Most successful investors compare peer companies to examine the relative strengths and weaknesses of their investment choices. A strategic and careful comparison helps in identifying the latest industry trends and picking stocks that offer the most profit.
Through this article, let us understand in detail how you can compare stocks, calculate relevant financial ratios, and make valuable assessments in easy steps.
Also read: Types of stock trading
Why should you compare stocks as a trader?
One of the major benefits of comparing stocks is that traders can identify companies performing better than their peers. This understanding helps traders manage risk more effectively. If a stock consistently underperforms compared to its competitors, it indicates underlying issues that could lead to losses for traders. Thus, a strategic and accurate comparison often gives lucrative opportunities for profitable trades.
Let us take a look at some other major benefits:
Market trends analysis
When traders compare stocks, they can:
Analyse broader market trends within specific sectors
Identify which stocks are leading or lagging within a sector
This analysis allows traders to understand the overall market sentiment
Using it, traders can adjust their trading strategies accordingly
Profit maximisation
The stock comparison also enables the identification of stocks that are undervalued or overvalued relative to their peers
- Using this information, traders can plan to:
- Buy undervalued stocks
- Sell overvalued stocks
- This way, traders can maximise potential profits and their overall portfolio returns
Diversification
Stock comparison enables traders to diversify their portfolios effectively
It allows for investing in stocks of different companies operating within the same sector
This diversification spreads risk and minimises the impact of adverse events affecting any single stock
Also read: Invest in stock market
How to compare stocks?
Most traders compare stocks operating within the same sector to make stock comparisons meaningful and more effective. That is because companies within the same industry often operate in similar business environments. They face comparable regulatory frameworks and market conditions. This similarity allows for more accurate comparisons. Let us see how you can compare stocks in easy steps:
Step I: Collect financial data
Shortlist companies operating in the sector in whom you want to invest
Gather financial statements
You can include in your collection:
Income statements
Balance sheets
Cash flow statements
Repeat the process for each company
Step II: Calculate critical financial ratios
This is the most important step where you will be computing important financial ratios focusing on a company's:
Profitability
Liquidity
Leverage
Valuation
Read the table below to know what ratios to calculate:
What financial ratios do you have to calculate? |
What do they mean? |
How are they calculated? |
How can you interpret it? |
Return on Equity (ROE) |
This ratio assesses the profitability of a company in comparison to the investments made by shareholders. |
(Net income)/(Shareholder's equity) | A higher ROE indicates that a company is effectively utilising shareholders' funds to generate profits |
Net profit margin |
This ratio measures the percentage of revenue that translates into net income after accounting for all expenses. |
(Net income)/(Net sales) |
|
Current ratio |
This ratio assesses a company's ability to meet its short-term obligations with its short-term assets. |
(Current assets)/(Current liabilities)
|
|
Debt-to-equity ratio |
This ratio measures the proportion of a company's financing that comes from debt compared to equity. |
(Total debt)/(Shareholder's equity) |
A lower ratio suggests that a company relies less on debt financing, which may reduce financial risk. |
Interest coverage ratio |
The ratio measures the company's capability to fulfil its interest obligations using its operational earnings. |
( EBIT* )/(Interest expense)
*Earnings Before Interest and Taxes (EBIT) |
|
Price-to-earnings (P/E) ratio |
|
(Current market price)/(EPS*)
*Earnings per Share |
|
Also read: Share market
Step IV: Analyse growth prospects
Evaluate each company's growth potential
To do so, you can examine:
Historical revenue
Earnings growth rates
Future growth projections
While analysing, also consider factors like market share and product innovation
Step V: Evaluate competitive positioning
Compare each company's:
Market position
Competitive advantages, and
Barriers to entry
For a strong evaluation, you must assess the following factors:
Brand strength
Customer loyalty
Technological capabilities
Step VI: Risk assessment
Identify and evaluate risks associated with each investment
For a complete risk assessment, you can include the following types of risks:
Industry-specific risks
Operational risks
Macroeconomic risks
Assess the likelihood and impact of these risks on each company's future performance
Step VII: Make comparisons and draw conclusions
In this last step, you have to compare:
All the financial metrics
Growth prospects
Competitive positioning
Risk profiles
Do this for each company you had shortlisted in Step I
Now, perform a SWOT (strengths, weaknesses, opportunities, and threats) analysis for each investment option
Based on your analysis, invest in the shares presenting the most attractive investment opportunities
Investor tip: Always remember that stock comparison is not a ‘one-size-fits-all’ approach. It requires careful consideration of multiple factors. Hence, you must conduct thorough research and analysis to make informed investment decisions.
Conclusion
When you compare stocks within the same sector, you can identify performance disparities and capitalise on profitable opportunities. A meaningful comparison can be made by evaluating financial metrics, growth prospects, and competitive positioning. To begin with, gather financial statements of the sectoral companies you want to invest in. Next, calculate important financial ratios and look for each company’s growth prospects and their individual competitive positioning. Lastly, compare all the metrics to identify the most profitable stocks.
