Simple Mathematics Behind Stock Analysis and Selection

Updated on June 25, 2019
Babu Mohan profile image

I am a marketing professional from India holding a postgraduate degree in Management. I am a health conscious individual.

Consider the Long-Term Approach

At any particular time, stock markets may not appear to be driven by logic and reason. But over a longer period, logic and reason can explain market movements.

I have lost money with a short-term approach. I have made all my good investment decisions with a long-term approach. Stock market returns are more likely to be attractive if one stays invested in good companies for a long time, say ten years at the minimum.

Trading room in action
Trading room in action | Source

Key Metrics to Use In Analyzing Stocks

Stock analysis is not rocket science. The following simple metrics are more than enough to assess a stock.

  1. Sales

  2. Profitability

  3. Key ratios like PE, P/B and debt-equity ratios

  4. Dividend yield

  5. Historical trends

Below I describe how to use these metrics in stock analysis and stock selection.

1. Sales

Sales is the first factor one should look at. Loyal customers and good sales indicate a healthy company. It's easy to hear about many good companies doing well in the marketplace in visible industries like fast-moving consumer goods (FMCG), pharma and automobiles. In unfamiliar categories, like certain industrial products, we can get the sales numbers through an internet search.

The company's sales should be compared with those of its competitors to see its relative strength. If a company has good sales numbers, then it clears the first test.

2. Profitability

Net profit margin = net profits / sales

The higher the net profit margin, the better the financial health. So profitability is the next step in assessing stocks.

Some companies report good sales but are not profitable. It is possible that such a company is in an initial investment phase and will make profits later; but it's also possible that such companies do not have a sustainable business model to survive in the long run.

There are so many companies that are already profitable with good sales numbers. Instead of wondering whether a loss-making company will become profitable later, we can keep it simple by sticking to companies that are already profitable.

3. Key Financial Ratios

A company with good sales and profitability may not be attractive if its share price is very high. Buying expensive stock may not give us great returns. Good companies whose stocks are available at reasonable or bargain rates offer more potential for growth. Would we buy a new Mini for $1 billion just because we love the car? The same logic applies to stocks as well. We should buy good stocks at the right price.

Financial ratios like PE, P/B and debt-equity ratio help us understand if a share is priced right or not.

Price-earnings ratio (PE) = share price / earnings per share

A PE ratio for a stock less than the index PE may mean that the stock is undervalued. A higher PE ratio for a stock may mean that it is overvalued. The lower the PE, the better the prospect of returns. The Dow Jones Industrial had a PE of around 19 on 17th January 2019 and the Indian Nifty had a PE of around 26.

Price-to-book ratio (P/B) = share price / book value per share

A lower P/B ratio is preferable. For instance, a P/B ratio of 100 means that the stock is overpriced by 100 times over the book value. This would mean that the stock is way too expensive compared to its asset value.

Debt-equity ratio = total debt / equity capital

Debt-equity ratio is a critical metric, because more debt exposure may indicate a risky business model. A lower debt-equity ratio is always a healthy sign. A company's debt-equity ratio should be less than the average debt-equity ratio of the industry. One should choose companies with a debt-equity ratio of 1 or less.

Stock Comparison Table: An Example

 
Company A
Company B
Company C
Sales
$14.5 million
$14.5 million
$100 million
Net profit margin
8%
7%
2%
PE ratio
14
16
42
Dividend yield
3%
2.5%
0.5%
Clearly Companies A and B have better value than Company C, as shown by all parameters except total sales.

4. Dividend Yield

A dividend is a portion of the company's profits that gets distributed to shareholders. A dividend is a sign that the company's profits are real. It is a great source of passive income that has the potential to grow over time. A dividend income is handy even as we enjoy the benefits of long-term capital appreciation when the share price goes up.

Dividend yield = dividend per share / share price

The dividend yield for Dow Jones Industrial is 2.33% and Indian Nifty is 1.24℅. One can find stocks with higher dividend yield than the respective indices.

After applying these first four metrics, our list of good stocks will shrink but we should be left with some gems. There is still one final test to apply: the stock's history.

5. Historical Trends

Look at the historical performance of the company over the last five or ten years.

One should identify stocks whose sales, profits and dividends are growing over the years. A consistent dividend payout coupled with growing sales is a very healthy sign. Once we look at several companies using all these five metrics, we can select the best investment options.

The compound annual growth rate (CAGR) of sales, profits and dividends is a handy measure of how well the company has fared over a given period.

CAGR for a 5-year period = (Year 5 sales/Year 0 sales)1/5 - 1

Besides numerical analysis, one should also look at the qualitative aspects. For example, online retail is threatening to take a huge share of market from brick-and-mortar retail. The younger generation is becoming conscious of their looks, which means growth opportunities for personal care products and services. The internet has become an integral part of our lives and concerns about security mean companies specializing in online security hope to do well. Such qualitative insights are useful.

Can we go wrong when we find a growing company with a dividend yield that beats bond yield or deposit rates? As exacting as this requirement may seem, we can find such hidden gems in every market. If we stick to fundamentals and stay invested for the long term, we can see the best possible returns from stock markets.

Illustration of Historic Sales Trends

 
Company A
Company B
Company C
Year 0
$10.0 milllion
$16.0 million
$98.0 million
Year 1
$11.0 million
$15.0 million
$98.0 million
Year 2
$11.5 million
$15.5 million
$102..0 million
Year 3
$12.5 million
$14.5 million
$101.0 million
Year 4
$14.0 million
$14.5 million
$99.0 million
Year 5
$14.5 million
$14.5 million
$100.0 million
Company A seems to be on a better growth path with a CAGR of 7.7%. All things considered, Company A is the best stock, with a good PE ratio, dividend yield and sales growth.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

Questions & Answers

    Please leave your valuable comments.

      0 of 8192 characters used
      Post Comment
      • Babu Mohan profile imageAUTHOR

        Mohan Babu 

        9 months ago from Chennai, India

        Thanks Umesh Chandra Bhatt for your valuable comments. Hope there was some new information for you.

      • bhattuc profile image

        Umesh Chandra Bhatt 

        9 months ago from Kharghar, Navi Mumbai, India

        Well explained. Thanks.

      • Babu Mohan profile imageAUTHOR

        Mohan Babu 

        10 months ago from Chennai, India

        I agree with you Eurofile. Long term perspective is a main if not the only requirement to be a successful investor.

      • Eurofile profile image

        Liz Westwood 

        10 months ago from UK

        Your article echoes the impression that I have picked up about stocks. Namely that you have to be in the market long term to make the big overall gains.

      working

      This website uses cookies

      As a user in the EEA, your approval is needed on a few things. To provide a better website experience, toughnickel.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

      For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://toughnickel.com/privacy-policy#gdpr

      Show Details
      Necessary
      HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
      LoginThis is necessary to sign in to the HubPages Service.
      Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
      AkismetThis is used to detect comment spam. (Privacy Policy)
      HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
      HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
      Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
      CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
      Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
      Features
      Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
      Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
      Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
      Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
      Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
      VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
      PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
      Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
      MavenThis supports the Maven widget and search functionality. (Privacy Policy)
      Marketing
      Google AdSenseThis is an ad network. (Privacy Policy)
      Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
      Index ExchangeThis is an ad network. (Privacy Policy)
      SovrnThis is an ad network. (Privacy Policy)
      Facebook AdsThis is an ad network. (Privacy Policy)
      Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
      AppNexusThis is an ad network. (Privacy Policy)
      OpenxThis is an ad network. (Privacy Policy)
      Rubicon ProjectThis is an ad network. (Privacy Policy)
      TripleLiftThis is an ad network. (Privacy Policy)
      Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
      Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
      Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
      Statistics
      Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
      ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
      Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)
      ClickscoThis is a data management platform studying reader behavior (Privacy Policy)