When you decide to invest in the stock markets, it’s essential that you first do your homework. Your goal in a stock market investment is to find a reasonable value, especially if you plan to stay invested for a longer period. However, before you pick a stock and put complete faith in the performance of a company, you must carry out a thorough research. Most investors review the company fundamentals to check its business viability and whether it is suited to their investment portfolio. Considering that the investor aims to become a part owner of a company, it is important that he/she is willing to conduct a proper analysis. So, how can one go about it?
Here, we will discuss the basic math that investors should know before investing their hard-earned money in stocks.
Financial ratio calculations
Financial ratios are arithmetic calculations that use a company’s financial data to arrive at some crucial information. These ratios help investors know about the company’s past performance, expected returns from a stock investment, and at what timeline he/she can expect the stock to provide returns. Therefore, it is important for stock market investors to know some of these basic calculations.
Mentioned here are the key ratios that can be helpful for investors.
1. Return on Equity (ROE)
Investors invest in stocks to earn returns. ROE helps in:
- measuring the percentage returns that can be earned on an investment made in a stock.
- comparing profitability of companies within the same industry.
- highlighting a company management’s capability.
Higher the ROE, better the company’s management is at achieving business growth while adding value to shareholder wealth.
RoE can be calculated as = Net income / shareholder equity
2. Earnings Per Share (EPS)
EPS is the net profit earned by a company during a certain time period against each of its shares outstanding. It can be calculated as:
EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares
Investors must look at EPS annually or quarterly while keeping in mind that preferred shares do not form part of this calculation.
3. Price-to-earnings (P/E) ratio
The price-to-earnings ratio tells us whether a company is over or undervalued. A low P/E ratio means stock or company is undervalued in comparison to its peers within the same sector. It is calculated as:
P/E ratio = (Market price per share/ Earnings per share of past 12 months)
4. Price to earnings growth (PEG) ratio
This ratio is tells investors about the relationship between:
- the stock price,
- earnings per share (EPS) and
- the company’s growth.
PEG ratio less than 1 indicates that the company’s stock can be a good investment. It is calculated as:
PEG ratio = (PE ratio/ Projected annual growth in earnings)
Power of compounding
Compounding, in investment parlance, is an asset’s ability to fetch earnings, which can be reinvested with an objective to generate additional earnings. It refers to fetching earnings from previous generated earnings. Let’s take an example to understand how compounding can help in multiplying returns from stock investments:
Suppose an investor invests Rs. 10,000 in TCS stocks.
- In the first year, the share price rises by 10%. Thus, the investment grows to Rs. 11,000. Since the company is showing good performance, the investor stays invested in the stock.
- Next year, the share price appreciates by an additional 10%. Thus, the value of Rs. 11,000 now grows to Rs. 12,100.
Thus, the share price appreciates by Rs. 1,100 in the second year instead of only appreciating by Rs. 1,000 like in the first year. This is because the Rs. 1,000 gained in the first year has also grown by 10%.
Extrapolating this further, an investor can understand that the investment has the potential to grow further as the previous earnings begin to provide returns, too.
Compounding has the power to transform regular investment money into an income-generating tool. It helps investors generate returns on an asset’s reinvested returns.
Compounding requires three things to work in favour of an investor:
- the original investment amount should remain invested,
- the earnings should be reinvestment and
- time
The more time an investor gives to a stock market investment, the more he/she can accelerate the income potential of the original investment.
Calculating the odds of making positive returns
If we all knew how to pick the right stocks, we would all be successful at stock trading. Stock picking cannot be done randomly or by taking a chance. Market experts and seasoned investors mostly pick stocks by using the math of probability while designing their stock market trading strategies.
What is Probability – It is the likelihood of an event to occur.
In stock market terms, if an investor wants to identify and buy a stock that will rise in value, he/she needs to consider different probabilities that are in the stock’s favor, such as news about the company, past performance, market trend, fundamental analysis and technical charts, etc.
Thus, if most of these statistics suggest a high probability of positive performance, then it may be a good investment. The decision to invest also depends on an investor’s risk appetite, investment goals, and time horizon.
Conclusion
Stock market investments do not necessarily require an investor to have an in-depth statistical knowledge. However, with the help of the above-mentioned basic mathematical formulae and approaches, an investor can use an organized approach to investing. This can ensure success in the long run while also controlling the quantum of losses in some cases.
FAQs
To invest in the stock market, you can download the Fisdom app on your smartphone. The app allows a seamless process for KYC, trading and demat account opening.
Stock market investments or simply, stock investments can help an investor build a well-balanced portfolio to achieve financial goals through wealth creation and risk minimization.
There are many approaches to identify a profitable stock, two of the most common ones being usage of fundamental and technical analysis. Apart from this, seasoned investors learn to identify profitable stocks by closely studying the company, its management, its future plans, strategies, etc.
Fundamental analysis provides an insight into the company’s structure, past performance, strategic decision-making, management capability, etc. to gauge long-term stock performance. Technical analysis helps traders know the price movement patterns, especially while day trading.
It is not necessary to be good at math to invest in the stock markets, however, basic math can help an investor identify good stocks and know how much returns they can expect from the same.
