While comparing two stocks, it’s of utmost importance to do a thorough analysis and research of the fundamentals of the companies. This would help you to assess the strength of the companies and make a prudent choice. This is the only way to identify strong stocks that can withstand adversity and offer stable returns despite the turbulence in the market.
When we do the fundamental analysis of a company, we try to look at various ratios. These include the Price-to-Earnings or P/E ratio, Price-to-Sales or P/S ratio, Earnings Per Share or EPS, Debt-to-Equity or D/E ratio, Return on Equity or RoE, among others. These ratios provide a glimpse into the performance of the company. However, unless you don’t compare them to other companies in the same sector, it’s it difficult to judge whether they are suitable investments.
Analysts and investors analyze stocks all across the world to conduct equity analysis. It is a quick and efficient way to find out stocks that are overvalued and those that can be included in the portfolio. While a stock can be evaluated in several ways, comparing with other stocks in the sector, is a preferred way to find quality stocks in which to invest.
Comparable valuation
A sure-shot way to evaluate a stock is to compare it to its peers. The method is simple- choose one financial ratio (P/E, D/E, RoE, among others). It would help if you found the ratio for the company in which you are interested. Then you could prepare a list of all the companies in the same space in that sector. You need to find the selected ratio for all the companies in the peer group. It’s important to analyze how the companies stack up.
Before making any comparison, it’s important to understand the ratios. A high P/E ratio means the stock is overvalued since its price is high relative to its earnings. On the other hand, a low P/E ratio implies that the stock is undervalued and could be a potential investment opportunity.
A high P/S ratio means the investors are willing to pay more for each unit of sale. This too indicates an overvalued stock. On the other hand, a low P/S ratio can be a possible undervalued stock that could be considered.
A high D/E ratio indicates that the company has been funding a big portion of its business through debt. This is an important ratio because this helps you to understand if the company has high growth rates due to efficient business decisions or high obligations.
Other important matrices
There are other essential matrices to compare a company such as RoE, RoA, margins (gross, operating and profit), D/E ratio, among others. Yet another significant matrix happens to be the Expected Annual Earnings Growth. Investing in a company with a high expected annual earnings growth with strong fundamentals make a lucrative deal.
It’s important to invest in a company that has a higher Return on Equity than the sector average. It makes financial sense in terms of profit. It reveals that the company has proven a better potential of converting its equity capital into profits.
Porter’s Five Forces
Porter’s Five Forces also helps you to analyze the competitiveness of a company. This is important since the success of any business depends heavily on how a company manages its competition. It’s important to analyze by looking at the following factors- the threat of substitution, the risk of new entrants, negotiating power of suppliers, power of consumers and the overall competitive landscape.
Financial statements
Sometimes, two companies in the sector have similar financial statements. This is when you need to assess the quality of the management of both the companies involved. It’s wise to opt for a company that has stable management without frequent changes.
Conclusion
When you are analyzing a stock, it’s important to do proper due diligence about the company. While financial statements reflect the financial strength of the company, you don’t ignore other competitive aspects of the company. Unless you try to judge a company concerning its rivals, you won’t get the right picture. In the real business world, too, the company is constantly competing with others in the sector. If we take into cognizance all the necessary metrics and compare all aspects, we could make more informed choices. Whether you lose or gain money depends on choosing the right stock.
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