Before we get into stocks, let us talk about chocolates. What did you visualise when you read “chocolate”? The tastiest chocolate you have ever eaten, right?
But how do you know that chocolate tastes the best? It is because you have tasted other similar chocolates, and the taste of this is superior to the rest.
Assume you have eaten only one kind of chocolate all your life. Will you still feel that it is the best chocolate ever? No, because you don’t know how the other chocolates taste.
Comparison is essential to rank items and choose the best option available. The same concept applies to stocks, as well – in a much more complex manner.
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What is stock comparison? Why is it critical?
Stock comparison is the process of comparing the shares of different companies based on multiple parameters like share price, financial statements, revenue, past performance of shares in the market, earnings per share, profits of the company, etc.
The market offers a large variety of investment options today. Multiple corporations from the same sector offer their shares to the public. Each stock comes with unique features. As an investor, it is essential to analyse the options available to determine what suits your investment goal the best.
Methods available for comparing stocks
Comparing share prices is a simple way analyse stocks. Apart from that, the various methods available can broadly be categorised as qualitative and quantitative techniques.
While the quantitative technique deals with numbers, using tools like – ratios and financial statements; the qualitative technique deals with those components that cannot be quantified, such as – the company’s management, employee behaviour and satisfaction, Corporate Social Responsibility (CSR), etc.
Qualitative analysis:
- The satisfaction of employees talks a lot about a company’s management. Paying good salaries and offering benefits to reward employees suggests that the company is doing well enough to pay its employees on time.
- Supplier satisfaction is as critical as employee satisfaction. Paying vendors on time shows that the company has enough funds to pay its dues.
- Annual reports of the companies indicate their vision, mission and future plans.
- CSR Activities represent the social concern of companies. CSR is mandatory in India. Analysing how companies fulfil this responsibility is a unique way to compare stocks in India.
Quantitative analysis:
Ratios are one of the popular tools used in stock comparisons.
- P/E ratio: Price-to-Earnings ratio
P/E ratio = Share price / Earnings per share
The earnings per share (EPS) indicates the amount an investor earns from each share held.
The P/E ratio is essential in determining how much an investor has to invest to earn a specific return from the investment.
Simply put, P/E suggests how much an investor should invest to earn a return of ₹ 1.
A high P/E ratio indicates that the stock is overvalued. It may also indicate that the stock prices are rapidly growing.
Similarly, a low P/E ratio may indicate undervaluation or slow growth of stock prices. The investment required to earn profits is less.
An ideal P/E ratio is usually below 20.
- PEG ratio: Price/Earnings to Growth ratio
A modification to the P/E ratio, the PEG ratio includes the component of growth, making this an exhaustive source of comparison.
PEG ratio = PE ratio / Growth of EPS
The PEG ratio indicates the earning potential of a stock in the future, i.e., how the EPS is expected to grow.
A high PEG ratio indicates overvaluation or a slower growth rate of EPS.
A low PEG ratio indicates undervaluation or a high growth rate of EPS.
A PEG ratio is considered ideal if it is below 1.
Also read: Understanding stock valuations using PEG ratio analysis
- Debt to Equity ratio
The D/E ratio represents the total amount of debt against the total capital invested by shareholders.
D/E = Total debt / Total equity
It indicates the dependency of companies on debt funds to run the business.
A high debt-to-equity ratio suggests that the company has more liabilities, and most of its income will go into managing debt commitments.
A low debt-to-equity ratio is an indication that the company doesn’t rely heavily on debts.
An ideal debt-to-equity ratio is 2:1.
- Return on Equity (ROE)
ROE = Net income / Shareholder’s capital
The ROE ratio represents the amount of earnings against the total capital invested by shareholders.
This is a significant ratio in measuring a company’s performance and profitability. It suggests how well the company is utilising its capital to earn profits.
ROE is expressed in percentage, and an ideal ROE is between 15 to 20%.
This is one of the most commonly used techniques to compare shares of different companies.
- Interest coverage ratio
Interest coverage = EBIT / Interest on debt
EBIT: Earnings before interest and tax.
This ratio indicates how the company utilizes its earnings to take care of interest payments on debts.
A high ratio suggests that the company is comfortable paying interest on debt through its earnings.
A low ratio suggests that the earnings are not sufficient to pay interest, and the company has to arrange an alternate source for interest payments.
An ideal interest coverage ratio is 1.5 and above.
Apart from ratios, another common way to compare companies is by analysing their financial statements.
The assets and liabilities, operating profit, improvement in performance from past years, etc., can be assessed through financial statements.
Also read: Mastering revenue expenditure – Categories, impacts and management
Bottomline
Comparison of stocks is a critical step for the investor to decide where and how much to invest.
There are multiple websites online providing stock comparison charts. These charts help in comparing the financial aspects of two different stocks simultaneously.
Another way of comparing stocks is by using the concept of Porter’s five forces analysis to understand how competitor companies in the same industry are performing.
Investors must make use of these tools along with the ones discussed above to make informed investment decisions.
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