Tuesday, November 3, 2009

Evaluating Shares

We will try to understand few of the key methods to find out if a company is worth investing or not. With the number of companies in the market today, it is really tough to figure out which is worth investing. This is a time consuming exercise but if followed, it can provide rich dividends.

There are mainly 2 ways of selecting stocks.

  1. Fundamental Analysis - This is to know how good is a company and to invest in it for a long term. Fundamental analysis maintains that markets may misprice a security in the short run but that the "correct" price will eventually be reached. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security.
  2. Technical Analysis - This follows the price variations of a stock and lets you know if the stock has any short term gains. Technical analysis maintains that all information is reflected already in the stock price. Trends 'are your friend' and sentiment changes predate and predict trend changes. Investors' emotional responses to price movements lead to recognizable price chart patterns. Technical analysis does not care what the 'value' of a stock is. Their price predictions are only extrapolations from historical price patterns.
We will discuss about the Fundamental Analysis today.

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis. The term is used to distinguish such analysis from other types of investment analysis, such as quantitative analysis and technical analysis.

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:
  • to conduct a company stock valuation and predict its probable price evolution, 
  • to make a projection on its business performance, 
  • to evaluate its management and make internal business decisions, 
  • to calculate its credit risk. 
Even if you don’t plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms. The main idea behind Fundamental Analysis is Earnings of a company. 

Earnings are profits. It may be complicated to calculate, but that’s what buying a company is about. Increasing earnings generally leads to a higher stock price and, in some cases, a regular dividend.
When earnings fall short, the market may hammer the stock. Every quarter, companies report earnings. Analysts follow major companies closely and if they fall short of projected earnings, sound the alarm.

But only earnings are not enough to know if the company is worth investing. There are a number of fundamental analysis tools (read financial ratios), that we would discuss in the next few posts.

Keep checking this space for updates!


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