Do you recall being in school and creating an explosion in the chemistry lab by mixing the wrong elements? Or do you recall bashing your car against a wall, the first time you tried taking a reverse? Or burning the food in the kitchen because you didn't know how much cooking time was required? Life is full of events where accidents happen as a result of not knowing the basics of something. It is always important to understand how something functions before getting into it practically.
One such area of accidents is the Stock Market. If you know the basics, it is sometimes enough to give you a good start; however, not knowing the basics and getting into the market can prove to be very risky, or for that matter, an accidental move. One needs to be well-versed about the basics of the markets before starting an investing journey. In this article, let's get you started with some basic terms which you might come across or use in your daily investment activities.
Share market basics for beginners
Taking an investment decision based solely on luck is like standing in the middle of the road and praying to escape an accident. So conducting a proper fundamental analysis before putting in your money in a company will help you get good returns.
Adding to that, acquiring the data required for that analysis is no longer trouble. You can just go to Ticker and type in the name of the company you want. After that, you will see a display projecting all the financial data you will require to conduct the fundamental analysis for the company you want. All you have to do is interpret the numbers and comprehend them.
Here are a few tools and terms that will help you read the numbers and understand the story behind them:
Market capitalization is the total value of the firm with respect to the market. The market cap of a company can be arrived at by multiplying the total number of shares and the current trading price of a single share. To understand this better, let's take the example of one of the biggest FMCG companies in India, Hindustan Unilever Ltd. The current trade price is Rs. 2107.30, and the number of shares outstanding is 234.77 crores. Thus the multiplication of both the values will give you the market cap, which is, in this case, 4,94,738.52 crores. As far as the Indian Share market Basics is concerned, the companies fall under three broad categories when they are divided based on market capitalization. They are as follows.
Looks all easy. Doesn't it? But what do they mean to an investor?
Market cap is an essential component in the calculation of various other ratios. It also helps to classify and categorize companies. This is useful in comparing two different companies and in selecting the right stock.
Large cap companies are usually believed to be less risky than the other two categories, as these companies have a reliable history and are well-established. The stocks of these companies are highly liquid. Thus, it makes entry and exit easier. However, despite being less risky, these companies usually give lesser returns.
Medium cap companies can fetch good returns to their investors. But they are considered quite risky and are less liquid when compared to the large-cap companies. They project good growth and thus can fetch aggressive returns.
Small cap companies are those companies which have just emerged. They have huge growth potential. They are subject to economic problems, market volatility, competition, and various other market factors. Having said that, an investment in a good company can bring you enormous returns. All the large-cap companies were once under the small or medium capital category. Thus, an investor must divide his/her equity spending across all three categories.
An investor's portfolio should have the right mixture of these three categories based on his/her risk profile and financial needs. For example, a person who is retired wants to invest a portion of his savings into equities. In that case, large-cap companies will be recommended for him.
Source: Hindustan Unilever on Ticker
P/E ratio or Price to Earnings ratio
The next term an investor might constantly come across would be the P/E ratio. The P/E ratio is another important tool that is used to analyze the stocks of a company. The price to earnings ratio helps understand how much price can be paid for the stock. It establishes a relationship between the price of a share and the earnings per share.
To understand the P/E ratio, one must understand the EPS or the earnings per share.
Let's say a company has 5 partners and it has earned a profit of 100. In that case, the earnings per share will be Rs.20. Therefore, PE ratio = stock price/ earnings per share (EPS).
In the case of Hindustan Unilever Limited, the current EPS is Rs 28.70.
Usually, a higher ratio is backed by a bullish market (market with rising share prices) and vice versa. But before finalizing the nature of your stock or arriving at a decision, one should check the history of the price and valuation as well. It will give a clearer idea of what can be expected from the invested stocks.
Source: Hindustan Unilever on Ticker
The P/E ratio can be a useful factor in drawing a comparison between two companies. Usually, a company with a lower P/E ratio is preferred by investors as it has a higher potential to grow. However, the term "good P/E ratio" may differ from industry to industry. In other words, for example, what seems to be an ideal P/E ratio for the Pharma industry may not be an ideal one for the IT industry. However, one can compare the P/E ratio of two different companies and read the history of a particular company to arrive at a conclusion.
Sales and company growth
Another important parameter is the sales and the profit growth of a company. The comparison between a company's historical trends and its competitors will help you acquire a better knowledge of the stock you are about to invest in.
As a beginner, one will have to look at all these ratios before adding any stock to the investment portfolio. To get a better understanding through examples of real companies in the stock market, you can visit Youtube and watch the video tutorial to get a clearer understanding.
With this analysis of market cap and P/E ratio, an investor can filter companies that look like a healthy investment and then enter the next phase of their stock analysis. An investor can also compare the market caps of companies across different industries and can filter his/her choices.
Go ahead and start analyzing the data and trends of various companies, and hop on to the next blog series: Parameters of Fundamental Analysis of Stocks to go deeper into the stock market evaluation and the share market Basics.
To read all Master Class series Click Here.