The ability to make money on your investment is directly impacted by the stock you chose to invest in, but you already knew that. What you didn't know is how to pick these stocks from the many available. Choosing a stock to invest in can be very daunting, especially for a beginner who does not have much experience with the capital market. Perhaps you have heard of the reputation of Warren Buffet and his abilities to predict the future and know what will be profitable at the time. Statistically, the average stock-picker should get a return of around 9% a year, the market's historical average. Let's take a look at how ratios can help you find the best stock.
Ascertain your goals
The first step is to understand how the capital markets operate and how to leverage this knowledge to your advantage. The goals of everyone in that market is to make money. While some will choose it as a way of holding money, some will use it as their primary source of income. At the end of the day, you want to choose a stock that will align with your short term and long-term investment goals. A startup company is good for future cash flows, but when you are concerned with short term liquidity, then you should focus on investing in already established companies.
Use ratios and other stock basics to analyze shares
The terminologies of the stock markets can be very intimidating to a first-time buyer. As a matter of fact, some people get discouraged from investing at the sound of all the professional jargon of the markets. However, it is essential to learn the basics and use them to understand the stock you choose. Terms such as the p/e ratio will help you determine the price of a stock. The price of a share is meaningless if the p/e ratio is low.
Importance of ratios
Ratios give the quantifiable aspects of a company, such as profits, and they are easy enough to calculate. Since we know that some of the issues such as company morale or the programs of the R&D department are on a need to know basis, ratios are available for use in the public domain for decision making and performance evaluation.
The price to earnings ratio (p/e ratio)
The p/e ratio gives a comparison of the earning to the price at which the share is trading. It relates the market share price to earnings per share (eps) and reflects the price investors are prepared to pay for each pound of earnings of a company.
P/e ratio =
(net profit after tax/ no. of shares)
The dividend yield
The dividend yield relates the annual dividend income per share paid out by a company to its market share price and reflects how much income an investor receives for each pound invested.
Dividend yield =
Gearing relates the level of a company's debt to its market capitalization and reflects how deep a company is in debt. It is usually expressed as a percentage.
Gearing ratio =
Share indices
Share indices such as the Australian ASX 200 index are used in the measurement of the values of a section of the market. It bases the market capitalization of the various companies in the index and sometimes they can be used to measure the performance of the stock market for a nation.
Being listed as part of the index companies is prestigious and is very crucial for index investing.
