The patient and diligent investor’s guide to spotting hidden gems and finding value in a tough market
You’ve probably heard the adage, “One person’s food is another’s poison.” It’s as true for the gourmet as it is for the stock investor. Investors relish the idea of making a quick buck in a rising market. In a market which falls, there are other canny ones who short-sell and make money. Then there’s the bewildered investor who doesn’t know which stock to buy, when to buy and when to sell. This bewildered investor is the one see through the dust raised by stampeding bulls, standing on the sidelines in miserable indecision. He decides to join in the last lap. Then, when the stampede is suddenly called off, and the bulls have vanished into thin air, this poor guy discovers he’s stuck with a lemon. Think he’s going to make lemonade? Not him. He’ll just have a distress sale, and then stay far away from the stock market. So, is there a way for investors to identify good companies and time their decision right? Fortunately, yes, for those who have patience and diligence. The equity value of a company is the present value of future cashflows. It’s a truism that value lies in the eye of the beholder. “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it,” said the legendary Warren Buffett. He bought businesses that were high on growth, high on return on capital employed...and look where he is today. When he bought Coca-Cola, many thought he had made a mistake. But he bought it because it had the capacity to do better than the stock market, due to its high returns potential. Buffett advises investors to seek value. Let us look at it another way. One metric by which equity value is determined is the P/E ratio. How can you, as an investor, use it to spot hidden gems? Suppose you invested Rs 100 in a bank, at an annual return of 9%. You get Rs 9 on your Rs 100. So the invested-to-return ratio is 100/9, or 11.1. It’s the same way with stocks. You put in Rs 100, and the company has an earnings per share of, say, Rs 7. So its P/E is 100/7 or 14.29. In the bank FD, your risk is minimal and the payout is 9%. But in the case of equity, the payoff is the dividend plus the potential for share price appreciation. Equity is risky, hence the potential payoff must be significantly higher to make investing sense. So for companies that grow their profits significantly, the stock price is higher, and dividend earnings lower. The latter is made up for in terms of greater appreciation in the stock price. Another good guide is to identify fair valuation in equity. This is referred to as the PEG ratio. It’s the P/E divided by the growth potential of the company. If that number is 1 or less, the company is said to be fairly valued, and if it is more, it is said to be overvalued. Let’s pick a company and check it out. Birla Corporation has a market capitalisation of over Rs 1,296 crore. The latest sales and net profit figures (year ended March 2008) are Rs 1,996.78 crore and Rs 393.57 crore respectively, and have grown more than 11.27% and 20.64% over the previous year. EPS stands at Rs 51.1, and the estimate for FY09 is Rs 58.7, which represents 14.85% growth over the current EPS. The P/E for this company is 3.24. The PEG ratio is 3.24/14.85 or 0.22. That means you pay Rs 167 (current market price) for a share in Birla Corporation, and get an EPS of Rs 51.1. This is a return of 30.86%—much better than bank FDs! And that’s not counting possible appreciation in the price of the stock! Of course, the company is not going to pay out the entire profit as dividend. But the intrinsic value remains, which makes it a good stock to own. Now, if the company is doing so well, why is the share price so low? There could be many reasons. Perhaps the company is heading for slower growth in future. Perhaps it’s in an industry whose fortunes are cyclical. Competition could erode the margins or growth of the company. Indeed, brokers agree in their estimate that the EPS will come down in FY2010 to Rs 52. Besides, the company has a troubled past, and has faced industrial relations issues throughout its history. This is where patience and diligence count. If one studies companies carefully, one can identify good value buys. Always look beyond the numbers and then decide. That brings us to the next issue: time. Is this the right time to buy? What’s important is not timing, but time in the market. If you find a good company at a good valuation, the time is right. A time like this additionally presents an excellent opportunity to those who have the courage of conviction to buy now and hold on for later. So now could be the right time to buy good value stocks. The value proposition is important. If you’re convinced the company you’re buying is good, it should not bother you where the stock market is going. For, once you’ve bought a good stock, its value does not diminish with the stock ticker’s oscillations. “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years”—again, the wisdom of Warren Buffett. Now there’s food for thought!
You’ve probably heard the adage, “One person’s food is another’s poison.” It’s as true for the gourmet as it is for the stock investor. Investors relish the idea of making a quick buck in a rising market. In a market which falls, there are other canny ones who short-sell and make money. Then there’s the bewildered investor who doesn’t know which stock to buy, when to buy and when to sell. This bewildered investor is the one see through the dust raised by stampeding bulls, standing on the sidelines in miserable indecision. He decides to join in the last lap. Then, when the stampede is suddenly called off, and the bulls have vanished into thin air, this poor guy discovers he’s stuck with a lemon. Think he’s going to make lemonade? Not him. He’ll just have a distress sale, and then stay far away from the stock market. So, is there a way for investors to identify good companies and time their decision right? Fortunately, yes, for those who have patience and diligence. The equity value of a company is the present value of future cashflows. It’s a truism that value lies in the eye of the beholder. “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it,” said the legendary Warren Buffett. He bought businesses that were high on growth, high on return on capital employed...and look where he is today. When he bought Coca-Cola, many thought he had made a mistake. But he bought it because it had the capacity to do better than the stock market, due to its high returns potential. Buffett advises investors to seek value. Let us look at it another way. One metric by which equity value is determined is the P/E ratio. How can you, as an investor, use it to spot hidden gems? Suppose you invested Rs 100 in a bank, at an annual return of 9%. You get Rs 9 on your Rs 100. So the invested-to-return ratio is 100/9, or 11.1. It’s the same way with stocks. You put in Rs 100, and the company has an earnings per share of, say, Rs 7. So its P/E is 100/7 or 14.29. In the bank FD, your risk is minimal and the payout is 9%. But in the case of equity, the payoff is the dividend plus the potential for share price appreciation. Equity is risky, hence the potential payoff must be significantly higher to make investing sense. So for companies that grow their profits significantly, the stock price is higher, and dividend earnings lower. The latter is made up for in terms of greater appreciation in the stock price. Another good guide is to identify fair valuation in equity. This is referred to as the PEG ratio. It’s the P/E divided by the growth potential of the company. If that number is 1 or less, the company is said to be fairly valued, and if it is more, it is said to be overvalued. Let’s pick a company and check it out. Birla Corporation has a market capitalisation of over Rs 1,296 crore. The latest sales and net profit figures (year ended March 2008) are Rs 1,996.78 crore and Rs 393.57 crore respectively, and have grown more than 11.27% and 20.64% over the previous year. EPS stands at Rs 51.1, and the estimate for FY09 is Rs 58.7, which represents 14.85% growth over the current EPS. The P/E for this company is 3.24. The PEG ratio is 3.24/14.85 or 0.22. That means you pay Rs 167 (current market price) for a share in Birla Corporation, and get an EPS of Rs 51.1. This is a return of 30.86%—much better than bank FDs! And that’s not counting possible appreciation in the price of the stock! Of course, the company is not going to pay out the entire profit as dividend. But the intrinsic value remains, which makes it a good stock to own. Now, if the company is doing so well, why is the share price so low? There could be many reasons. Perhaps the company is heading for slower growth in future. Perhaps it’s in an industry whose fortunes are cyclical. Competition could erode the margins or growth of the company. Indeed, brokers agree in their estimate that the EPS will come down in FY2010 to Rs 52. Besides, the company has a troubled past, and has faced industrial relations issues throughout its history. This is where patience and diligence count. If one studies companies carefully, one can identify good value buys. Always look beyond the numbers and then decide. That brings us to the next issue: time. Is this the right time to buy? What’s important is not timing, but time in the market. If you find a good company at a good valuation, the time is right. A time like this additionally presents an excellent opportunity to those who have the courage of conviction to buy now and hold on for later. So now could be the right time to buy good value stocks. The value proposition is important. If you’re convinced the company you’re buying is good, it should not bother you where the stock market is going. For, once you’ve bought a good stock, its value does not diminish with the stock ticker’s oscillations. “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years”—again, the wisdom of Warren Buffett. Now there’s food for thought!
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