How a lay man, who is not a business man can evaluate a share. Before a common man enters a share market his biggest obstacle is his mental block of loosing money in the stock exchange. He has continuously fed with the information that share market is only for those financially elite who understands money. Common man should merely stick to Indirect Investments in shares like Mutual Funds, ULIPS etc. If you will ask a fund manager (on all talk shows on TV's) they will always suggest a first time investor, common man not to invest directly in the share market. They all are making fool of us. Selection of a good share is like buying vegetables from the market. We all know the value of Onion is Rs 20/kg. If you go in the market looking for onion, the shopkeeper tells you the value of onion as Rs 19/kg, instantly you will consider it a good buy. Probably you will buy few Kgs extra in this situation. If the value of onion shoots to Rs 30/Kg we will try to cut down the consumption.
The same (simple) theory applies to shares as well. It is important to know what the right value of the share is (like for onion it was Rs 20/Kg) at a particular moment of time. And to know this is no rocket science to know if the share is a 'good-buy' or 'good-sell'.
There is a three (3) steps guideline in selection of individual stocks for long term.
Step 1 - Identify Industries of Future
Do you know which industries are going to grow bigger and stronger in India in the years to come? India is investing hugely to develop its infrastructure to meet its ever growing demands of roads, flyovers, bridges, power, housing, shopping malls which in turn means growth of steel, cement, real-estate, power generating industries to speak of few. The industries you expect to do better than others are ideal places for you to invest.
Step 2 - Identify Companies of Future
Once you know from step1 above that which industries are for future, start picking-up specific companies in which you would like to invest your money. These companies must be in line with your analysis done in step1. Like if you thick Steel industry has future in India then you can pick companies like Tata Steel, SAIL, Jindal etc. As a rule of thumb try to pick your personal best 20 companies.
Step 3 - Study the companies Financial Statements.
(1) Earnings Per Share (EPS)
You can calculate the earning per share if you know the following:
a. Profit after tax of a company (PAT)
b. Number of shares on issue (N)
EPS = PAT / N
Ideally, for a good share, earnings per share shall increase from year to year. The higher the value the better is the performance.
(2) Price Earning Ratio (P/E)
You can calculate Price earning ratio if you know the following:
a. Earning Per Share (EPS)
b. Price of a share (P)
P/E = P / EPS = (P x N / PAT)
There is not one right P/E ratio for all companies. Instead each company has a normal P/E range. When the companies stock price breaks that range its time to ask why. If the P/E ratio is too high its an indicator that its stock price is too high. Or else the company is growing too fast. If P/E ratio is low, it can mean either that bad times are setting in or that the company's price is a bargain. A rule of thumb for considering the P/E ratio authentic even when the P/E ratio has crossed its barrier is (*) The stock is still a good buy if the P/E is at or below the annual growth rate of the companies earnings. In simple words, a stock that normally has a P/E ratio of 15 might be a good buy even when sold at 25 times its earnings if its profits were also growing by 25% per year.
A higher P/E ratio means that investors are ready to pay more for each share (P) as compared to its earning. The higher the price earnings ratio, the greater premium you are paying to buy the stock. This means you have more confidence on this share that it will deliver the returns to your investment. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per rupees of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay Rs20 for Rs1 of current earnings.
However, the P/E ratio is not 100% reliable indicator for stock purchase. One must take care the following before considering the P/E ratio for evaluation a share:
(a) It is useful to compare the P/E ratios of one company to other companies in the same industry.
(b) It is useful to compare the P/E ratios of a company to the market (like NSE or BSE)
(c) It is useful to compare the P/E ratios of a company to the company's own historical P/E.
(d) It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.