Investing in shares is not a piece of cake. For sure shares investment is not easy but it is not as difficult as thought by majority. What makes shares a difficult proposition is the lack of knowledge. When we talk about share market investment we must know some basic rules of investing in shares.
The knowledge of these basic rules cannot guarantee profits but what it can do is to help you take calculated risk. When we talk about ‘risk’ you can be certain that there will be price volatility but ‘a calculated risk’ can ensure can ensure profits in long term. This is the reason why all qualified investors always suggests long term investment backed by fundamental analysis of shares.
These are two great combinations of share analysis. Long term investment backed by Fundamental analysis is great tool in hand of investors. Why I call this combination as ‘great’ because these two on their own has the power to turn your short term losses into profits. How?
When you are investing in shares backed by Fundamental Analysis, you are making sure that the company you are selecting to buy shares are ‘Fundamentally Strong Companies’. All fundamentally strong companies shall have two important characteristics, (1) It should have capability to increase its earnings year after year and (2) The market price of share should not be overprices.
In order for the company to increase its profits year after year they shall have a combination of strong business fundamentals. Fundamentals like increasing sales volume and consistent or increasing profit margin. In order to maintain a continuous growth in sales and profits certain basic business tenets like a strong brand name, efficient and honest managers, strong infrastructure and above all competitive advantage drives growth.
Often companies invests money to modernize and expand their business process. Indirectly by modernizing and expanding its business, a company is working to increase its sales and profitability. All world class companies invests on regular basis to expand and modernize its capacities. With increase in sales, the profit figures increases and subsequently there will be increase in the Net Worth of the company. Net Worth (also called as Shareholders Capital) is the fund that was initially invested to run the company (means no of outstanding shares multiplied by its face value) plus any retained earnings.
With increase in the profits there will be increase in the retained earnings, which in turn will increase its Net Worth. Net worth of the company is directly linked to the retained earnings figures. The retained earnings values expressed in the balance sheets are all cumulative figures. Suppose in year 1 id retained earnings was $100, in year 2 the retained earning is %75 then cumulative figure after year 2 will be $175. With increasing retained earnings the net worth also climbs.
The market price of shares always rise in proportion to the net worth of the company. An increasing Net worth of the company will mean proportionate increase in the market price of share. Some people use the book value figures as their comparison with market price of share.
But I prefer to go as multiples of Net Worth. Suppose the Net worth per share of a company is say $1 and it is currently trading at $10, it means it is trading 10 times its net worth. Net year if the net worth increases to $1.2 it means the market price is likely to rise to $12. So Net worth figure is a good yardstick for investors to forecast the future price of shares.
But all these theories will fail in case an investor buys an overvalued share or overpriced share. This is the biggest mistake an investor can do while trading in shares. Never buy an overvalued share. When I mean overvalued share what do I mean? We were discussing the Net worth of a company, we also discussed the multiple of net worth at which a particular share is prices in the market.
Net worth per share of a company is say $1 and it is currently trading at $10, it means it is trading 10 times its net worth. So what do we mean by overpriced, if multiple is 5 then it is overpriced? If multiple is 10 then it is overpriced? If multiple is 15 then it is overpriced? The answer to all this question is ‘No’.
A share is valued not only on basis of its current net worth but also on basis of its capacity to generate future earnings. A company which has reasonable competitive advantage, has sound managers who run the business and has good infrastructure can generate consistent future earnings.
But this is only a hypothesis, there is one rule which can help investors actually evaluate the shares whether they are overvalued or undervalued. This stock analysis tool is called “Equity Yield” method. This is great investing formulae that helps investors make a decision that whether a share in overvalued or undervalued. The best thing about earning yield rule is that almost anyone can use it as its understanding and application is very easy.
Conclusion
So the bottom line of share market investing is without understanding the fundamental advantages of a company and without analyzing that whether a share is undervalued or not, It means invest in shares blindly.
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