THE BEST INDICATOR(S) TO INVEST IN THE STOCK MARKET

   A single cloud doesn't forecast rain. When there are more clouds, yes, there is the possibility. Watching clouds get darker and darker and we say, “Don’t forget umbrellas.” And the rain follows. Similarly, in the Stock Market, there are certain indicators which predict
a high possibility of certain stocks going bullish. This article aims at the bottom-up fundamental analysis of a stock in the simplest jargon which will help a layman like me to select the stock with the highest probability of rising among its peers. One thing to be borne in mind is that this discussion applies to the long-term investment and the comparison should always be made among the companies of the same sector.

    STOCK MARKET: BEST INDICATORS TO INVEST

   

P/E Ratio (Price to Earning Ratio)

: This is one of the most popular ratios of fundamental analysis. This ratio indicates how much you are willing to invest per currency unit of profit in that particular stock. A P/E ratio of 25 and above is considered momentous. But how reliable can a P/E ratio be in a market which is governed by predictions, media, assumptions, trends and sentiments? Every time a batsman comes on the pitch to bat, he is expected to deliver a ton. How many players are able to translate these expectations into reality? The same thing applies to the stock market. Although popular, P/E ratio is not reliable. The real skill lies not in investing in stocks with a high P/E ratio but finding stocks with a low P/E ratio with better prospects of future growth. It lies in identifying those sleeping bulls, who, when they get up, are difficult to stop once they start running!

   

PEG Ratio (Projected Earning Growth Ratio)

: This is a close relative of P/E ratio and it is affected by the same factors as described above. This ratio is derived by dividing P/E ratio by the forecasted growth in earning per share. This is the ratio of sentiments vs analytical prediction or that of dreams to reality. Such quotients at the most indicate that the stock which you are willing to invest in, has a very low probability of running into a loss.

   P/B Ratio (Price to Book Ratio)

: Just as every one of us has two faces – a true face inside and a face shown outside with all smiles, a share also has two values. A market value created due to market hype and real, book value based on accounts of the company. This ratio doesn’t have much utility other than checking overenthusiastic investors who are rushing to buy overpriced stocks.

   These three matrices described above are like those politicians who always like to remain in the limelight but there is no guarantee that they will fulfill their promises. 

"The stock market goes up or down, and you can't adjust your portfolio based on the whims of the market, so you have to have a strategy in a position and stay true to that strategy and not pay attention to noise that could surround any particular investment."

- John Paulson

   There are certain indicators which give valuable information about a company by parts but not as a whole. Just like BP, blood sugar, temperature, oxygen concentration or electrolytes; which do not describe the total health of a patient but they are invaluable, the following indices will point out how safe a company is to trade in.

   

EPS (Earning per Share)

: This is another most popular and widely used stock ratio. What P/E is to the future, EPS is to the present. Stay away from negative EPS as it indicates a loss. It is calculated by dividing net income of the company by the total number of shares issued. Does a high EPS mean one should buy that share as early as possible? Not necessarily. It may plummet tomorrow. It may also climb up. Your luck. Another thing is, the net profit of a company is not as reliable as operating profit because it is influenced by one time incidental expenses (loss or profit) and hence, there is a tendency to panic or to get carried away. It is better to travel at 60 km/hr on a smooth road than to travel on a bumpy road at 100 km/hr. Perhaps you may reach a speed of 200 km/hr or beyond in the long run.

 

D/E Ratio (Debt to Equity Ratio)

: Divide total liabilities (debt) by total equity to get this ratio. This is the ratio of doubt vs trust. The numerator indicates that finance generated by the company after seeking out for its creditors while the denominator indicates the amount the investors have invested willingly. Higher liabilities mean higher risk levels, that too, with additional regular interest expenses. Higher equity value means higher confidence shown by the investors in the performance of the company. Ideally, equity should override the debt and D/E ratio shouldn’t exceed one. If it is more than two, check the balance sheet. If the amount of secured loans is more than that of the unsecured loans, stay away from the company. If the ratio shows an increasing trend, the company needs to be admitted in ICU.

   

ITR (Inventory Turnover Ratio)

: This ratio tells us how many times the average inventory of a company was sold in the year. It is derived by dividing the total cost of the goods sold to average inventory. The higher the demand for the goods, the higher the ratio will be. A lower value indicates stagnation.

   

Receivables (Debtors) Turnover Ratio

: I Know a grocery shop down the lane in a supermarket that had to be closed down because the owner failed to recover his outstanding credit payments. His RTR must have been too low. It is derived by dividing net credit sales to an average receivable amount. Never mind the calculations, all the figures are available on the balance sheets. RTR of a company is 4:1. It means that out of every 5 currency units given on credit, the company is able to recover 4 IN TIME. The point is, credit sales are equivalent to the loans extended without interest and hence, a company has to be efficient in receiving its credit money. Just reverse this ratio and instead of receivables (debtors) you get deceivable (traitors) turnover ratio!

• The best indicator of your PHYSICAL health

   

ICR (Interest Coverage Ratio)

: This ratio shows whether the company is walking on its legs or with the help of a walker. In fact, this should be the first ratio one should glance at after opening a balance sheet. This is the ratio of a company’s operational profit (EBITDA) to its interests payable. Naturally, a company needs to have its operational profit several times that of the total interest payable in order to pay its interests which is one of the many expenses of current liabilities. When the margin between these two is wide enough, a company is able to generate net profit after squaring up all the liabilities. Creditors demand that this ratio should at least be 1.5 in order to issue debt to the gasping company. ICR below 1 indicates the condition of the company to be critical but chances are timely resuscitation could review the company. Let ICR slide below 0 and it means that the company is sinking into a coma.

   Now let’s go to the actual battlefield and scrutinize a few ratios, which experts claim to be the best indicators of the stock market.

   

ROE (Return on Equity)

: This value is comparable to the interest rates on the fixed deposits that we keep in the banks. ROE value indicates how much you get on per 100 units of your investment in your currency. It is also known as RONW. In accounting terms, net profit divided by shareholders’ total amount. Let’s probe into it a bit. What amount is the denominator talking about? The amount on Jan 15, Feb 7, March 20 or April 26? This is a highly volatile figure and one should take the average of all trading days. Some experts consider the average of equity value at the beginning and at the end of the financial year. Suppose, at the beginning, the value is 5 million, at the end 3 million and 15 million in the middle, what denominator should one choose? So, this ratio is not a perfect tool. This will hold good for bank calculations where amount invested is constant throughout the year but as far as the stock market is concerned, the word ‘average’ is meaningless.

 

 ROCE (Return on Capital Employed)

: This ratio tells how the direct income of a company is affected by indirect factors, or let’s say, how the net operating profit (EBITDA) of a company is affected by long-term assets. It is derived as a percentage of net operating profit divided by permanent assets less current liabilities. This type of comparison requires a bit of deep reflection into it. It’s like considering height, age and extent of a tree when asked about an estimate of the total number of fruits on it. The number of branches multiplied by average fruits per branch would have given a direct and better estimate. In this ratio, factors like equity net worth, inventory (goods: raw and ready), and receivable accounts are not considered which are directly related to a company’s profit.

   Let’s consider another example. Joe used his own truck for the periodic work of his company and his boss allowed him to claim the expenses. Joe considered the following factors while claiming the bill: 1. Petrol and parking expenses 2. Expenses to replace spares on the truck, if any 3. Salary of the driver he has employed 4. Cost of his garage in which he keeps the truck overnight 5. The cost of the land on which the garage is built in his farm 6. The cost of the road he has constructed to drive his car, tractor and truck to ply between his farm and his house. 7. The cost of a new music system in his truck when the old one was stolen due to his driver’s negligence when Joe had sent his truck on some company work. How many factors would Joe’s boss comply with? What is the role of fixed tangible assets while calculating the current cycle? ROCE must be taken with a gram of salt. Are there any indicators available that are better than ROCE?

   Current Ratio: We are not concerned about the past, we are not worried about the future, we want to know how the company is performing in present circumstances. This is what most of the investors like you and me are curious about. Current ratio (also called Working Capital Ratio) is the ratio of current assets to current liabilities. Current assets include current cash, securities, accounts receivables and inventory. Current liabilities include dividends payable, the current fraction of deferred revenue, current maturities of long-term debt and interests payable. A current ratio above 1 means your cow is consuming fodder worth 100 currency units and producing milk worth 150 currency units. Considering all debts and liabilities, if it continues to give milk worth 200 currency units, this is the opportunity for you to employ your surplus income in purchasing another cow and expand your business. A current ratio above 1 also means that the company needn't take debt – in fact, it should repay – and it needn’t sell its long-term assets. A good corporate governance would always keep a current ratio between 1 and 2.

   Another close variant of the current ratio is quick ratio, also known as Acid Test Ratio which doesn’t take the inventory into account. This is what makes it more stringent. More stringency means more limitations and an inability to apply it in a broader sense while choosing a stock. Hence, it is not a good yardstick to assess the financial health of a company.

   Now, out of the complicated jumble of ratio benchmarks described above, which ratio satisfies the following requirements:

1. The ratio that takes operating profit into consideration rather than net profit
2. The ratio which focuses on the current turnover
3. The ratio, in which as far as possible, either the numerator or the denominator would be constant

   Unfortunately, there is not a single ratio which includes all these factors. But there is a simple solution to this.

   Let’s consider the following ratio:

                            Operating profit (EBITDA)
Eka ratio =   -----------------------------------------------
                         Total No. of equity shares issued

   Like any ratio, it is best practice to employ the Eka ratio in the peer group. If you stumble upon a stock which has –:
1. A good comparable Eka ratio with company’s operating profit for the current year more than that of the previous year
2. interest coverage ratio > two
3. which is in the lower half of 52 weeks high-low scale; that would be a wonderful opportunity to        invest and there is a high probability that the stock will be riding high in subsequent months and      that would be the true utility of this highbrow!

  

    I would modify Eka ratio as follows:

                              Operating profit (EBITDA)
Eka ratio =   --------------------------------------------  +  patience
                          Total no. of equity shares issued

    Buying a stock without studying its ins and outs is like buying medicine from a medical store just by watching any news or advertisement. Buying a stock on the recommendation of an analytical expert is like buying medicine with a doctor’s prescription. Buying stock after evaluating certain matrices is like buying medicine after studying those people who took it over a time (how many lived and how many died!). This gives one confidence and the right direction for future judgment.

   If the weather continues to be fine, provided the crops flourish, the natural calamity doesn't strike, your country doesn't get involved in the war, the board members of the company you have invested remain loyal and if you maintain enough patience in your heart, there is the highest possibility that the Stock Market bulls will be going to take your portfolio by horns!

"Stock market corrections, although painful at the time, are actually a very healthy part of the whole mechanism, because there are always speculative excesses that develop, particularly during the long bull market."

- Ron Chernow