Benefits of stock split for ordinary investors

With the stock markets reaching dizzying heights, stock prices of many top companies have become unaffordable for many small investors. In such a situation, these investors have just 2 options: either wait for the markets to crash, which can be a very long wait or buy when a company goes for a stock split.

What is a stock split? How does it benefit small investors? In a stock split, the total number of free shares of the company is divided into bigger number of shares, without impacting the shareholder’s equity or the stock’s overall market value. E.g. if the company announces 5-to1 stock split, it means that for one share of the company that each shareholder holds, he now gets 5 shares. He doesn’t have to pay anything to avail of these 5 shares.

Also the market value of the share will be divided by 5. E.g. if the market price of the share is Rs 1000, the new market price of the share now becomes Rs 200. Moreover the company’s market capitalization now becomes 5 times it original market capitalization. The company can achieve this without diluting its equity.

Normally companies take this step if they think that the price of their share has gone so high that many small investors are reluctant to pay the price. With this step, the company brings the stock price within the reach of ordinary investors. HDFC took this step some time back.

An investor gains by buying the shares of good companies at low prices, as stock split doesn’t  affect the company’s performance. However it is important not to get swayed by the stock split when making investment decisions. Instead it is crucial to focus on company performance, management reputation, company’s growth prospects, future plans and its position vis-à-vis its competitors.

How to use ETF tactics to safeguard your investments?

Exchange-traded funds (ETFs) are a type of mutual fund that works like shares, as they can be traded on the stock exchange. Just like stocks, their prices are affected by the trading that takes place on the stock exchange. However they do offer some tactics to help you safeguard your investments. So what are they?

  • Proper timing: Proper timing is the key to maximizing your returns. You should have proper timing for both buying and selling the stocks, as you won’t gain anything by holding on to the stocks by hoping that the situation will improve. Instead it is advisable to exit the stocks if there is a decline of 8% in the value of the stock from its highest price. Then once the market has stabilized, you can again buy the stock. It will help you in saving some amount of capital.
  • Stop orders: Place a stop loss on your stocks so that if their prices go below this figure, you can sell them. It will help you in protecting your downsides and lower your losses.
  • Selling: Sell your ETF to raise cash if you are in desperate need of money, as  it will help you in getting necessary cash for your needs. Alternately you can invest that money in some low-risk investment avenue like bank FD or government bonds, to protect your money.
  • Rebalance your portfolio: Divide your portfolio amongst stocks, bonds, gold and mutual funds. This means if the stocks are not doing well, you always have other investments to fall back on. Similarly divide your stocks amongst those belonging to different sectors. So if one sector like IT is not doing well, it will be offset by good performance of another sector like FMCG.

 

Follow these tactics and protect your wealth even during the downtimes.

Mistakes people make when investing in equities

Today stock markets are at an all-time high. The companies are reporting rise in their profits and are giving out hefty dividends. Yet why are investors not making any money? Why are only a few investors getting richer?

Well, here are the reasons why this happens. Avoid these mistakes and see a rise in your wealth.

  • Concentrating a lot on growth: A company may have taken a lot of debts in order to fuel its growth. But its profits may be sinking. This means the company is in big trouble when the recession strikes or when the interest rates go up, as it can make it difficult for the company to meet its obligations. Instead it would be better if the investors pay attention to the company’s financial statements to avert their losses.
  • Overconfidence: Many people tend to adopt the same approach to stock investing as mutual funds. They buy more of poor-performing stocks if the stock price goes down, as they would do with a mutual fund. But while mutual fund is a collection of different stocks, direct stock investing involves only one stock. So if the stock is performing poorly, sell it and move on to better performing stock.
  • Concentrated portfolio: When a particular sector is doing well, people tend to accumulate more of the companies included in the sector and ignoring others. Similarly if small and mid-caps are doing well, people tend to accumulate more of them and ignore others. This lop-sided portfolio will end up ruining your wealth.
  • Excess activity: Different analysts and brokers have different opinions about the stocks in your portfolio. While one broker recommends you sell stock A, another will tell you to buy the same stock. The result – balance sheets of the brokerages go on increasing. And of course, it is from your pocket.

 

No wonder with all these mistakes, people don’t make any wealth in the markets. Stop these mistakes and watch your wealth soar.

What is the difference between dividend from mutual fund and company

Manish was advised by his mutual fund advisor to invest in a mutual fund that had just announced a dividend of 10%. Accordingly, Manish invested in the fund only to find that the value of the fund had decreased. Manish was shocked with this development as he considered the dividend from the mutual fund same as that of the dividend from the stock.

Manish is not alone. There are many such gullible investors who are taken for a ride by unscrupulous financial advisors. Also sheer ignorance makes people think dividends from mutual funds are the same as the dividends from stocks. But this is not true. Here are the differences between both of them.

When a company declares a dividend, it does so from its income. But when a mutual fund declares a dividend, it does so from the capital appreciation of its NAV. Now the money with the mutual fund is your money as the fund’s job is to collect money from multiple investors and invest in different companies on your behalf. When the share prices of the underlying companies go up, it will push up the NAV of the find, which the fund will then give as a dividend.

The share price of the company is decided by the market and not by the dividend. But in case of a mutual fund, the NAV of the fund decreases by the value of the dividend declared. E.g if the NAV of the fund is Rs. 20 and the fund declares a dividend of Rs 4, the NAV of the fund after the dividend would be Rs. 16.

Also unlike shares, opting for dividend will help in growth of your investment. Hence if you are looking to save for any long-term goal like retirement or children’s education, go for the growth option. So next time your mutual fund broker advises you to invest in a mutual fund just because it is giving a dividend, ignore it.

Tips to protect yourself from stock market losses

You have bought stocks just because your aunt, your friend and your milkman had bought stocks. Initially you were euphoric, dreaming about big bucks that the stocks would fetch. But soon your joy turned to sorrow, when you saw the value of your stocks started fluctuating wildly. If you are in this situation, then read on for some tips to safeguard yourself against stock market losses.

• Study the fundamentals of the company: Many investors are swayed by the stock prices, but ignore the fundamentals of the company. This means if the price you are paying for the stock does not justify its value, then you are sure to lose money in the long run. This is evident from the stock prices of companies like Himachal Futuristics that today are available at Rs 14 from the Rs. 33.40 during 2003. So the investors in this stock have lost heavily.
• Think long-term: Stocks are not a gamble but an asset class that will make you rich over long-term. Many people don’t understand this and so end up losing money.
• Expect volatility: Over the short-term, stocks are expected to be volatile. Markets are irrational and they react to slightest bit of good of bad news. This introduces volatility in the markets.
• Avoid greed and fear: The legendary investor Warren Buffett says, “”The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.” It is a fact that greed and fear have been responsible for people losing money in stocks.
• Don’t churn the portfolio: Government and brokers do love it when you keep on churning your portfolio. They are the ones who end up becoming rich, as you have to pay brokerage and taxes each time you buy and sell stocks. So avoid the temptation of churning your portfolio.
• Diversify your portfolio: This is last but the most essential tip. Diversification will help you meet your financial needs during the time of crisis. It will also ensure you don’t have to sell your stocks for a loss, just to meet your crisis.

Current ratio – the key to company’s operations

Till now we have seen the important valuation ratios that help you decide whether the stock is worth buying or not. Now let us take a look at the operational efficiency of the company. It highlights how effectively the company is able to run its business. The first ratio that we look at the Current Ratio.

This ratio tells you the amount of liquidity available with the company in order to fulfill its business commitments. It is obtained by dividing the current assets (those assets that can be quickly sold off to get cash) by its current liabilities (immediate debts).

Current ratio=Current assets ÷ Current liabilities

Usually, if the current ratio of 2:1 for a stock is regarded as suitable, since it gives a sufficient safety margin to the company in order to fulfill its operating cash requirements. If the current ratio is low, the company may have to raise money from other sources like borrowing from lenders both individuals and financial institutions or distribute new equity for fulfilling their commitments.

But if the ratio is very high, it implies the company is not using its assets optimally. It is just sitting on its assets. This can significantly affect the company’s long-term returns. Compare the current ratio of the company you are interested in with that of its rivals.

Price-to-book value ratio – a useful valuation tool

Another important valuation tool used is price-to-book or P/BV ratio. This ratio indicates to what extent the company’s share price highlights the  shareholders’ portion in the business.
It is calculated as:

P/BV = Share price / Book value of one share (BV)

BV = Share capital + reserves and surplus

A high P/BV ratio (>1) implies the company’s stock is undervalued or the company earns revenue and is expected to see a higher return on the assets. On the other hand, if the ratio is < 1, it implies the stock is overvalued or the company does not earn a good return on the assets.

It is an excellent measure to value stocks of companies involved in capital intensive businesses like banks, auto and manufacturing. But don’t use it for companies operating in IT and pharma sectors as these companies how very low tangible assets.

However even this ratio does have its share of drawbacks.

• It does not represent the true value of stocks in services sector.

• It fails to represent the true value of companies with high debts. This is because high debt offsets the value of the company’s assets. This can lead to errors in taking investing decision.

Discounted Cash Flows (DCF) – an important valuation tool

Last time, we saw that just PE ratio is not enough for us to understand the true valuation of the company. There are many other aspects you need to look at when choosing a company for investment. One of them is called as Discounted Cash Flow (DCF).

DCF is the most complete valuation method. It consists of predicting a company’s expected cash flows and then discounting them by your expected  rate of return from the stock to its present value.

If the value obtained from DCF valuation exceeds the present market price of the stock, the stock can be considered to be a bargain. If it is less than the current price, then sell the stock.

For this, you need the following 4 factors:

• Free cash flow: Free Cash flow is the amount of money that can be withdrawn from business without affecting the company’s business. It is responsible for determining the company’s investment worth. However calculating it is very complex, so instead you can use net cash generated by the company in its last year of operation. You can get this figure from the company’s balance sheet.
• Discounted rate: It is the rate of return that you think the stock will generate. Keep it realistic to prevent disappointments later on. A rate 15% can be considered to be realistic and is twice the rate of risk-free return.
• Period: To calculate DCF, you need to find out the life expectancy of the company or the period by which you can expect to recover your money. If you are not able to estimate this period, you can assume it to be 5-10 years.
• Residual worth: Usually lifespan of most businesses exceed 5-10 years than what we had estimated above. Hence it becomes essential for you to assign a value to remaining life span of the company. This can be achieved by adding the company’s current net worth or asset value to previous year’s cash flow.

You can then enter these figures in an Excel sheet to get the figure that the company’s shareholders will earn as net cash from its operations for the period under consideration. From this figure, the company’s present debt is deducted and the balance is divided by the company’s equity to get the DCF.

Why you shouldn’t depend only on PE ratio?

As we saw last time, PE ratio is one of the most popular ratios used in determining the value of the stock. However despite its claims of helping you choose the bargain stocks, this ratio does have its own share of drawbacks. Here are the drawbacks of PE ratio

• PE ratio varies from sector to sector. A PE ratio that is considered high in one sector may be treated as low in another sector. E.g. IT companies usually have higher PE ratios than manufacturing companies. This is because IT companies are expected to show more growth over the period of time than manufacturing companies.
• PE ratio is not totally neutral. If the company declares it has received a new order or bagged a new client, is enough to send the PE ratio soaring.
• Also low PE may mean the lack of investor confidence in the company. It can imply serious problems with the company. So always find out more about the company’s background.
• One of the factors used in calculating EPS is assumed. It is based on the expectation of the company’s future performance. But this can be a problem as the company may not be able to continue with its good performance in future. Moreover the business in which the company is operating can experience problems. This happened recently in the real estate sector.

So when selecting the stock, don’t just take a look at the PE ratio. You also need to look at various other ratios and aspects. We will cover it in next posts.

Price-Earnings (P/E) Ratio Explained

As we saw last time, P/E ratio plays a vital role in valuation of a stock. It indicates the margin of safety of the stock. It tells you about the relationship between the stock price and the earnings of the company. 

Let us say you buy a share of company A that gives you a return of 9% in one year.  Here the margin of safety is zero as a traditional bank account also offers you the same return, but without any risk.

So in order to lower the risk, the difference between both of them must be higher. The renowned investor Warren Buffett advises us this difference must be at least 1.25 – 1.5%.

But be warned: when the markets are on fire, each and every stock gets high price. Hence it makes the task of detecting stocks having higher margin of safety quite difficult. But during the bear run, it can throw up the plethora of opportunities for long term investors.

In the next part, we take a look at the drawbacks of this ratio.

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