To invest in stocks you need to understand a few terminologies about valuation. How do you figure out if the stock price of a company is overvalued or undervalued? There are many ways to do this but the most often quoted ratio is the P/E ratio, or the Price to Earnings Ratio.

But before you have that, you should understand EPS - or Earnings Per Share. Every company releases quarterly results in which it announces its profits, total equity capital and basic and diluted Earning Per Share. This means Net Profit divided by total number of shares. The idea here is - if a company has 10,000 shares in total, and the company makes 500,000 in profit (in a quarter), the EPS for that quarter is Rs. 50. If you "annualise" that EPS - meaning prorate it over a year, the EPS would be Rs. 200.

But of course the company may go through quarterly earnings changes, so you don't just multiple quarterly earnings by four. What you do is to take the LAST FOUR QUARTERS EPS, and add them up to get the "trailing four quarter EPS". This is the Trailing EPS.

Aside: How you get these figures is to go to http://www.nseindia.com and look for the last four quarter results. For instance this is the BHEL page, which has links to the last eight to twelve quarters of results. You can add them up manually, or visit sites such as moneycontrol.com or myiris.com to get a pre-added set.

Now, the past is the past. It is not the future, right? So some analysts will check the company and release estimates of how much the EPS will be for the next four quarters. This is called the "forward EPS".

P/E Ratio: How does the EPS help you? It does not. It's not reflective of anything in itself. You must take the stock price and divide it by the EPS, to get the P/E ratio. The P/E ratio, for BHEL for example is about 26 for the trailing four quarter EPS. If you consider that it's last quarter earnings will be the same over the next four quarters, the forward EPS is 108, and the forward P/E is about 22. (at todays price of 2350)

The P/E ratio (also called the "Earnings Multiple") needs to be compared in the same sector that a company is in. P/E of a sector is usually at similar levels - for instance, tech companies have P/E of around 30-35, PSU banks 5-10, Private banks 22-25 and so on. BHEL might sound high at 26 - but other heavy engineering companies like Praj Industries have an even higher P/E.

Other factors can influence P/E - visibility of earnings (longer the better), order book, brand name etc. What people generally say is that the P/E should reflect the percentage growth in earnings of a company. That means if BHEL gets a P/E of 26, it should grow at 26% (net profits) - now the most recent quarter has shown much more than that - 45%+ so the company is still undervalued by that measure. Forward growth looks robust, with an order book of more than 30,000 cr. and going forward, I would expect that even if the P/E is lowered (because of a correction), BHEL's earnings growth itself would cover it and the stock price will sustain itself.

There's one more thing called "diluted EPS". When a company issues stock options, or raises capital using convertible debentures, the number of shares issued will increase when the stock options are exercised or when the debentures are converted. Eventually this means an increase in the number of shares, that is sure to happen, it just hasn't happened yet. So the company needs to release the "diluted EPS" meaning the total known number of shares that must be used for the EPS calculation. Always use diluted EPS when making any P/E comparisons.

Note here that forward P/E calculations can be based on unknown numbers - every analyst will have his or her own set of numbers. Always take an average of multiple numbers when you analyse estimates.

ave you ever experienced the following scenario: you buy 1 kg of apples at Rs 100 per kg, only to find out they were available at Rs 80 per kg just a few feet away? Arent you disappointed at having to pay more for the same quality of apples?

The same also applies to stocks.

If you buy a share of company A for Rs 100 and later on find out that the share of company B, with better earning prospects, is available for Rs 60, it is bound to disappoint you.

So how do you find quality bargains? How can you decide if the current stock prices make sense? Does the price justify the earning prospects of the company?

The answer to these questions is: Price-Earning (PE) ratio.

Introduction to PE ratio: PE ratio is one of the most widely used tools for stock selection. It is calculated by dividing the current market price of the stock by its earning per share (EPS). It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company.

PE = Market price / EPS

Assume there are two companies A and B, operating in the same sector. If PE of A is 30 and PE of B is 22, then B is considered to be a better buy, as the market price has not gone up to reveal the earnings prospects of the company. But A is considered to show higher growth prospects as compared to B.

How does PE help?

Understanding PE gives the investors an idea if the stock has sufficient growth potential. Stocks with low PE can be considered good bargains as their growth potential is still unknown to the market.

If the PE is high, it warns of an over-priced stock. It means the stocks price is much higher than its actual growth potential. So these stocks are more liable to crash drastically. This was evident in the recent market crash when the stocks of all Reliance companies fell sharply.

This will allow savvy investors to sell their holdings before the stock price crashes.

Drawbacks of PE ratio

Interpretation of PE ratio is heavily dependent on comparison of the company with its peers. Also PE that is considered very high in certain sectors can be considered very low in other sectors.

For instance, companies in IT and telecom sectors have higher PE ratio than the companies in manufacturing or textile sectors.

Also PE ratio is not totally neutral. Any major announcement of a major order or acquisition by the company will certainly push up its PE. On the other hand, low PE may not indicate a good buy but could signify more serious issues facing the company. So it is very important to perform a thorough research into the background of the company, before investing.

Besides EPS itself is assumed, as it forecasts future growth based on past performance. However, there is no guarantee that the company can continue to maintain its performance each year. Also the sector in which the company is operating may experience problems as was recently seen for the IT sector.

So PE ratio cannot be considered to be a totally reliable indicator of cheap, good stocks.

Yet, PE ratio remains one of the most important ratios when it comes to stock selection.

In times of economic decline, many investors ask themselves, What strategies does the Oracle of Omaha employ to keep Berkshire Hathaway on target?

The answer is that the esteemed Warren Buffett, the most successful known investor of all time, rarely changes his long-term value investment strategy and regards down markets as an opportunity to buy good companies at reasonable prices.

In this article, we will cover the Buffett investment philosophy and stock-selection criteria with specific emphasis on their application in a down market and a slowing economy.

The Buffett Investment Philosophy

Buffett has a set of definitive assumptions about what constitutes a good investment. These focus on the quality of the business rather than the short-term or near-future share price or market moves. He takes a long-term, large scale, business value-based investment approach that concentrates on good fundamentals and intrinsic business value, rather than the share price.

Buffett looks for businesses with a durable competitive advantage. What he means by this is that the company has a market position, market share, branding or other long-lasting edge over its competitors that either prevents easy access by competitors or controls a scarce raw-material source.

Buffett employs a selective contrarian investment strategy: using his investment criteria to identify and select good companies, he can then make large investments (millions of shares) when the market and the share price are depressed and when other investors may be selling.

In addition, he assumes the following points to be true:

* The global economy is complex and unpredictable. * The economy and the stock market do not move in sync. * The market discount mechanism moves instantly to incorporate news into the share price. * The returns of long-term equities cannot be matched anywhere else.

Buffett Investment Activity

Berkshire Hathaway investment industries over the years have included:

InsuranceSoft drinksPrivate jet aircraftChocolatesShoesJewelryPublishingFurnitureSteelEnergyHome buildingThe industries listed above vary widely, so what are the common criteria used to separate the good investments from the bad?

Buffett Investment Criteria

Berkshire Hathaway relies on an extensive research-and-analysis team that goes through reams of data to guide their investment decisions.

While all the details of the specific techniques used are not made public, the following 10 requirements are all common among Berkshire Hathaway investments:

1. The candidate company has to be in a good and growing economy or industry. 2. It must enjoy a consumer monopoly or have a loyalty-commanding brand. 3. It cannot be vulnerable to competition from anyone with abundant resources. 4. Its earnings have to be on an upward trend with good and consistent profit margins. 5. The company must enjoy a low debt/equity ratio or a high earnings/debt ratio. 6. It must have high and consistent returns on invested capital. 7. The company must have a history of retaining earnings for growth. 8. It cannot have high maintenance costs of operations, high capital expenditure or investment cash flow. 9. The company must demonstrate a history of reinvesting earnings in good business opportunities, and its management needs a good track record of profiting from these investments. 10. The company must be free to adjust prices for inflation.

The Buffett Investment Strategy

Buffett makes concentrated purchases. In a downturn, he buys millions of shares of solid businesses at reasonable prices.

Buffett does not buy tech shares because he doesnt understand their business or industry; during the dotcom boom, he avoided investing in tech companies because he felt they hadnt been around long enough to provide sufficient performance history for his purposes.

And even in a bear market, although Buffett had billions of dollars in cash to make investments, in his 2009 letter to Berkshire Hathaway shareholders, he declared that cash held beyond the bottom would be eroded by inflation in the recovery.

Buffett deals only with large companies because he needs to make massive investments to garner the returns required to post excellent results for the huge size to which his company, Berkshire Hathaway, has grown.

Buffetts selective contrarian style in a bear market includes making some large investments in blue chip stocks when their stock price is very low.

And Buffett might get an even better deal than the average investor: His ability to supply billions of dollars in cash infusion investments earns him special conditions and opportunities not available to others. His investments often are in a class of secured stock with its dividends assured and future stock warrants available at below-market prices.

Conclusion

Buffetts strategy for coping with a down market is to approach it as an opportunity to buy good companies at reasonable prices.

Buffett has developed an investment model that has worked for him and the Berkshire Hathaway shareholders over a long period of time. His investment strategy is long term and selective, incorporating a stringent set of requirements prior to an investment decision being made.

Buffett also benefits from a huge cash war chest that can be used to buy millions of shares at a time, providing an ever-ready opportunity to earn huge returns.

The following 8 financial ratios offer terrific insights into the financial health of a company and the prospects for a rise in its share price.

1. Ploughback and reserves

After deduction of all expenses, including taxes, the net profits of a company are split into two parts dividends and ploughback.

Dividend is that portion of a companys profits which is distributed to its shareholders, whereas ploughback is the portion that the company retains and gets added to its reserves.

The figures for ploughback and reserves of any company can be obtained by a cursory glance at its balance sheet and profit and loss account.

Ploughback is important because it not only increases the reserves of a company but also provides the company with funds required for its growth and expansion. All growth companies maintain a high level of ploughback. So if you are looking for a growth company to invest in, you should examine its ploughback figures.

Companies that have no intention of expanding are unlikely to plough back a large portion of their profits.

Reserves constitute the accumulated retained profits of a company. It is important to compare the size of a companys reserves with the size of its equity capital. This will indicate whether the company is in a position to issue bonus shares.

As a rule-of-thumb, a company whose reserves are double that of its equity capital should be in a position to make a liberal bonus issue.

Retained profits also belong to the shareholders. This is why reserves are often referred to as shareholders funds. Therefore, any addition to the reserves of a company will normally lead to a corresponding an increase in the price of your shares.

The higher the reserves, the greater will be the value of your shareholding. Retained profits (ploughback) may not come to you in the form of cash, but they benefit you by pushing up the price of your shares.

2. Book value per share

You will come across this term very often in investment discussions. Book value per share indicates what each share of a company is worth according to the companys books of accounts.

The companys books of account maintain a record of what the company owns (assets), and what it owes to its creditors (liabilities). If you subtract the total liabilities of a company from its total assets, then what is left belongs to the shareholders, called the shareholders funds.

If you divide shareholders funds by the total number of equity shares issued by the company, the figure that you get will be the book value per share.

Book Value per share = Shareholders funds / Total number of equity shares issued

The figure for shareholders funds can also be obtained by adding the equity capital and reserves of the company.

Book value is a historical record based on the original prices at which assets of the company were originally purchased. It doesnt reflect the current market value of the companys assets.

Therefore, book value per share has limited usage as a tool for evaluating the market value or price of a companys shares. It can, at best, give you a rough idea of what a companys shares should at least be worth.

The market prices of shares are generally much higher than what their book values indicate. Therefore, if you come across a share whose market price is around its book value, the chances are that it is under-priced. This is one way in which the book value per share ratio can prove useful to you while assessing whether a particular share is over- or under-priced.

3. Earnings per share (EPS)

EPS is a well-known and widely used investment ratio. It is calculated as:

Earnings Per Share (EPS) = Profit After Tax / Total number of equity shares issued

This ratio gives the earnings of a company on a per share basis. In order to get a clear idea of what this ratio signifies, let us assume that you possess 100 shares with a face value of Rs 10 each in XYZ Ltd. Suppose the earnings per share of XYZ Ltd. is Rs 6 per share and the dividend declared by it is 20 per cent, or Rs 2 per share. This means that each share of XYZ Ltd. earns Rs 6 every year, even though you receive only Rs 2 out of it as dividend.

The remaining amount, Rs 4 per share, constitutes the ploughback or retained earnings. If you had bought these shares at par, it would mean a 60 per cent return on your investment, out of which you would receive 20 per cent as dividend and 40 per cent would be the ploughback. This ploughback of 40 per cent would benefit you by pushing up the market price of your shares. Ideally speaking, your shares should appreciate by 40 per cent from Rs 10 to Rs 14 per share.

This illustration serves to drive home a basic investment lesson. You should evaluate your investment returns not on the basis of the dividend you receive, but on the basis of the earnings per share. Earnings per share is the true indicator of the returns on your share investments.

Suppose you had bought shares in XYZ Ltd at double their face value, i.e. at Rs 20 per share. Then an EPS of Rs 6 per share would mean a 30 per cent return on your investment, of which 10 per cent (Rs 2 per share) is dividend, and 20 per cent (Rs 4 per share) the ploughback.

Under ideal conditions, ploughback should push up the price of your shares by 20 per cent, i.e. from Rs 20 to 24 per share. Therefore, irrespective of what price you buy a particular companys shares at its EPS will provide you with an invaluable tool for calculating the returns on your investment.

4. Price earnings ratio (P/E)

The price earnings ratio (P/E) expresses the relationship between the market price of a companys share and its earnings per share:

Price/Earnings Ratio (P/E) = Price of the share / Earnings per share

This ratio indicates the extent to which earnings of a share are covered by its price. If P/E is 5, it means that the price of a share is 5 times its earnings. In other words, the companys EPS remaining constant, it will take you approximately five years through dividends plus capital appreciation to recover the cost of buying the share. The lower the P/E, lesser the time it will take for you to recover your investment.

P/E ratio is a reflection of the markets opinion of the earnings capacity and future business prospects of a company. Companies which enjoy the confidence of investors and have a higher market standing usually command high P/E ratios.

For example, blue chip companies often have P/E ratios that are as high as 20 to 60. However, most other companies in India [ Images ] have P/E ratios ranging between 5 and 20.

On the face of it, it would seem that companies with low P/E ratios would offer the most attractive investment opportunities. This is not always true. Companies with high current earnings but dim future prospects often have low P/E ratios.

Obviously such companies are not good investments, notwithstanding their P/E ratios. As an investor your primary concern is with the future prospects of a company and not so much with its present performance. This is the main reason why companies with low current earnings but bright future prospects usually command high P/E ratios.

To a great extent, the present price of a share, discounts, i.e. anticipates, its future earnings.

All this may seem very perplexing to you because it leaves the basic question unanswered: How does one use the P/E ratio for making sound investment decisions?

The answer lies in utilising the P/E ratio in conjunction with your assessment of the future earnings and growth prospects of a company. You have to judge the extent to which its P/E ratio reflects the companys future prospects.

If it is low compared to the future prospects of a company, then the companys shares are good for investment. Therefore, even if you come across a company with a high P/E ratio of 25 or 30 dont summarily reject it because even this level of P/E ratio may actually be low if the company is poised for meteoric future growth. On the other hand, a low P/E ratio of 4 or 5 may actually be high if your assessment of the companys future indicates sharply declining sales and large losses.

5. Dividend and yield

There are many investors who buy shares with the objective of earning a regular income from their investment. Their primary concern is with the amount that a company gives as dividends capital appreciation being only a secondary consideration. For such investors, dividends obviously play a crucial role in their investment calculations.

It is illogical to draw a distinction between capital appreciation and dividends. Money is money it doesnt really matter whether it comes from capital appreciation or from dividends.

A wise investor is primarily concerned with the total returns on his investment he doesnt really care whether these returns come from capital appreciation or dividends, or through varying combinations of both. In fact, investors in high tax brackets prefer to get most of their returns through long-term capital appreciation because of tax considerations.

Companies that give high dividends not only have a poor growth record but often also poor future growth prospects. If a company distributes the bulk of its earnings in the form of dividends, there will not be enough ploughback for financing future growth.

On the other hand, high growth companies generally have a poor dividend record. This is because such companies use only a relatively small proportion of their earnings to pay dividends. In the long run, however, high growth companies not only offer steep capital appreciation but also end up paying higher dividends.

On the whole, therefore, you are likely to get much higher total returns on your investment if you invest for capital appreciation rather than for dividends. In short, it all boils down to whether you are prepared to sacrifice a part of your immediate dividend income in the expectation of greater capital appreciation and higher dividends in the years to come and the whole issue is basically a trade-off between capital appreciation and income.

Investors are not really interested in dividends but in the relationship that dividends bear to the market price of the companys shares. This relationship is best expressed by the ratio called yield or dividend yield:

Yield = (Dividend per share / market price per share) x 100

Yield indicates the percentage of return that you can expect by way of dividends on your investment made at the prevailing market price. The concept of yield is best clarified by the following illustration.

Let us suppose you have invested Rs 2,000 in buying 100 shares of XYZ Ltd at Rs 20 per share with a face value of Rs 10 each.

If XYZ announces a dividend of 20 per cent (Rs 2 per share), then you stand to get a total dividend of Rs 200. Since you bought these shares at Rs 20 per share, the yield on your investment is 10 per cent (Yield = 2/20 x 100). Thus, while the dividend was 20 per cent; but your yield is actually 10 per cent.

The concept of yield is of far greater practical utility than dividends. It gives you an idea of what you are earning through dividends on the current market price of your shares.

Average yield figures in India usually vary around 2 per cent of the market value of the shares. If you have a share portfolio consisting of shares belonging to a large number of both high-growth and high-dividend companies, then on an average your dividend in-come is likely to be around 2 per cent of the total market value of your portfolio.

6. Return on Capital Employed (ROCE), and

7. Return on Net Worth (RONW)

While analysing a company, the most important thing you would like to know is whether the company is efficiently using the capital (shareholders funds plus borrowed funds) entrusted to it.

While valuing the efficiency and worth of companies, we need to know the return that a company is able to earn on its capital, namely its equity plus debt. A company that earns a higher return on the capital it employs is more valuable than one which earns a lower return on its capital. The tools for measuring these returns are:

1. Return on Capital Employed (ROCE), and

2. Return on Net Worth (RONW).

Return on Capital Employed and Return on Net Worth (shareholders funds) are valuable financial ratios for evaluating a companys efficiency and the quality of its management. The figures for these ratios are commonly available in business magazines, annual reports and economic newspapers and financial Web sites.

Return on capital employed

Return on capital employed (ROCE) is best defined as operating profit divided by capital employed (net worth plus debt).

The figure for operating profit is arrived at after adding back taxes paid, depreciation, extraordinary one-time expenses, and deducting extraordinary one-time income and other income (income not earned through mainline operations), to the net profit figure.

The operating profit of a company is a better indicator of the profits earned by it than is the net profit.

ROCE thus reflects the overall earnings performance and operational efficiency of a companys business. It is an important basic ratio that permits an investor to make inter-company comparisons.

Return on net worth

Return on net worth (RONW) is defined as net profit divided by net worth. It is a basic ratio that tells a shareholder what he is getting out of his investment in the company.

ROCE is a better measure to get an idea of the overall profitability of the companys operations, while RONW is a better measure for judging the returns that a shareholder gets on his investment.

The use of both these ratios will give you a broad picture of a companys efficiency, financial viability and its ability to earn returns on shareholders funds and capital employed.

8. PEG ratio

PEG is an important and widely used ratio for forming an estimate of the intrinsic value of a share. It tells you whether the share that you are interested in buying or selling is under-priced, fully priced or over-priced.

For this you need to link the P/E ratio discussed earlier to the future growth rate of the company. This is based on the assumption that the higher the expected growth rate of the company, the higher will be the P/E ratio that the companys share commands in the market.

The reverse is equally true. The P/E ratio cannot be viewed in isolation. It has to be viewed in the context of the companys future growth rate. The PEG is calculated by dividing the P/E by the forecasted growth rate in the EPS (earnings per share) of the company.

As a broad rule of the thumb, a PEG value below 0.5 indicates a very attractive buying opportunity, whereas a selling opportunity emerges when the PEG crosses 1.5, or even 2 for that matter.

The catch here is to accurately calculate the future growth rate of earnings (EPS) of the company. Wide and intensive reading of investment and business news and analysis, combined with experience will certainly help you to make more accurate forecasts of company earnings. (Source Rediff)

Rakesh Junjunwala rightly defined the stocks markets as Markets are like women always demanding, unpredictable and volatile. No one know whats next. For an instance take it Does any one knows when this recession is going to end ? No, no can say it accurately, one can just predict but as all know that the future is uncertain.But what one can do is spot out some value stocks in this badly beaten markets and think of long term investment in them. But a question comes here that which company to invest in?The answer to the above question is invest in the company in which you have faith and confidence and more over of which you are aware of.

Here are few easy steps to identify Multibagger stocks.

1. Go for a company which gives regular dividend. Dividend paying stocks mostly lie in A group category. 2. Preferably go for a Mid cap stock which in future can become a large cap. Mid cap stock have a greater chance to move upwards and that to fast. Preferable a stock whose market cap is less than 1000 Crores. 3. Go for a stock in a particular sector which is in boom. 4. Look out for the companies financial. In this check out the companies profit f last 4-5 years and check it out that it is increasing every year. One can also check out EPS of the company. 5. Check out whats running these days, Say for example there is a invention of a new technology which will be in demand in a near future. An excellent example is invention of 3G. Even TATA Nano can be taken in consideration as it is only one of its kind being the cheapest car in the world. 6. Check out for a companies order value. There are various companies which have a good amount of orders for future which are of great importance to a company. 7. One can also look out for a company which has good amount of land / property. Unitech had a lot of lad which can in the eyesight by end of 2005. An investment of Rs 40,000 then would be worth over 1 crore by the end of 2007. 8. Last and not the least be confident in your stock.

Few dont s in selecting a multibagger stock.

1. Dont select a Penny Stock. 2. Dont loose hope in your company. 3. Dont depent on others , do your own research.