How to buy stocks for beginners ? Buying stocks can be tough for beginners, but this article is here to help. I’ll walk you through the process of how to buy stocks if you are a complete beginner in this area. You will learn how to pick a stock, screen and shortlist companies for investing, and perform fundamental analysis to generate good returns. Let’s get started.
How to buy stocks for beginners : Lesson #1 Understanding the stock market
Stock market is where people come to buy and sell a special type of financial product – the stocks. Stocks and Stock market are two separate concepts, but are often confused as one and the same thing. The former is a product and the later is a market. This is one of the most critical lesson if you want to lean how to buy stocks for beginners.
What are Financial Products ?
A financial product is anything that is bought with an anticipation of earning profit. Example of financial products include stocks, bonds, REITs, mutual funds, ETFs, Derivatives etc…The word anticipation is important here because there there is a difference between earning profits and anticipating profits.
A financial product can only be called an asset if it generates income for you. To become a good investor, you need to have a good knowledge about financial products, and you should be able to tell:
- Which financial products are assets
- which financial products are potential assets
- which financial products are not an asset at all.
All financial assets are financial products but not all financial products are financial assets.
How to buy stocks for beginners : Lesson # 2 What is an asset?
A financial asset is anything that generates income. The income is expressed in monetary terms, so we can say that a financial asset is something that generates money. The money is the store of value that the asset generates. So it is not the money that is important, but the value that the asset generates. Money is just the vessel for storing the value.
One of the most important lesson here is that we need to stop thinking about assets in terms of money, and start thinking about assets in terms of value it provides. The value is another name for utility or usefulness. For example, a fertile land is an asset if and only if it is employed for agricultural use. Similarly, a real estate is an asset if and only if it generates income in the form of rent (commercial or residential) by providing people a space to live or do business.
Asset vs Potential Asset
If you want to learn how to buy stocks for beginners, you need to understand the between an asset and a potential asset. Think of a potential asset like a girlfriend or boyfriend. Your girlfriend, for example, can be your “potential wife” but you cannot call her your “actual wife”. But there is a possibility that she might become your wife some day if you work hard enough to impress her. Similarly, a potential asset has the possibility of becoming a real asset some day, but there is no guarantee. People “anticipate” that a potential asset can one day generate real income and they buy it with the expectation of future profitability. The value of a potential asset is thus derived from this anticipation of future income. Example of potential assets can be a land in a very remote area which might one day generate income for you in the form of rent. Another example of potential asset can be a stock that does not generate any income currently but it might start giving dividends in future if the company is able to grow its profit.
There is risk associated with owning both assets and a potential asset, but risk with later is more. For example, there is a difference between buying a diamond ring for your “potential wife” and your “actual wife”. A “potential asset” carries greater risk of ditching you. A real asset carries less risk. Both carries risk nonetheless. It is possible that your spouse might divorce you, but the chance of being divorced is lesser than the chance of being dumped by a girlfriend or boyfriend.
Do you know that contracts or agreements made between individuals to receive fixed amount of money in exchange for something at a future date can also be called an asset if it carries the potential of generating an income ? Forward contracts like futures and options are an example of such assets. These are technically called derivatives. Other examples of assets include – mutual funds, intellectual property rights, books that generate royalties, music albums and movie rights etc…
Can Stocks be called assets?
A stock can be called an asset if it is generating income in the form of earnings per share (EPS), provided you have bought it at a correct price level.
EPS= Total Profit/Total share outstanding
You can easily find the EPS of a stock online on sites like Investing.com
A stock can be a potential asset if people anticipate that it will generate income in future, but currently it does not. For example, if you have bought a stock at an overpriced level, it may not be an asset for you at the moment, but if you hold it for let’s say, ten years, and the earnings grow consistently in that period, at some point the return on your investment will become reasonably good, and the stock will become an asset. This may sound a bit complex at the moment but it will all start to make sense as you read through this guide.
How to buy stocks for beginners : Lesson #3 All Investment is speculative
This might sound contrary to what you have learnt from the mainstream financial gurus. Most experts on finance like to draw a distinction between investing and speculation. They have very sophisticated explanation about the differences between investors and speculators, but I disagree completely. I believe that all investment is speculation; it’s just the degree of risk that differs.
Even investing in the so called blue-chip stocks is speculation. You are speculating that the company will continue to be profitable, and the stability in its revenue will sustain forever. We have seen that this is not the case always. Even the corporations that seem too big to fail, do fail when the external factors align against it. These factors are plenty. A company involved in coal production would have thought that it will be in business forever. But now they a face an existential threat due to rise of renewable energy. According to an article on Newsweek, 11 coal companies in US have filed for bankruptcy since Trump took office !
The shift in people’s thinking and the sensitization of human minds toward climate change and sustainable living are posing unsurmountable risk to some of the biggest companies in the world that have thrived on exploiting the planet for decades.
The loss in revenue of a company usually occurs when a substitute product comes into the market and competes with the existing products. A company with good management is aware of the risks that may arise and they survive by adapting to the changing needs of people. Those that don’t, go extinct. So, even if you are investing in some really stable blue-chip stocks, you are still speculating that factors like good management, demographic demand, and competitiveness will hold. If you are good at monitoring these factors, the degree of speculation in your investment choice is less. However, if you are investing in a company without understanding these factors, the degree of speculation is high.
Are Bonds speculative too ?
A bond is an asset only if the real return generated from it is positive. Real return is the return generated after adjusting for inflation.Paisa and the Passive
Investing in bond is speculative because the value of a bond is derived from the ability of the borrowers to repay. When you buy a bond you are speculating that the people to whom you have lent you money to are going to make their payments on time with interest. Some people think that lending money to government by buying government bonds are safe and there is no risk involved. They call it “risk free investment”, and the interest earned from government bonds (usually 10 years government bond) is called risk free rate of return. Currently, it is around 6 percent. The below screenshot from Tradingeconomics.com shows the 10Y government bond yield of India. At some point it was above 9 percent. Today it has become 6 percent. And during the pandemic it went as low as 5.7 percent.
The reason why they call it risk free return is because such bonds are backed by the government’s ability to repay. A government can never default on its payment because it owns the money printing machine. However, you should be careful with such a mindset because the return generated by government bond is not risk free in “real terms”. As you can see above that the yield fluctuates and this rate of return has been going down all over the world.
The variability in inflation rate makes the “real returns” on bonds a floating figure. Remember, all bonds are backed by the ability of the borrowers to repay in terms of value, not money. The reason why government bonds are risky is because governments can pay you simply by printing money without delivering the value. But comparing to returns from all other asset classes, the return generated by 10Y government bond can be called the “least risky”.
Excessive printing of money by government causes inflation and erodes the value of your return.
While the returns from bonds might seem low, this does not mean that they are not a good investment. I include them in my portfolio because some bonds are good for portfolio diversification. And if carefully selected, they can help you create stability in your portfolio income. I have invested in dynamic bond funds from ICICI and KOTAK as a part of portfolio diversification.
My parents prefer investing in government schemes that guarantee a fixed risk free return because they find it the safest option. In the later part of the guide, we will see how this risk free rate can used as a benchmark to value stocks.
Is speculation Bad ?
So if all investment is speculation, is that a bad thing ? Well, even living involves some degree of speculation on a daily basis. Isn’t it? When you take your car out of the garage for a ride, you are speculating that it does not break down in the middle of the road. When you board a flight, you are speculating that it does not crash. When you propose your partner for marriage, you are speculating that they do not turn down your proposal.
So if living is driven by speculative decisions, should you stop living? Of course not ! Similarly, investments are driven by speculative decisions , but it does not mean you should stop investing. You can always make good speculative decisions. For example, putting your seat belt on when driving lessens your risk of dying in a accident. There is still a risk, but it is greatly reduced. Similarly, in the world of investment, you have to put your financial seatbelts on before going out on a investment ride. Knowledge about how the money works is the financial seatbelt that you need to protect yourself from headwinds. It is also very crucial if you want to learn how to buy stocks for beginners.
How to buy stocks for beginners : Lesson #4 What is a Financial Market ?
Let us dig deeper into the dynamics of a stock market.
A market is a place where goods are bought and sold. Anything can put up for sale. Your old shoes can be put up for sale on eBay. A piece of chewing gum that pop star Britney Spears once chewed and spitted out was sold for $14,000 on ebay! A violin case from the famous Titanic ship was once auctioned for more than a million dollars. And trust me, this is true: someone apparently, “trapped” a breath of air that Brad Pitt exhaled in a jar and it was bought by someone at an auction, for $340!
If a used chewing gum, a piece of wreck, or even a celebrity’s exhaled breath can be sold for significant amount of money, it should not come to you as a surprise that the ownership of company can also be listed for sale. A market where ownership of a company is on sale is called the stock market. A stock market is a type of financial market.
Unlike physical marketplaces like your neighborhood grocery store, financial markets like the stock market operate in the digital space with the help of specialized enterprises called exchanges. According to Wikipedia,
A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds, and other financial instruments.
There is difference between an exchange and a broker. Brokers are the intermediaries that provide retail investors a platform to buy and sell stocks on a exchange.
Exchanges and brokers together provide the necessary infrastructures needed for electronic buying and selling of financial products. They match buyers of financial products with the sellers and thus aid in the process of price discovery. The advantage of having an exchange is the transparency that it creates. By bidding on the prices of financial products in real time, the price discovery is smooth and efficient. We will learn more about the process of price discovery in a later section where I will be teaching you how to predict future stock prices using laws of economics.
Choosing a financial product
There are a lot of financial products to shop from in the financial markets. Some of the most common ones are stocks, bonds and mutual funds. Some not so common ones are mortgage backed securities, collateralized debt obligations, future contracts, option contracts, swaps and many more. Whenever you shop for a product, it is important to look for it’s genuineness. When buying a physical product like eggs, we often rely on certain factors to decide if the egg is genuine and worth your money. You may look at it’s size, color and smell. You may also look at the brand and decide if the product is genuine or not. Unfortunely, buying a financial product is not as simple as selecting eggs at the supermarket. You cannot look at it’s size, or color or smell because it is not a tangible product. The only way to decide if a financial product is worth your money is by looking at special attributes and deciding what is the intrinsic value of that product.
How to buy stocks for beginners : Lesson #5 Trading vs Investing
Before you buy a financial product like stocks, you need to be very clear in your mind about your motivation for buying. What is your motivation for buying an egg? Perhaps you want to use it to make omelets. But there can be other motivations as well. Maybe you are a wholesale buyer of eggs who intend to sell eggs to retail stores at a higher price. That makes you a trader of eggs. Another types of buyer maybe be interested in buying fertilized eggs that can hatch into chickens. For them, these eggs are assets that can produce income. Such buyers can be called investors of eggs. It is therefore very important to understand what kind of buyer you are in the financial market. Are you a trader who intends to buy financial products at a cheaper price and sell it to others at higher price? Or are you an investor who plans to buy a financial product with an intention to hold it and earn income from it in the form of profits from revenue?
Who are traders?
If you are able to procure something at a lower price and sell it at higher price, you are a trader. There are traders in all kinds of markets. We have stock traders who buy stocks at a lower price and sell it at a higher price to make a profit. We have traders in the commodity markets who buy commodities like gold and silver at a lower price and sell it at higher price. These traders are not the producer of the items that they sell. The only merit that can be attributed to them is their ability to buy low and sell high. (We also have traders who sell low and buy high. They are called short sellers.)
Who are Investors?
If traders make money from price difference in assets, investors make money by milking their assets. Milking is a good term to explain the difference. If assets are cows, then traders can be described as someone who buys a cow at a lower price and sell it at a higher price. Traders are always on the look to purchase a cow at lower price so that they can sell it at higher price. Investors on the other hand buy a cow and make money by selling its milk. That is a lame metaphor but it works !
Investors don’t sell their cows because they make money by selling the milk. If you want to learn how to buy stocks for beginners, you need to select an approach for buying stocks.
Should you be a trader or investor?
What is the best option then? To buy cows and sell them at higher price? Or to buy cows and make money selling its milk? Well, it is up to you. I have been both a trader and investor. These days I only focus on investing because trading needs lot of active involvement on a daily basis, and I do not find enough time to do it. Also, you will find that in the long run, investing is more lucrative than trading!
If you think trading is a good option for you, you can do it provided have sound knowledge about the financial world. Stock Traders are usually given a bad name, but I believe they are necessary evil in the market because they help in creating liquidity among asset classes. In theory, traders help in efficient price discovery by enabling competition, and keeping the price of an asset reasonable in the long term. Traders also create lot of volatility which creates short term earning opportunities. Do not worry if you do not understand some of the terms because I are going to make these concepts very easy to understand in the coming sections.
How to buy stocks for beginners : Lesson #6 Valuing you Financial Cow
How do you value a cow ? Let say you bought a cow for thousand rupee, and the cow gives ten liter of milk daily during its lactation period. You sell the milk at the 20 rupee per liter. Assuming that the cow will produce milk for five year, your total milk output during the dairy lifecycle will be roughly five hundred liters. The money that you will make from that cow in five years will be five thousand rupee. So if you bought a cow at thousand rupee and made five thousand rupee in five years, your return on investment (ROI) is twenty percent. Simple Mathematics.
ROI = (Total Profit/Total Investment) * 100
A good investor always buys an asset at price where the return on investment (ROI) is attractive. Like in the above example, 20 percent is an attractive ROI.
A benchmark used to measure how attractive is an investment is by comparing it to what you would receive if you had invested the same amount in a ten year government bond. Is it more profitable to invest thousand rupee in a cow that gives 20 percent ROI? Or is it more profitable to invest in a 10Y government bond that only pays 6 percent? Apparently, cow is a better investment. However, the risk with investing in cow is higher because if the cow dies in second year or stops giving milk due to some disease, you lose your money. If you invest in a government bond, the chance of losing money is zero because a government can never default on payment.
When you chose to invest in a stock, only select those that give you a ROI much higher than what you would get by investing the same money in a government bond. This way you can balance the risk with reward.
If you can determine how much milk a cow can generate over its dairy life cycle before buying the cow, you have some really good cow buying skills. If you can determine how much profit a company can generate over lifetime before buying the stock of that company, you have some really good stock buying skills
Risk Vs Reward
As an investor of stocks, you are willing to take some risks because the prospect of reward is stronger. One thing to note here is that as the price of cow increases, the return on investment decreases. It is unreasonable to buy this cow at a price above 3000 rupees because at this point the return on your investment is lower than the return on a 10 year government bond.
In stock market, individual stocks are like cows. You must be careful when buying it. If you are an investor, you should buy it at a price where the return on investment is greater than the return on 10 year government bond. To find out the ROI of a stock at current price level , you can simply find out the pe ratio of the stock from sites like Investing.in, and use the below formula:
ROI at current price level = 1/PE*100
So if the PE ratio of WIPRO is 27.59, the ROI at current price level will be 3.6 percent. This is lower than the return on a 10Y government bond. If you can easily get a return of 6 percent by investing in government bonds, buying WIPRO at a PE of 27.6 may sound like a bad idea.
But there is a catch here ! Even a stock with low ROI at current price level can be a good investment if the projected growth is strong. We will learn about selecting stocks using PE ratio in detail after we have covered some fundamentals.
Stocks are not always correctly priced
The price of an asset is greatly influenced by what people think it is worth. And the valuation that they come up with may be irrational.
If someone can pay $14000 for a spit out chewing gum, it is no surprise that there are people in the world of investing who would pay irrational amount of money for stocks that has the same value as a spit out chewing gum. The price of stocks often reaches irrational level because of human emotions. How exactly does human emotions affect the price of a stock ? Let us understand it with the help of a story.
How to buy stocks for beginners : Lesson #7 The Story of the Golden Egg
Once day a mountain hiker showed up at the local museum store with a golden egg. Said he bought it from a mysterious yogi he met while trekking in the far reaches of the Himalayas!
The egg was special. Not just by color but also by its size; it was double the size of a normal chicken egg! The collector at the museum shop was intrigued by it at the first sight.
“How much do you want for this egg?”, he asked the hiker, examining the egg under his thick magnifying glasses.
“Well, this egg is one of a kind", the hiker replied, "The yogi I got it from was no simple man. He told me that 21 days later the egg will hatch and the bird that will come out of this egg will poop 24 carat gold.”
“You got to be kidding me”, the museum guy replied in a shock.
“I know it cannot be true.", the Hiker said, "How much will you pay for this egg anyway? This is definitely a museum material. I doubt it is an egg at all. Looks like some kind of egg shared rock.”
“Well, certainly this is not some gold pooping bird. But this egg is special in a different way. I can give you 100 rupees for this.”
The hiker was satisfied and the deal went through. The egg was sold for 100 rupee. Two days later, a trader showed up at the store looking for the golden egg. Someone had told him that the museum is selling an egg that when hatched will produce a 24 Carat gold-pooping bird.
“Yes. I do have a golden egg”, the museum guy acknowledged.
“How much for?”, asked the trader.
“Well, as you know, there is a lot of rumor going around.", the museum guy replied, "I do not know if the bird that will come out of this egg is really gonna poop gold or not. But this is a great souvenir to have. You can buy it for 200 rupee. And who knows if the stories are really true? You will be the richest man in no time”
200 rupee did not seem much for the egg. If the stories are true the investment would soon be worth in millions! The trader bought the egg for 200 rupees and happily brought it home.
In the meanwhile, word spread like wild fire. People were curious to know if the stories were true. And as days passed by, more and more people started believing in the stories. They wanted to buy the egg and change their fate forever. They were willing to risk their money in hopes that the egg can make them rich so they started approaching the trader with biddings of higher and higher price. When someone was willing to pay 1000 rupee for the egg, the trader decided to sell it. He was not sure if bird will poop gold or not, so selling it for 1000 rupees seemed to him like a good deal. There would be no regrets, he thought.
As days passed by, the egg changed more hands. The cycle continued. People were willing to pay exorbitant amounts for the egg and the price of the egg grew with every new buyer that it passed on to. On the 20th day it was worth 1 lakh rupees. The last buyer of the egg was a merchant. He believed in this story so much that he risked his entire life's savings on the egg!
The merchant brought the egg home and carefully placed it on a stack of hay. His heart was racing as the anticipation of watching the egg hatch. Then it finally happened ! A crack on the eggshell. Followed by more cracks. The merchant watched in delight as a cute little hatchling came out of the egg. It looked like a normal bird. But did it really poop gold ?
The merchant cared for the bird greatly, feeding it the best quality feed until it grew into an adult. But the bird never pooped gold. Days went by. Months went by. The bird never never pooped gold. The merchant was fed up. And with a great regret, he sold the bird at a wildlife game shop for 20 rupees. That was the most that anyone was willing to pay for it.
What does it teaches about how to buy stocks?
The above story teaches us a lot about investing in stock markets. Just like the egg whose price kept on rising due to the anticipation that it will we worth in millions one day, people have a tendency to drive the prices of stocks higher than what it is worth. It happens with stocks, bonds, derivatives, commodities, real estates and every other “potential assets” where this bunch of uninformed speculators venture. The heard mentality is always at play. In fact, the tendency of people to consider an financial product good just because its price is rising is the cause for all financial disasters.
The anticipation sometimes stretches long enough that a big irrational asset bubble is created. Consider the price of bitcoin for example. People investing in bitcoins at an exorbitant rate think it is worth the irrational price. Their valuation of bitcoin is based on irrational fact and heard mentality, not on intrinsic evaluation. It similar to the merchant who bought an overpriced egg in anticipation that the bird that comes out of it will poop gold every day.
But when is that day of judgement for bitcoin going to come? In the story, the judgement day for the egg was on the 21st day when the egg hatched. It was on that day when the merchant found out that his “potential asset” is not an “asset” at all. The question we need to ask is when is the judgement day for financial markets arise? If you buy a stock (or any financial product) at an exorbitant price, when will the bubble burst?
This leads us to one fundamental question – what should be the value of something? How do we determine if a stock is priced correctly? How do we find out if the rise in price of assets like stocks and gold are justified?
Learning to find out the intrinsic value of a stock is a very important skill if you want to be a good investor. I have discussed about a stock valuation technique that I use in the later part of this page. However, if you want to learn about stock valuation in detail, I recommend that you read The Intelligent Investor by Benjamin Grahams.
There will continue to be wide discrepancies between price and value in the marketplace, and those who read their [Benjamin] Graham & Dodd will continue to prosper.Warren Buffet
How to buy stocks for beginners : Lesson #8 The Bandwagon Fallacy
If you have watched the movie Mean Girls, you can probably remember a scene where everyone in the high school was copying Regina, the antagonist, no matter how ridiculous her actions seemed. Everyone was following Regina’s lead just because she was so popular. This is a classic case of bandwagon effect and it has wide implications in the world of investment.
Bandwagon fallacy is based on the assumption that the opinion of the majority is always valid. If everyone believes it, so you should too. The phenomena is psychological and this tendency is popularly known as herd mentality.
Ever since the pandemic forced people to spend more time indoors with not much activities to engage into, the interest in trading and investment has skyrocketed. People who never bothered about stock market suddenly became interested in it. Normally they would go out and spend their money in some bars and pubs, but with lockdowns in effect there was not much to do than to be at home. Many people turned towards trading to give their adrenaline a pump. It is no surprise that trading apps like Zerodha saw a huge spike in the number of users since the lockdowns began. According to sources,
Zerodha was adding 70,000 to 1 lakh new customers per month before the covid-19 began. During the pandemic this number rose to 1.5 lakh to 2 lakh new customers per month.
The trend is believed to continue. As more and more novice traders with no sound knowledge of financial markets join the trading bandwagon, the volatility and irrational price movements will continue to rise.
These traders often engage in buying and selling of securities (another name for stocks) without any proper financial understanding of how Price Discovery words in the security markets. It is because of them that the markets get heavily influenced, and wanders into a zone of irrational exuberance. In order to protect yourself from losses in a market that is driven by the irrationality of human mind, it is therefore important to understand what true investing is all about. After all, you do not want to commit the same mistake that the merchant from our story did.
Expectation of Profitability
One thing that is common in all the potential assets is the expectation of profitability. This expectation can be real or delusional. And that makes assets classification a risky thing. If you think something carries a potential to generate income, you would probably categories it as a potential asset. But your thinking can be wrong! An expectation of future profits based on assumptions carries a nature of risk. People’s assumptions may prove out to be wrong, just like the assumption about the golden egg was proven wrong. When it happens, the potential asset loses its value. The only thing that tells a good investor from a bad one is the ability to identify if something that is touted as a potential asset is really an asset with sound intrinsic value or is the golden egg from our story.
How to tell if the price of stock will rise or fall ?
When investing in the stock market, it is very important to understand what drives the price of stock and and down. The usual answer you’d find is that the price is governed by the laws of supply and demand. But what does it exactly mean? Can you predict the future price of a stock based on information available in the present?
If you learn how to predict the “future growth” of a company’s profit, you will be in a position to forecast the future price trajectory of a stock with ample precision. The technique I used to make money in the stock market is based on estimating the future growth rate of a company’s profitability. It is this very knowledge of stock price forecasting that gives me an edge in investing.
Predicting the future price of a stock is a lot like predicting the probability of a hurricane. With the help of weather forecasting we are able to predict with a great precision when the storm will hit human settlements. It gives us the power to minimize damage by preparing in advance. Based on the forecasts, the government might relocate the local residents, thereby, preventing loss of lives. They might also use the forecasting data to asses the level of back up and defense needed to mitigate the effects of storm.
Stock market forecasting is no different. A good forecast can tell us when the financial storm will hit the markets. It can help up relocate the positions of our portfolio holdings and mitigate financial damage. It can help a trader put bets wisely. It can help an investor plan their long term stock selection strategy for maximum return. This is a tremendous power to have.
How to buy stocks for be How to buy stocks for beginners : Lesson #9 Stock Selection Technique based on “projected profit growth”
Note – Things are about to get a little mathematical. If you find these calculations little difficult, do not worry because I have also provided an easy alternative at the end.
In order to select a good stock, the first step is to decide which sector you want to invest in. Every sector is different and the opportunity for growth differs. Sectors like FMCG have less potential for growth. On the other hand, sectors like technology have a great growth potential.
The reason why finding good stock in technology sector is much easier is because the growth potential of tech companies is almost limitless. There is a limit to how much food we can consume, but there is no limit to what we can do with technology. The latest iPhone will someday become outdated, and newer forms of technology will replace it. Backpacking across the globe might become boring some day and backpacking to moon and Mars might be the next hippy ambition. Today it is Brandon and Bezos. Tomorrow it will be our kids ! So the scope for tech companies to make such ambitions become reality are endless.
Select your price range
Stocks come in all price range. There are penny stocks that will cost you less than rupee. There are also stocks like MRF that costs more than 25000 rupees for a single unit. I usually prefer selecting stocks in small to mid price range. For the purpose of demonstration, I will use the example of WIPRO here. It is a tech stock and at time of writing this guide it was trading at around 528.85 rupee per share.
How to buy stocks for beginners : Lesson #9 Analyzing the fundamentals
Now let us analyze some fundamentals for WIPRO.
The current EPS for WIPRO is 19.06. (You can easily get this information on sites like Investing.com)
An EPS of 19.06 means that for every share that you buy at current price level of 528.85, you get 19.06 rupee in return every year, provided the profit of the company remains constant. The ROI at current price level will be:
ROI at current Price Level = EPS/Share Price*100
=19.06/528.85*100 = 3.6 percent
Using PE Ratio
Another way to find ROI at current price level is to use the PE Ratio:
ROI at current Price Level = 1/PE Ratio*100 = 1/27.59*100 = 3.6 percent
The ROI at current price level for WIPRO at 528.85 is thus 3.6 percent.
This seems to be very less because a 10Y government bond gives you way higher return without any risk. The return on a 10 year government bond is around 6 percent so you might think that it would make more sense to put your money in that safer government bond than a risky stock like WIPRO.
But what if WIPRO share was available at 400 rupee at the same profit level? In that case, the ROI will be 4.7 percent. It is still less than what you would earn from a 10Y government bond.
What if the price of WIPRO falls to 50 rupee? Okay, now we are getting into fantasy. But let us imagine that WIPRO shares are available at 50 rupee and profit generated by the company per year has not changed. The return on investment in that case will be 38.1 percent !
Wow that is a good return on investment, and it is much higher than what you would get from a 10Y government bond!
Alright, we know that this is fantasy. WIPRO shares are not available at 50 rupee. But does that mean we should not invest in WIPRO today?
You can still invest in stocks with low ROI
Even if the ROI of WIPRO is less than the 10 year government bond at current price level, investing in WIPRO can still be a good option ‘provided’ the growth rate of EPS is high. Remember the difference between assets and potential assets? At current price level of 528.85 rupee and an ROI of 3.6 percent, WIPRO may not be an asset because if you adjust this return for inflation, it will be a negative return. However, WIPRO can be a potential asset if the the growth rate of company’s profit is positive. And if you hold it for long term, it might become a real asset some day!
But how ?
We know that a company’s profit is not constant. Sometimes it makes more profit and sometimes less. Some companies are able to grow their profits constantly by improving their business through capital expansion (re-investing their profits to scale up their operations).
The below screenshot from Screener.in shows the quarterly EPS of WIPRO from 2018 to 2021. The EPS figure is updated every quarter and it can be found in a company’s financial statement.
We can easily plot the EPS on a graph to understand EPS growth trend. The below graph clearly shows that the EPS of WIPRO is growing every quarter.
According to Screener.in, the EPS of WIPRO is growing at a 10 years Compounded profit growth rate (CAGR) of 7 percent. It means in the last ten years, the company was able to grow its profit at the rate of 7 percent per year on average. We can assume that the company’s EPS will continue to grow at a rate of 7 percent per year for next 10 years as well.
If we believe that the EPS of WIPRO will grow by 7 percent per year over then next 10 years, we can calculate what the EPS of WIPRO is likely to be 10 years from now, provided that the growth rate remains constant at 7 percent. You can use the compound interest formula to calculate this:
EPS after 10 years =Current EPS * (1+growth rate)^10
Using the above formula, our EPS comes out to be 37.49. Now we can use this future EPS to calculate future ROI.
ROI after 10 years = (Projected EPS/Share Price 10 years ago)*100
The future ROI after 10 years comes out to be around 7.2 percent.
Therefore, if you buy WIPRO at a price of 528.85 rupee today, 10 years later the ROI will be 7.2 percent provided the growth rate of EPS remains constant during this time. The ROI from WIPRO will continue to increase every year as long as the profit growth remains constant. So if you hold the share for another ten year, the EPS will be 73.76 and ROI will be 14 percent.
So our analysis shows that WIPRO is a good investment at current price if you are planning to hold it for long term. It is important to note here that we have assumed that the rate of profit growth will remain constant forever. If by some reason, WIPRO’s profits decline, and the growth rate comes down, it will impact the analysis significantly.
How to buy stocks for beginners : Lesson #10 How does this impact the stock price ?
If you buy WIPRO at a price of 528.85 today, you can be sure that its price will rise in next 10 years provided our assumption about profit growth holds true. When EPS increases, the PE decreases. And when PE of a stock is low and the projected growth is high, it attracts investors. The demand for such shares increase and this drives the price of stock high. Simple Economics.
An easy alternative for how to buy stocks for beginners
If you find these calculation tough, do not worry. You can easily earn money in stock market by investing in mutual funds and ETFs without bothering yourself with crazy calculations. Because I spend more time in my travel ventures, I do not invest in induvial stocks by myself. I prefer investing in mutual funds and ETFs instead. Below screenshot shows some of my fund holdings:
How am I able to select good funds? Well that is a different concept all together.
Having a good understanding of economy is essential if you want to be good at selecting your investment instruments, be it stocks, bonds, funds, REITs, gold or derivates. If you look at the above screenshot, you can see that my portfolio is globally diversified. In order to invest in the assets of other nations, you need to have a good understanding of the state of economy of that nation.
How to buy stocks for beginners : Lesson #11 Understanding the economy
Every asset derives it’s value from economic activity. Therefore it is very important to understand what economy is.
What is economy ?
In most simple terms, Economy means people’s ability to produce goods and services for the consumption of others.
The world is filled with people of different professions. Some of us produce food. Some produce furniture. Some produce software. Some produce movies. And so on. These goods are traded with each other in markets and this makes the world go around.
When we say that the economy of a nation is good, it means that people are productive enough to produce all the goods and services they need. Everyone produces something that are good at and exchanges it for items that they can’t produce with those who can. When the economy of a nation is good, the gains in the stock market reflect the economic reality. If the stock market rises in a bad economy, it a sign that inflation is getting out of control. The high return in stocks in a bad economy comes at the cost rising prices of goods and services.
Gross Domestic Product (GDP)
GDP is an important factor to consider when making investment decisions. It is also important if you want to learn how to buy stocks for beginners. All assets are backed by economic activity, and GDP is a good measure of economic activity of a country in a given time period. A good economy means that the businesses are making profit. As a result, the stocks are paying good dividends, the chances of default on bonds are less, real estate rents are pouring in consistently, and people have enough money to indulge in irrational exuberance by bidding up the price of every kind of asset high. On the contrary, when the economy is bad, the opposite happens. Companies default. Bonds become risky. The value of cash is eroded. Speculative assets crash. And with it all its derivatives like futures, swaps and asset backed securities are impacted.
How do you determine if the economy of a nation is doing well? One of the best ways to monitor this is looking at GDP growth rate. A positive GDP growth rate indicates that the economy is growing. A stagnant GDP growth means the economy is neither growing nor declining. And a negative GDP growth rate means that the economy is declining.
Below screenshot from Trading Economics show the GDP of US from 2010 to 2020. (The GDP was lower in 2020 because coronavirus restricted economic activity, and the economy is expected to be back to it normal level of growth.)
Emerging economies have high growth potential
Poorer nations that have recently adopted free market economy will naturally have a very high GDP growth as compared to countries that are already developed. The investment opportunities in such countries are tremendous. But at the same time more risky.
In poorer countries, construction of new roads, new electric power plants and basic infrastructure development can contribute to a very high GDP growth. Developing nations also have the benefit of hindsight, meaning that they already have the knowledge and technology need to fuel economic growth. But this does not mean that these countries are more wealthy that the countries where GDP growth is not very high. Developed countries already have well build infrastructures like roads and highways, so there is not enough scope for growth. The growth in developed countries is contributed by innovation. For example, when people have everything they want, they will get bored and need new things. It’s human psychology. If everyone becomes billionaires, there will be market for space tourism. Such markets are likely to form in developed countries, and these ambitions will contribute to their economic growth.
The takeaway is that you need to take these factors into consideration when diversifying your portfolio globally. Diversifying your portfolio globally gives you opportunity to benefit from the economies around the world. The knowledge of economy can greatly help you in learning about how to buy stocks for beginners.
Human Development Index (HDI) as a measure of economic potential
The map below shows human development index rankings of the world.
Countries like united states, Australia, Canada and European nations have a very high HDI. It means the government are more efficient in those nations. And the economic potential is robust. Investing in financial assets of countries with high HDI is safer than those with lower HDI. The risk reward ratio needs to be considered because emerging nations have good growth potential even though they carry more risk of default. A good balance needs to be established when diversifying your portfolio globally. The knowledge of how money and economy works comes in handy when making a such a decision.
Sovereign Bond Ratings as a measure of economic potential
Sovereign Bond Ratings are another way to determine the economic health of a nation.
Countries with a good bond rating means that there is ample confidence in their economic future. It tell us that investing in bonds of these nations are less risky, and somewhere it also means that the economy overall is in good health. If economy is in good health, the chance of defaults on bonds are reduced. In countries with good bond rating, the businesses are thriving, and major asset class like stocks are likely to give good returns. These ratings are revised from time to time. Sometimes a country’s rating can upgraded if it shows a promise of better economy and some times it can be degraded. A good investor keeps an eye on such changes. Knowledge about sovereign bond rating can help you learn how to buy stocks for beginners greatly.
Closing Remarks on how to buy stocks for beginners
The world of stock market can feel confusing and intimidating. In order to make money in the stock market you need to have a sound knowledge of how money and the financial markets work. There is no shortcut to success in the world of investing. You can predict the future price of a stock by creating intelligent projections about future profit growth. Also , if you want to be good at investing in mutual funds, ETFs and global financial instruments, you need to have basic idea about how economy works.
Always remember that stock are financial products, and just like any product in the market, their price is determined through the laws of supply and demand. Because stocks are valued in monetary terms it is very important to understand what money is, and how it works. Having sound financial knowledge of money will help you determine the psychology that drives the price of stocks up or down.
The importance of Financial Literacy
Financial Literacy is a shield that protects you against bad decisions related to money. A financially educated person makes wise decisions and avoid falling into the trap of get rich quick schemes that promise you a prospect of earning money without working.
The holy grail of financial advice these days linger around "generating huge returns and beating the market". There is a lot of hype around investing in highly speculative assets like cryptocurrencies. But investing in those assets without a good understanding of money can be very risky.
When too much money enters the financial system, it gets absorbed into highly speculative financial assets like gold and bitcoin and inflates their price. People think that the gains in those so called assets are their profit, but in reality it is not. True wealth is measured in terms of how much goods and services of value are produced. Indicators like GDP measure the actual value of wealth not the speculative returns investment bubbles like bitcoin generates.
Parking a lot of money in speculative assets does not create any value. The increase in their price does not lead to a rise in actual goods and service produced. So if your money multiplies a hundred times in gold or bitcoin, that does not necessarily add value to the society. Speculative assets are like a blackhole that sucks money from the financial system making them unavailable for businesses that produce goods and services of real value.
Law of Large Numbers
The law of large number has proven time and again that speculative traders who invest without the understanding of money and stock market are losers in the long run. Only real investors make money. To become a real investor, you need to boost your financial IQ and make yourself familiar with the concept of money. I have read countless books on money and finance, and now I am in a position to make good investment decisions across all asset classes. I have made money as a trader. I invest in mutual funds, ETFs, stocks, bonds and REITs. I invest in economies of other nations. The knowledge of money has changed my life. The best advice I can give you is: Learn, Learn and Learn. Investing will come naturally to you if get past the threshold needed to be financially enlightened.
Kishlay Singh is the author of Paisa and the Passive: Financial Literacy in Plain English
Disclaimer All the information on this page is published in good faith and for general information purpose only. You should consider seeking independent legal, financial, taxation or other advice to check how the website information relates to your unique circumstances. The examples used in this page is for demonstration purpose only, and should not be taken as a stock buying recommendation.