What are the Things to know before investing in stocks?
Benjamin Graham who is known as “the father of value investing” and also the mentor of Warren Buffett recommended several things that a defensive investor must know before investing in any stock. These important things are:- Adequate Size of the Company, Strong Financial Condition, Stable Earnings, Earnings Growth, Moderate Price to Earnings Ratio, Moderate Price to asset ratio & Dividend Pay out.
Let’s explain these important things in details
1. Adequate Size of the Company:- According to the market capitalization of the companies, stocks are categorized as – the mega cap, large caps, mid caps, small caps, micro caps and the nano caps. Micro cap companies have greater market capitalization than nano caps but less than small, mid, large and mega cap companies. Here what Graham says is that the stocks of the very small size companies should be avoided as they are affected very badly in adverse situations.
2. Strong Financial Condition:- To make a continuous growth during the adverse situation, a company should have sufficient funds to survive. If a company suffers heavy debt burden then most of its earnings will go in paying out the debt interests. As a result, it will affect the net profits and may ultimately lead to bankruptcy. Here what we have to check is that – the current assets should be at least twice the current liabilities and the debt should not exceed twice the stock equity at book value.
3. Stable Earnings:- Before investing in stocks of any company, an investor should check whether their earnings are stable or not. To know that, check the company’s balance sheet and see their annual earnings figure for the last 10 years. This will depict the clear picture about their earnings stability.
4. Earnings Growth:- After knowing earnings stability of the company, an investor should also check the earnings growth because the company having only stable earning but not the remarkable growth will give nil return in future. Here what Graham suggests is that there should be a minimum increase of at least one third in the earning per share (EPS) in the last ten years (using three years averages at the beginning and the end).
5. Moderate Price to Earnings Ratio:- The price at which an investor enters into the stock plays a crucial role in portfolio because buying any good stock at high price is as same as buying the wrong stock at low price. Here what Graham prefers is the P/E ratio (Profit/Earnings ratio). He suggests that the current price should not be more than 15 times average earning of the past three years.
6. Moderate Price to asset ratio:- Here what Graham suggests is that the current price should not be more than 1.5 times the book value.
7. Dividend Pay out:- Before investing in stocks of any company, an investor should check whether the company should have a history of paying dividends or not. Here, Graham suggests investors to invest in such stocks which have a history of uninterrupted dividend payments for at least the past 20 years.