Want to buy a stock? Read this first

eciding you want to invest in the stock market and deciding which stocks to buy are two very different decisions.

The first is easy.

The second is not so easy.

A smart investor should never invest in (buy stocks of) companies he doesn't know much about. Relying on 'advice' from friends is not always a great idea. Do some groundwork yourself.

How to check if a stock is worth buying

Where does one begin?

The best place to get information about a company is from the horse's mouth: the company -- especially if an expert certifies what the company management is telling you is true.

We are talking here about the company's annual report or its profit and loss statement and balance sheet, which have been audited by chartered accountants.

There is a wealth of information in a company's annual report.

The chairman's statement will tell you about the management's future plans.
The directors' report will tell you how the company performed in the preceding year.
For a personal analysis of the company's earnings and profits (or lack of them), there is no substitute to the profit and loss account and the balance sheet.

What's in a share? Money!

What is a P&L account?

Simply put, it gives the company's performance over a period of time, usually a year. It tells you whether the company made a profit or loss over the period.

How does a business make a profit? Well, its income needs to be more than its expenses. If its expenditure is more than its income, then the company is running on a loss.

You don't have to be an accountant or have a degree in commerce to read a company's financials. It is quite easy to grasp the basics.

Make money with shares

A sample P&L account

Profit and Loss Account for the year ended March 31. All figures in Rs/lakh.

	2004	2003
Income
Sales	110	80
Less: Excise Duty	10	8
Net Sales	100	72
Other Income	20	18
	120	90
Expenditure
Materials	50	40
Other Expenses	30	25
Interest	5	10
Depreciation	10	10
	95	85
Compensation paid under VRS	20	-
	115	85
Profit for the year before tax	5	5
Tax	2	2
Profit for the year	3	3

Income

Under this heading, you will find that sales are the biggest item. Sometimes, people talk about gross sales and net sales.

Gross sales = Total sales including excise duty.

Net sales = Total sales - excise duty.

'Other income' refers to all those items that contribute to income but do not form a part of the company's sales. This could include dividends or interest income from the company's investments, profits from sale of assets or investments, sale of scrap items, income from services and so on.

The point to remember is that, usually, most items in 'other income' are items not directly related to the company's business. For instance, a manufacturing company may earn income from some smart investments.

In other words, 'other income' may not necessarily recur every year.

Expenditure

Expenditure is the expense on raw materials, wages, salaries, administrative expenses, advertisements and publicity, charges for power consumption and so on.

The item 'interest' refers to the interest the company pays on its loans.

Depreciation refers to the wear and tear of the equipment used by the company (this is just a notional estimate). The need to provide for depreciation arises because a company needs to set aside a sum every year so that it can buy new machinery when needed.

Exceptional items

In the above example, we have another item: Compensation paid for VRS in 2004. This is reported separately from other items of expenditure because it is an 'exceptional item'. Which means, it does not occur every year.

For instance, in the example, it didn't occur in 2003.

Profit

Deducting expenditure from income gives the profit.

In the example, profit before exceptional items is Rs 15 lakh (120 - 95) in 2004, while it is Rs 5 lakh (90 - 85) in 2003. Despite the fact that profits before tax are the same in both 2003 and 2004, it is only because of the lump sum VRS payments made in 2004; otherwise, the profit this year would have Rs 20 lakh.

If this payment is left out of the picture (as it should be, because a VRS payments means the wage bill in succeeding years will decrease), the company has performed much better in 2004 than in 2003.

Please remember that profits by themselves carry little meaning. You will always have to compare profit in a particular period with those in the preceding period to arrive at any conclusions.

In the above example, we can see the company has done better in 2004. Sales have gone up by 38.8%, while profit before exceptional items has gone up by 200%.

How to invest in an IPO

You can now analyse a company's P&L account.

1. Did sales increase?
2. Did it result in higher profits?
3. Have profits been artificially boosted by higher 'other income'?
4. Have exceptional items led to lower profits?
5. Have interest costs gone up?
6. Have raw material costs been contained?

What are quarterly earnings?

The quarterly earnings reports are nothing but the P&L account for a particular quarter (three months).

Also read the 'Notes to the Accounts' at the end of the P&L account or quarterly earnings reports. These tell you whether the company has changed its methods of accounting, or other material factors that have affected the profits of the company.