InvestorQ : What are the factors to observe before investing in shares and mutual funds?
Priyanka N made post

What are the factors to observe before investing in shares and mutual funds?

Answer
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2 months ago


I am assuming you want to know the quantitative filters one can apply to separate the good quality stocks and mutual funds from among the lot. There are many filters than you can apply. I am covering some of them. However, do note that these are not enough by themselves and have to be looked at in combination with qualitative factors to get accurate results. 

Some quantitative filters for finding good stocks are:

a) P/E ratio: The price to earnings ratio or P/E ratio tells us the amount an investor pays per unit of profit earned by the company. 

b) D/E ratio: The debt to equity ratio or D/E ratio shows the proportion of equity to debt that a company is using to finance its assets. As a thumb rule, the D/E ratio should be less than 1.

c) Free Cash Flow: Free cash flow is the left-over cash of the company after it has paid off its operating expenses and capital expenditure. It shows the efficiency of a company at generating cash and is considered as an important indicator in determining whether a company has sufficient cash to reward shareholders through dividends and share buybacks. 

d) Current Ratio: This is basically the current Assets /current liabilities.  It is a measure of the short-term solvency of the firm as current assets are used to pay the current liabilities. Current Ratio higher than 1 is favorable.

e) ROCE: This is a measure of the returns that a company is realizing from its capital. The resulting ratio represents the efficiency with which capital is being utilized to generate revenue. In general, investors tend to favor companies with stable and rising ROCE numbers.

Some quantitative filters for identifying good mutual funds are: 

Standard deviation: Standard deviation measures by how much a fund’s returns typically exceed or fall short of its average return. The higher the value of standard deviation, the greater will be the volatility in the fund's returns. The standard deviation allows a fund's performance swings to be captured into a single number.

a) Sharpe Ratio:  This measure uses standard deviation to measure a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories.

b) Alpha:   In a nutshell, alpha is the difference between a fund's expected returns based on its beta and its actual returns. Alpha is sometimes interpreted as the value that a portfolio manager adds, above and beyond a relevant index's risk/reward profile. If a fund returns more than what you'd expect given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha.

c) Beta:   Beta is the measure of a fund's volatility relative to the market or benchmark. For example, if a fund is benchmarked against the Sensex, a beta of more than 1 would imply that the fund is more volatile than the index. And a beta of less than 1 would imply lesser volatility.

d) Peer Group Average: Funds performance is compared to its Peer Group to evaluate its position. Compare funds that buy large, undervalued companies with others with the same style so-called large-value funds.