Choosing the Right Companies to Invest in- Part 1??
Investing in the stock market is an art. You increase your probability dramatically with the right knowledge. In short, you are actually sifting out the right companies to invest in. ‘Right companies’ mean the companies that have the potential to grow profitably in the future. There are five important financial parameters, which can help you sift the gold from the sand.
- Return on Equity- Return of Equity or ROE measures the rate of return on the ownership interest of the common stock owners. It is a financial ratio. Return on equity gives you an insight on the corporation’s profitability by revealing how much profit a company generates with the money the shareholders have invested. It tells you how good the company is in using its investments to grow earnings. To get ROE, net income is divided by the total equity. Take note that net income is for the full fiscal year and that total equity does not include preferred shares.
- Intrinsic Value- Intrinsic value is an important indicator to identify the real value of a company or an asset. It is based on the perception of a company’s true value including all aspects of the business, both tangible and intangible. This technique intends to find out if a company exceeds or falls below its current market value. If it is below, it means that the company is undervalued.
- Retained Earnings- It refers to the percentage of net earnings not paid out as dividends but retained by the company to be reinvested in its core business or to pay off debt. In most cases, companies retain a percentage of their earnings in order to invest in the areas where the company can create growth opportunities, such as buying new machinery and spending the money on more research and development. To calculate retained earnings, add the beginning retained earnings to net income and subtract any dividends paid to shareholders. It is believed by great investors that if a company does not utilise its retained earnings well, then you should be looking for others who do.
- Profit Margin- Profit margin rests on a simple principle. It measures how much out of sales, a company actually keeps in earnings. A higher profit margin indicates a more profitable company that has better control over its costs. To compute profit margin, simply divide profit be sales. Remember that the higher the net profit margin, the higher are the chances of your investments multiplying.
- Owner’s earnings- This is not technically a financial ratio. Owner’s earnings determines how much profit the true owner of the company gets. Factors that make up this determinant are goodwill, depreciation or huge pension returns. It can be defined as the sum of net income, depreciation, amortization minus capital expenditures, and minus additional working capital needs. According to some great investors, owner’s earnings are the true measure of earnings.