select a stock that will last for at least 50 years from now.
Are you investing solely on past performance?
Don’t rely only on the earnings reports and past performance. Past performance doesn’t guarantee future returns. Always watch out for the management’s efficiency, peer competition, along with earnings, and valuation ratios.
Do you gauge the valuations solely on the basis of the Price to Earnings Ratio?
Even some growth stocks have a high P/E ratio, but the growth stocks have the potential to multifold your investment in the long run. However, when you find an undervalued stock you should analyze why the stock is undervalued.
Should you invest in mid-cap stocks?
Even though mid-cap stocks are more volatile in comparison to large-cap stocks, mid-cap stocks have a high potential to enhance the earnings. Thus mid-cap stocks increase their market share. The mid-cap stocks can become a large-cap company in the long run. Since the large-cap stocks have witnessed saturation and the chances are higher that they will deliver multi-bagger returns. On contrary, a mid-cap stock with robust earnings can deliver multi-bagger returns in the long run.
Have you diversified your portfolio?
Warren Buffet advises the retail investors not to put all of their investments in one industry or a sector. Let’s make it clear why you need to diversify your portfolio. When your portfolio consists of only airline stocks, then the chances are higher that your portfolio will plummet when the airline industry gets any bad news namely, an infinite pilot strike.
But when you diversify your stock portfolio among airline stocks and railway stocks, then when airline stocks plummet the railway stocks tend to rise. The problem in airline will lead the passengers to look for railway. This is the cheaper option also for the passengers.
From the above example, it is clear when you are investing in a specific industry or sector the chances are higher that your stock portfolio will plummet. Instead diversify your portfolio across various sectors namely airlines, technology, infrastructure, consumer durables to minimize the risk.
- Read also: 15 Best Indian Stocks to Buy for Long Term Investment
- Read also: 10 Golden rules of investing in stock markets
Are you a first-time investor and confused about how to pick a good stock to invest in? Join our online course to pick winning stocks. Enroll Now!
Hope this article will help you to find how to pick the best stock to invest in. Feel free to comment if you have any doubts so that I can help you to clear your doubt.