When you were a child, you were probably thrilled to bits by the park in your neighbourhood. Then you grew a little older and perhaps visited a local national park or botanical – a local attraction. The park in your neighbourhood paled a little in comparison. Then you grew a little more and were taken to a tiger reserve. By now that little park in your neighbourhood – while probably still dear and convenient to you – has lost all sense of being superlative in your mind. However, this only happened after you started comparing it to other parks

In all likelihood, you pay anything from Rs 2 to Rs 20 to enter your neighbourhood park. However, when there’s tens of thousands, or even lakhs, of rupees at stake – by way of your stock market investments – comparison becomes pretty much compulsory.

In order to conduct an apples to apples comparison between stocks, investors usually start by comparing two stocks within a single sector. The question is, what measure should you use?

Use key ratios in fundamental analysis for comparison

Price-to-earnings ratio, price-to-earnings growth ratio, price-to-sales ratio, price-to-book ratio and debt-to-equity ratio are commonly used to compare two stocks within a single sector. These ratios are referred to by their abbreviations, namely P/E ratio, PEG ratio, P/S ratio, P/B ratio and D/E ratio.

In all P/E ratio, PEG ratio, P/S ratio and P/B ratio, the price of the stock is held against other factors, namely earnings, earnings growth, sales and book value of the company, to ascertain whether the stock price is justified. Then, the stock price is compared to other stocks within the same sector. The stocks chosen for comparison will usually be the base stocks’s competitors or its peers, or else, the sector’s leading names. Stocks that display lower ratios in comparison to their peers are usually seen as preferable. This is because they are construed as having that much potential for growth; or that they are currently ‘undervalued’ and may have the potential to return well in the future.

Debt-to-equity ratio evaluates the company’s ability to manage it’s functioning on its own steam (and earnings). A high D/E ratio means that the company is relying heavily on borrowed capital. This could be a sign of cracks in the way the company and its finances are being managed. So you definitely want to invest in a company with a lower D/E ratio than peers or industry average.

Use key measures in fundamental analysis for comparison

Fundamental analysis also includes measures such as return on equity (ROE) and return on assets (ROA). As the names suggest these measures evaluate whether a company is using its resources judiciously. You are about to supply them with additional resources – by way of your investment capital (no matter how small your contribution is). Isn’t it only logical to check their ability to use resources efficiently to churn out good returns?

Overall use of financials for comparison

Fundamental analysis in fact involves a deep dive into a company’s financials.

You could also compare margins such as profit margins, gross margins and operating margins of various companies within a sector to see how they fare against each other.

Revenue, losses, growth (or reduction) in revenue or losses can also be used to measure stocks against one another. For example, maybe company A and company B both have losses of Rs 10 lakh, but company B has reduced its losses from Rs 16 lakh two years ago and Rs 14 lakh last year, whereas company A has been witnessing increasing losses over the last few years. The investor might want to consider company B over company A, if, of course, all other factors bode well for company B.

Similarly, maybe company X has a revenue of Rs 100 crore, whereas company Y has a revenue of Rs 90 crore, but company Y also posted losses of Rs 2 crore, where company X posted a loss of Rs 14 crore. Company Y might just be the better of the two options.

Take projections into account for comparison

Stock market investors make their own stock price predictions based on technical analysis. You could compare the projected growth of a stock to that of another from the same sector.

Additionally, you can use the projected earnings of a company to evaluate its potential as compared to its peers. Remember to check the authenticity of projected earnings as these could be inflated or favorably presented with the very goal of drawing in research-lazy investors.

Evaluate competitiveness for comparison

You can look at the company’s supplier contracts, it’s allied businesses, any resources that it has at its disposal the competitors do not, and similarly, any future-preparedness that it boasts. Do a SWOT analysis to figure out how competitively the company is placed. Then, do the same for a few other companies in the sector and decide if your initial choice is still the best investment.

Other factors one might give points to is the track record of management, legal cases if any against companies, frequency and distribution of dividend distribution. Of late, investors are also using the ecological and social implications of businesses when considering whether they are worthy of investment capital.

Conclusion

The best stock in a sector must still be evaluated against other stocks on the market before you decide to add it to your portfolio. After sector-based comparison, many investors also compare the stock’s performance to that of benchmark indices in order to evaluate whether their performance is actually any good. Lastly, investors must not fail to check if the stock matches their risk appetite.