This is the process we adopt before taking action to buy the share. Please note that the steps are arranged in order of priority, i.e. Business Analysis is the most important followed by Financial Statement Analysis and so on. Or put it in another way, there are times we may consider buying stocks that pass the Business Analysis but not Pricing Analysis but there won't be incident for us to buy stocks that fail Business Analysis but pass the rest. The 4 steps process are as below:
1. Business Analysis - As an share investor, you are the owner of the business. Hence it is important to know if the company has good business prospect. This is in fact the main key idea for the whole investment process, which is to buy shares of companies whereby their business is likely to be profitable and growing over long term. If you own shares of such companies, you are on your way to good returns!
The next thing about Business Analysis is to learn how to differentiate between Value and Growth Companies. We should only buy 2 types of shares: one is Value shares whereby we expect the profit of the company to be stable and we buy such shares for regular dividends. The other is Growth shares whereby we expect the profit of the company to increase and hence we buy such shares for capital gains.
2. Financial Statement Analysis - This is where we check the financial health of the company. Some of the assessments include: whether the company is profitable, whether the profit is converted into cash, whether the company is able to service their short term liabilities, whether the company is taking too much debt, etc. We should only invest in financial healthy companies and this is the only avenue to find out! Please do not assume that big companies or branded companies are financially healthy. That is not always the case!
3. Pricing Analysis - After confirming the business potential and the financial health of the company, we need to find out if the price is reasonable. How we do so is to derive the fair value of the share and compare with the market price. Of course we should only be buying when the market price is below fair value or at least at fair value. The tools that help us to determine fair value are Discounted Cashflow, Price Earning Ratio, Price to Book Ratio and Dividend Yield analysis.
4. Risk Analysis - End of the day, investment is about taking risk for the additional return. There is no way to eliminate risks. The only thing we can do is to find out what are the risk we are taking and buy the share only when we are comfortable in assuming the risks. The risks are classified into these 3 categories, namely, Company Specific Risk, Credit Risk and Market Risk.
With the consideration of Portfolio Management and after going through these 4 steps, we are ready to invest in the share market!