# Stock Analysis and Selection Using Simple Math

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

Stock markets may not appear to be driven by logic and reason at a specific point of time. But over a longer period, logic and reason can explain market movements. Applying math helps in the long term.

The math behind stock market analysis is not complex. It involves simple numerical operations or comparing several values. Can't we say if five is bigger than three?

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 10 years at the minimum.

## 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-to-equity ratios
4. Dividend yield
5. Historical trends

I describe how to use these metrics in stock analysis and stock selection in the following sections.

## 1. Sales

Sales is the first factor one should look at. Loyal customers and good sales reveal the health of a 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 their profit and loss statement.

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 is the first positive sign.

## 2. Profitability

Net profit margin = net profits/sales

The higher the net profit margin, the better the financial health. Therefore, 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. Excellent 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. 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 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 point to a risky business model. A lower debt-to-equity ratio is always a healthy sign. A company's debt-to-equity ratio should be less than the average debt-to-equity ratio of the industry. One should choose companies with a debt-to-equity ratio of 1 or less.

## Stock Comparison Table: An Example

Clearly Companies A and B have better value than Company C, as shown by all parameters except total sales.

Company ACompany BCompany 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%

## 4. Dividend Yield

A dividend is a portion of the company's profits that gets distributed to shareholders. A steady dividend payout from a company is an indication that its profits are real. It is a great source of passive income that has the potential to grow. 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

On 30th Dec 2019, the dividend yield for Dow Jones Industrial Average was 2.1% and Indian Nifty was 1.23℅. 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.

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 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 in the long term, we can see good returns from stock markets.

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.

Company ACompany BCompany 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

Mohan Babu (author) from Chennai, India on February 23, 2019:

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

Umesh Chandra Bhatt from Kharghar, Navi Mumbai, India on February 23, 2019:

Well explained. Thanks.

Mohan Babu (author) from Chennai, India on February 01, 2019:

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

Liz Westwood from UK on January 20, 2019:

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.