Never invest in something you don’t understand

Investing has to do with acquiring assets with the intention to keep for a long period and profit from the dividend that will be paid. [iStockphoto]

When deciding on what to invest in, you need to be very professional about it.

For example, if you are investing in a stock, understanding the company’s line of business will help you forecast if the company is going to be around for a long time or just another “dead cat bounce.” Yes, you might miss out on the next big thing but you’re better safe than sorry.

Investing in something you don’t have a grasp of is simply gambling. Imagine investing in a spaceship building company when you don’t even know how many planets are in our solar system.

Even Warren Buffet, a successful investor is famous for saying “I have three boxes on my desk: in, out and Too hard” once an investment is too hard to understand he avoids it and moves on. Investing shouldn’t be done out of FOMO.

Trading vs investing

Investing has to do with acquiring assets with the intention to keep for a long period and profit from the dividend that will be paid.

Trading, on the other hand, has to do with acquiring assets with an intention to sell in the short term and make a quick profit.

If you prefer trading

If you want instant gratification without an in-depth analysis of the stock, then you are probably any intraday trader.

Intraday traders trade any instrument that is liquid & has enough volatility for them to make a profit quickly. Traders can trade forex, stocks & other instruments. Intraday traders carry out a technical analysis of the stock and do not dig deep into other details like cash flow, income statement etc.

Traders then go ahead to trade on the price fluctuation of the stock or any other instrument like forex using margin and leverage and sell/square off the position at the end of the day. They do not really want to own a stock or instrument.

Safe Forex Brokers explains that intraday trading can be very risky because of the use of margins. Traders are mainly engaged in speculation & use high leverage to amplify their profits. But this can also amplify losses. Only experienced professionals should trade.

For example, forex brokers in Kenya can offer as high as 1:400 leverage.

If you prefer investing

To invest in stocks, you need to carry out an in-depth study of the company.

If you do not have time to carry out this analysis, it is better to invest in index funds or Mutual funds, REITs, ETFs etc. An index fund is like a basket of different stocks put together and managed by a licensed professional.

When you buy into an index fund you don’t bother about analyzing each stock, you just relax while the fund manager does the work for you and you get your return on investment as at when due. But you must understand the risks of the investment.

Please visit the Kenya CMA website for a list of licensed fund managers and for more information on the Kenyan capital market ecosystem.

Before you decide to invest in a company you need to carry out a fundamental analysis of the company to be sure if the company is strong and will be profitable in the long run.

Investing has to do with acquiring assets with the intention to keep for a long period and profit from the dividend that will be paid. [iStockphoto]

Fundamental Analysis

If you are an equity investor, carrying out fundamental analysis on the company whose stock you intend to invest in helps you to determine the ‘fair price’ of the stock as well as its intrinsic value. This entails studying its financial statements. It is based on the fact that some stocks may be undervalued or overvalued or at fair market value.

Fundamental analysis uses three financial statements to determine the value of a company’s stock. They are:

• Balance sheet
• Income statement
• Cash flow statement

Balance Sheet Explained

A balance sheet provides an investor with a detailed side by side comparison of a company’s assets on the left, vs. its liabilities and equity on the right-hand side. It shows the Net worth of a company at a glance.

Note to the investor: On a balance sheet, the total assets & the total liabilities plus total equity will always be balanced.

What are Assets?

An asset could be said to be a resource, physical or non-tangible, owned by an individual or group of people that could be used to produce value now or in the future.

Physical assets include property, vehicles, inventory, cash etc.

Non-tangible assets include goodwill, trademarks, brand perception etc.

What are liabilities?

Liability is a pretty way of saying debt. Liability refers to money owed by the company to non-shareholders or creditors. They include interest due on loans, payment owed to suppliers (account payables), tax to be paid to the government etc.

What is owners’ Equity?

This refers to the total investment that shareholders own in the company after all the liabilities were paid.

If the company were to go bankrupt, the owners’ equity is what would be shared amongst all the shareholders. For clarification, Owners' equity has to do with companies that have shareholders while Equity has to do with private companies with no publicly traded shares.

Owners’ Equity = Assets minus Liability

Equity could either be positive or negative

Positive equity:

This is when total assets can cover total liability and this is a good indicator

Negative equity:

This is when total assets cannot cover total liabilities and this can lead to insolvency and is a red flag to look out for on the balance sheet as an investor.

Income Statement Explained

Also known as the profit and loss (P&L) statement, this is the comparison between a company’s revenues and its expenses. It shows the profitability of a company as every business aims to bring in more revenue than its expenses.

It is calculated as:

Revenue minus Expense = Net Income

Dividends are paid to shareholders from income earned after taxes and the remainder could be reinvested.

If net income is negative, then the company is operating at a loss.

For a healthy company, cash inflows should outweigh cash outflows. [iStockphoto]

Cash Flow Statement explained

They say cash is king and so a company must always have available cash at all times to meet its daily operational needs.

The cash flow statement gives an investor an insight into how much cash entered the company, how much was spent and how much is left.  An investor should compare cash flows of previous years also.

For a healthy company, cash inflows should outweigh cash outflows.

Cash flow is divided into

• Cash flow from operating
• Cash flow from investment transactions
• Cash flow from financing transactions

Cash flow due to operations is the most important information on the cash flow statement. It tells an investor how much cash a company generates from its main line of business and an investor should pay special attention to this.

Cash flow due to investment gives a picture of cash used to expand operations like buying operational vehicles, buying property, building plants etc.

Cash flow due to financing gives a picture of loans taken, dividends paid etc.

Using Ratios to Analyse Stocks

Analyzing the three financial statements can seem like a lot of figures so expressing information in terms of ratios makes for easy digestion. Some commonly used ratios in fundamental analysis of stock are:

• Price to earnings ratio
• Price to book value ratio
• Debt to equity ratio

Price to earnings ratio (PE ratio)

Calculated as PE ratio = Price of stock/EPS, it gives the investor the ability to look beyond share price and investigate the true value of a stock. Generally, the lower the PE ratio, the higher the value of the investment as it means the stock is undervalued.

EPS or earning per share is calculated as EPS = Net income/outstanding shares

Consider we have three Kenyan mining companies A, B and C with data below. The companies have different stock prices but which company stock has the best value?

COMPANY	STOCK PRICE Kes	EPS	PE ratio
A	4	0.14	28.57
B	11	0.25	44
C	6	0.46	13

As seen from the table the company stocks have different prices but Company C has the stock with the best value because it has the lowest PE ratio. But you must also check the company for other factors to get a detailed picture.

Price to Book ratio (PB ratio)

Useful for companies with tangible assets, PB ratio tells an investor how much shareholders pay for the stock as compared to the book value of the stock.

PB ratio = Price per share/Book value per share

Note, book value per share = (asset-liability)/shares outstanding

Example:

Consider a Kenyan company with data below

Stock price = Sh25

Book value = Sh200million

Total shares = 20 million units

Book value = Sh200million/20million units = Sh10

Therefore, PB ratio = Sh25/Sh10= 2.5

In a nutshell, a PB of 2.5 as seen above means investors are paying 2.5 times more for the stock of the company than the stock is actually worth and the stock is overvalued. A lower PB ratio below 1 means the stock is undervalued.

An undervalued stock has the potential of adding value in future, it is worth more than is currently being paid for it.

Debt to Equity ratio (DE ratio)

Debt is an integral part of doing business as companies take loans to expand their business. If the debt is not properly managed, it can lead to insolvency.

DE ratio = Total liability/shareholders’ equity

DE ratio measures a company’s leverage. It tells an investor how much of the shareholder equity will be used to finance debt if the company should fold up.

Example

Two Kenyan companies A and B have the following data:

Company	Assets KSh	Liabilities KSh	Equity KSh	DE ratio
A	200,000	50,000	150,000	0.33
B	500,000	400,000	100,000	4

An investor looking to invest in either of the companies would choose company A as it has a lower DE ratio and is not highly leveraged. Generally, a lower DE ratio, usually between 1.8 to 2.5, is considered healthy.

Conclusion

Do not let the figures scare you, fundamental analysis of stocks has been automated and Apps are available online to help you with some of the mathematics. The key takeaway is before you invest do some research and after the research, if you are still not convinced, throw the idea in the ‘too hard box’

Article by: Saurav Singh

Content provided by Safe Forex Brokers.