Confused? How to choose stocks from same sector for investment?

There are many stocks in a sector but an investor prefers to choose one or two stocks for investment. The ultimate goal of the long-term investor is to earn superior returns. But how to choose the best stock for investment is a challenge? The best method for stock selection is to study the fundamental aspects of the company. The fundamental analysis helps the investor to understand the growth potential of the business and make an informed investment decision. Although, fundamental analysis is a time-consuming method but this will help the investor to take right investment decision.

The general understanding about the fundamental analysis is to have a look at different ratios like Price-to-Earnings or P/E ratio, Earnings Per Share or EPS, Debt-to-Equity or D/E ratio, Return on Equity or ROE, Return on Capital Employed or ROCE etc. These ratios help to understand the performance of the company, but will not help to conclude whether the company is the best investment in the sector unless it is compared with peer companies.

Therefore, comparing the companies in the same sector is the best way to select the stock for investment. Now let us understand how it can be done.

Follow Relative valuation method:

The first step for comparing the companies in the same sector is comparing the relative valuation of one company with its competitors in the market. The following steps should be followed to compare relative valuations.

Pick any of the financial ratios like PE PB, ROE, ROCE, EV/EBITDA etc.

Make a list of companies who are the competitor to the company the investor has selected to invest in

Calculate the ratio for all the companies including the company the investor is keen to invest in. The investor can follow a table format this makes it easy to compare the valuations.

Let’s take an example to understand the concept

Suppose the investor decides to invest in an FMCG company HUL. Now the investor has to calculate and compare the ratios of HUL with all the companies with whom HUL competes in the market.

Source:5paisa Research

Before comparing the ratios, it is important to understand these ratios

P/E ratio – A high P/E ratio means the stock is possibly overvalued as its price is high as compared to its earnings. On the contrary, a low P/E ratio means that the stock is undervalued and can be a great investment opportunity.

P/B ratio- PB ratio that's greater than one means that the stock price is trading at a premium to the company's book value whereas, P/B ratio less than one means the stock is trading at an attractive valuation and offers an investment opportunity.

ROE- ROE indicates how effectively a company's management uses investors' money. Increasing ROE over time can mean a company is good at generating shareholder value. On the contrary declining ROE can mean that management is making poor decisions on reinvesting capital in unproductive assets.

These ratios can also be compared to the industry average to get a clearer picture. The investor can include more ratios based on his requirements. Another important aspect the investor should consider is future earnings growth. However, calculating projected numbers is a tedious task and requires detailed research. Therefore, we recommend investors to read research reports of 4-5 research analysts who have expertise in calculating the projections. The investor can refer to the broking companies’ websites where the research analyst of the respective broking company generally publishes the research reports of the companies under their coverage list. It is essential to understand the future prospects of the company where the investor is currently planning to invest to earn huge returns in the long-run.

As of now, we have focussed on quantitative aspects, now let’s turn our attention to the qualitative aspects for a complete analysis of the stock.

There can be times when two or more companies in a sector have similar financial statements making it difficult to differentiate between them. This is when you need to start looking at the qualitative aspects of the company.

Study the management of the company:

The investor should look at the management of all companies under comparison. Choose for companies that have a stable management team without frequent additions or deletions. Check on how long the managers have worked there and what type of compensation they get as well as factors like stock buybacks to see how well management is doing. It is also important to understand the quality and skill of a company's management for estimating future success and profitability of the company.

Understand companies core business

The investor should study the business model, revenue generation model, future prospect of the products of the company, how it got started? How long they are in the market, what is the revenue and profit margin they have been maintaining as of now and historically? Answer to this question will help to make an informed investment decision.

For example, film entertainment companies like PVR and Inox generally earn revenue from sales of movie tickets, sale of food and beverages, advertising income etc.

Product competitiveness:

It is essential to understand how competitive is the product of the company in the market. This is because the success of any business depends on how the company manages its competition. Analyze this aspect by looking at factors like the threat of new entry, the threat of substitution, bargaining power of suppliers, bargaining power of buyers and Competitive landscape. This theory of analyzing the competition is popularly known as the porter five forces model.

Customers and Geographic exposure:

The investor has to find out about the customers of the company. Does the company have a few big customers or many small customers? Do they focus on niche market, or do they cover all segments of customers? To understand a company, getting answers to the above questions is essential. Because then you will understand where the company stands in mind of the customers. Additionally, the investor also has to find out the geographical exposure of the company. Does the company only operate in certain territories? If yes, why? Do the company cover only urban or rural areas? What is their sales-break-down as per each territory? Where they sell more, and why? Asking yourself these questions and searching for answers will help you know the company well and make wiser choices at the end of the day.

Corporate Governance:

If the corporate governance of a business is not in order, the whole business will suffer sooner or later. So, checking out the corporate governance of a company is of utmost importance. The investors need to find answers to the questions such as are the rules of the company in line with the company’s mission and vision? are they legally compliant with the government’s policies? Are the company serving every stakeholder of the company? If the answer to the above questions is “YES” then usually, the company is pretty good at corporate governance.

Conclusion:

While researching a stock, it is important to get as many details about the company.  While the financial statements are a quick way to look into the financial position of the company, ensure that the qualitative and quantitative aspects are not ignored. If the company is not compared with its competitors, the investor will not get the true picture and will find it difficult to take a final call on investment.