Before you plan to buy a stock, you need to know how to value a company, most people buy a stock either based on its 52 week low/high, peer advise, hype, likability, partial metrics etc. What you ought to do is value the company and see if the stock price is less or more than its intrinsic value.
Here are some methods you can adopt
- Discounted Cash Flow method (DCF) — popularized by Warren Buffet
- Intrinsic value — [EPS × (8.5 + 2g) × 4.4]/Y
- Graham’s number — Square Root of (22.5) x (TTM EPS) x (Book Value per Share)
- X times revenue/profits (where X depends on industry type, example IT Services industry would be anywhere between 2 to 4 times the revenue, 15 to 20 times earnings)
Once you have a fair idea on how much the company is worth, you need to factor in the margin of safety, discount the value by 10 to 25% (depending on the perceived business risk) to derive the stock price you would be comfortable to pay.
Apart from valuation check on the following before you decide to buy
- Sound management
- Company’s competitive advantage (MOAT)
- Does the company have zero or acceptable debt
- Industry outlook for the future
- Prospects for growth for next 10 years
- Do I understand the business model?
- Competitor analysis
- Does the business have pricing power?
- Market share & mind share?
- What are the downsides?
- Free cash flow
- Gross Margins, ROCE, ROE
- Earnings growth last few years
- Interest coverage ratio