What stocks to buy? What are undervalued stocks?

What stocks to buy for profitable investing?

Investor should try to “buy fundamentally strong stocks which are undervalued“. Why undervalued?

Because undervalued stocks can fetch higher returns in long term.

Why fundamentally strong stocks?

Because fundamentally strong stocks represent those companies which are doing good business. Higher returns are only the result of good business practices.

People get confused about which stocks to buy. To clear the confusion, there is one sentence:

Buy only fundamentally strong, undervalued stocks.

If we can keep our investment understanding as simple as these 6 words, we will be sorted.

No matter how complicated is the decisions, one must stick to this simple rule.

People who practice short term trading in stocks, do not follow this rule. They will rather buy anything. Why?

Because they believe in profiting from momentum investing.

But this is not the investment practice which I promote in this blog.

How to know if the stock is undervalued?

When market price of stock is less than its intrinsic value, it is undervalued.

So to know if the stock is undervalued, one must know how to estimate its intrinsic value.

The other easier way of knowing if the stock is undervalued or not is wait and watch method.

The easiest time to find undervalued stocks in India is in a falling market.

How to know if the market is falling or rising?

Tracking stock market index will give this answer. Observing main indices like Sensex, Nifty, Nasdaq etc is better.

But it is not sufficient to see index movements alone.

To get a more meaningful idea, look deeper into the index’s PE & PB ratios.

[P.Note: Sensex’s PE & PB ratio can be found by visiting bseindia’s website.]

IndexSensex LevelsP/EP/BDividend YieldDate
SENSEX28,50018.633.091.22Apr’15
SENSEX34,00024.953.091.14Dec’17

It is interesting to observe index in terms of its PE, PB. I maintain a historical PE and PB database of Sensex. This gives me a general idea about the present valuation of stocks.

In above table you can observe the following:

  • Sensex jumped from 28,500 to 34,000 levels in 2.7 years (up by 15%).
  • PE of Sensex jumped from 18.63 to 24.95 levels in 2.7 years (up by 25%).
  • PB of Sensex remained same.
  • Dividend Yield of Sensex is down by 5%.

What these data tell about the market?

PE up by 25%, when the index is up by only 15%, is a strong signal of overvaluation.

PB remaining same means the companies are increasing their net worth at the pace of the market, which is very good.

Dividend yield coming down can mean two things, either overvaluation or, company holding more of its profits. When Net worth of company is growing fast, it is more likely that Sensex companies are holding more of their profits.

As a general rule of thumb, stocks having PE more than 15 may be overvalued. Similarly, stocks having PB more than 1.5 may be overvalued.

Though it is an outdated rule, but it still gives investors a feel about the price valuations.

Sensex Verses Individual Stocks

Price Earning (P/E) Ratio of Index represents average valuations of stocks listed in stock exchange. Presently P/E ratio of SENSEX is 24.95. Applying a rule of thumb, P/E above 15 hints at overvaluation.

In last 24 months, Sensex has risen by more than 8,500 points. This is the reason why P/E of Sensex is trading at 24.95 levels today.

When Sensex is rising it means its P/E ratio is also increasing. It implies that stocks may be getting overvalued too.

In this uptrend of Index there are some good stocks that gets left-behind.

Investors intention should be to track those fundamentally strong stocks which are undervalued.

Let’s take an example of Tata Steel to see how we can compare individual stocks with Sensex and derive a conclusion:

What stocks to buy - 1

This type of comparison of SENSEX with individual stocks gives insights about the market.

Lets see what we can decode about Tata Steel from above table:

  • Sensex rose @9.5% in last 5 years.
  • Tata Steel’s share price rose @8.95% in last 5 years. This growth is almost at par with Sensex.
  • But Tata Steel’s EPS fell @ -7.41% in last 5 years. This growth is not at par even with inflation.
  • PE ratio rose at a massive rate of 17.67% per annum. This indicates overvaluation.
  • This overvaluation is the result of falling EPS.
  • Dividend per share growth is almost at par with Sensex growth.
  • The dividend yield has almost been consistent in last 5 years. But it is on very lower side.

What we can conclude from this table?

As EPS of Tata Steel is falling, it indicates problems in its business fundamentals.

But as because this company has a very strong Management, it is still taking care of the shareholders interest in terms of market price appreciation and dividend earnings.

So does this make it a good stock for investing?

No, because it does not stand up to our basic investing rule (buy only fundamentally strong, undervalued stocks).

Tata Steel’s fundamentals may not be strong (falling EPS). It may also not be undervalued (increasing PE ratio).

To get a deeper understanding of Tata Steel we can use the stock analysis worksheet, but prima facie it doesn’t look too good.

This kind of understanding is possible when we compare Sensex movements with individual shares.

PE Ratio speaks much more…

PE ratio gives a broad idea about market whether it is overvalued or undervalued.

In years 1920, 1950, 2001 & 2008, stock market across the world saw its worst crisis. During these moments of turmoil the average PE ratio of stock market was at its rock bottom.

Investors who bought stocks during these times made handsome profits.

But this is only one side of the story.

There were investors who bought stocks only when stock market got revived. Like in year 2010. PE ratio of the market was at all time highs.

Buying stocks when market has already peaked is bad.

So does it mean that now, when Sensex is at 34,000 levels, market is overvalued?

Just because of the fact that Sensex is at all time high, does not make it overvalued.

Hence to answer this question we will have to look deeper (PE ratio) into historical data of Sensex.

What stocks to buy - 2

What you see in the above table is last 20 years Sensex data obtained from bseindia’s website.

I have indicated three points as “Max” in the above table. Out of these 3 points, 2 are those years when market peaked and subsequently crashed.

What was the PE ratio in those years? 23.89 (year 2001) and 22.61 (year 2002).

What is the PE ratio of Sensex today? It is 23.60.

Looking at this historical data, possible Sensex correction looks very probable any time soon.

But what Sensex patterns has to say about – what stock to buy?

If Sensex is tending towards overvalued levels, it does not necessarily mean that individual stocks are also overvalued.

But when Sensex becomes overvalued, market may crash.

When market crashes, stock price will also fall very rapidly.

Hence, it is better to wait for the possible stock market correction and then buy stocks.

[P.Note in the above table: After the indicated stock market crashes, the PE of Sensex fell close to our rule of thumb of 15 and then bounced back again]

Keep a watch on inflation…

In countries like India, investors must also look into inflation.

PE ratio is effected by inflation rates. How?

High inflation rates effects the sentiment of the market. Buyers/Customers feel the pinch of soaring prices.

Companies expenses goes up rapidly resulting in less profits.

When customers are buying less, and companies are making less profits, EPS is bound to fall.

When EPS falls PE ratio increases, making stocks overvalued.

This further pushed the investors away from investments.

Controlled inflation is good for the economy. But erratic and stubbornly high inflation rates are worrisome.

Having said that, it must also be noted that stock market do not work well in economies having low inflation rates.

Please see the below table to correlate the performance of Sensex with prevailing inflation in India.

What stocks to buy - 3
Between year 2000 and 2011 (11 years)

Inflation was rising rampantly in India. It rose from 4.84% (year 2000) to 12.11% levels (year 2011).

In the same period, Sensex rose from 5001 (year 2000) to 19,445 levels (year 2011).

The growth in Sensex was amazing at the rate of 13.13% per annum.

Between year 2011 and 2017 (7 years)

Inflation was falling in India. It fell from 12.11% (year 2011) to 2.19% levels (year 2017).

In the same period, Sensex rose from 19,445 (year 2011) to 33.848 levels (year 2017).

The growth in Sensex was decent at the rate of 8.24% per annum.

Could you get the pattern?

Between the periods when inflation was soaring (2000-2011), Sensex did better.

Between the periods when inflation was falling (2011-2017), Sensex still performed well but not as good as previous years.

What does it mean?

It does not mean that high inflation is better. But for a growing economy, too low inflation rate is also not good.

This is where our RBI needs to keep a proper check. Inflation should neither be too high nor too low.

So what it means for stock investors?

Investors must not feel scared when inflation is rising (in a controlled way). Market may perform better in those times.

So when one has to buy stock, keep a look at the varying inflation charts. If it is showing a downtrend, future growth may not be as great.

Look for fundamentally strong stocks

In addition to index, it is equally important to look at business fundamentals of individual stocks.

No matter how undervalued are the stocks, but if their fundamentals are weak, it will not be a good buy.

Many stocks trade at low PE & PB levels. But majority of them has weak fundamentals.

One must buy only fundamentally strong stocks.

Looking at the following parameters in stocks can give an idea about its fundamentals:

  • BALANCE SHEET (5 Year Data)
    • Share Capital – Ideally it must be constant.
    • Reserves – Ideally it must grow faster than inflation.
    • Net Block (fixed assets) – Ideally it must grow faster than inflation.
    • Current Asset / Current Liability Ratio – Must be above one (1).
  • P&L ACCOUNT (5 Year Data)
    • Sales – Ideally it must grow faster than inflation.
    • EBIT – Ideally it must grow faster than inflation.
    • EBIT Margin – Ideally it must grow with time.
    • Net Profit (PAT) – Ideally it must grow faster than inflation.
    • Dividend per share – Ideally it must grow at rate of PAT growth.
  • CASH FLOW (5 Year Data)
    • Net Cash Flow from operations – Must always be positive.
    • Growth in Net Cash Flow from operations -Ideally it must grow faster than inflation.
  • DERIVED RESULTS
    • Current Market Price < Intrinsic Value.
    • Piostroski F Score > 6.
    • Altman Z Score > 2.6.
    • Future Growth prospects – Ideally it must be more than inflation.
    • No bankruptcy threat.
    • Management must be efficient.
    • Overall financial health must be stable.
    • etc….

I know, this checklist can be endless.

Different people will use different parameters to evaluate their stocks. I use these parameters for my decision making.

If you want to avoid going into so much self calculations, you can use my stock analysis worksheet to get instant answers. Though it is not a stock advice tool, but it works.

Quick Tip: Check for potential investors:

A quick comparison of companies “Enterprise Value” and its “Market Capitalisation” gives a nice first hand idea of whether a stock may be undervalued or overvalued.

This is again one of the easier ways to identify undervalued stocks in India.

Stocks whose enterprise value is less than their market capitalization can be assumed to be trading at undervalued price levels.

How?

Enterprise value = Market Cap + (Debt – Cash)

Suppose there is a company which has huge cash reserves. Its cash level is so high that it can pay-off its total debt from its cash reserves only (cash > Debt). This is a rarest of rare case.

In such a case, using the above equation, the companies enterprise value will be less than its market cap.

Such companies can be assumed to be undervalued.

Undervalued Stocks in India (Enterprise Value < Market Capitalisation)

(Updated as on July’2018)

General Data…

SLCompanyPrice52-Week High52-Week LowMarket Cap (Cr)Size (Market Cap)Enterprise Value Less Than Market Cap?
1Tata Steel Ltd.571.1755.52517.9668502.35Large CapNo
2Hindustan Petroleum Corpn. Ltd.252.3492.8250.638499.38Large CapNo
3Rajshree Sugars & Chemicals Ltd.22.5574.821.963.38V.Small CapNo
4Dhunseri Petrochem Ltd.112.219775.1390.7Small CapYes
5Balrampur Chini Mills Ltd.62.6182.558.71431.17Small CapNo
6DCM Shriram Inds. Ltd.136.5370125.05237.49Small CapNo
7Indian Oil Corpn. Ltd.155.25231.48150150824.41Large CapNo
8Polyplex Corporation Ltd.422.55602406.251349.27Small CapYes
9Star Paper Mills Ltd.159.7318.55151.45248.64Small CapYes
10Rural Electrification Corpn. Ltd.100.75189.159919877.55Mid CapNo
11Tata Power Co. Ltd.72.05101.87119474.37Mid CapNo
12Tata Chemicals Ltd.691.65787.5560.417664.8Mid CapNo
13VLS Finance Ltd.64.75104.857251.69Small CapYes
14JK Paper Ltd.108.65169.988.71936.62Small CapNo
15Joindre Capital Services Ltd.244620.3533.21V.Small CapYes
16Lycos Internet Ltd.4.15103.8200.03Small CapYes
17PNB Gilts Ltd.27.9557.9527.8503.13Small CapNo
18Shreyans Industries Ltd.132.25245127.2181.79V.Small CapNo
19Vivimed Labs Ltd.59.4153.556.6490.6Small CapNo
20Vardhman Holdings Ltd.2841.662002805908.39Small CapYes
21Gujarat Narmada Valley Fertilizers & Chemicals Ltd.415.6548.52556445.99Mid CapNo
22Vakrangee Ltd.57.451530.856077.53Mid CapYes
23DCM Shriram Ltd.310.26282375041.4Mid CapNo
24Indiabulls Real Estate Ltd.149.7269.7141.556790.9Mid CapNo
25EID-Parry (India) Ltd.227.35392204.14023.1Mid CapNo

Price Valuation…

SLCompanyPricePEG (1Y)PEG (3Y)PEG (5Y)FCF Yield (%)P/EP/BDividend Yield (%)
1Tata Steel Ltd.571.10.010.070.1710.435.11.171.76
2Hindustan Petroleum Corpn. Ltd.252.30.060.050.048.945.331.517.92
3Rajshree Sugars & Chemicals Ltd.22.550.010.060.01248.952.390.484.44
4Dhunseri Petrochem Ltd.112.20.010.080.09236.667.460.361.79
5Balrampur Chini Mills Ltd.62.60.010.010.017.86.180.895.59
6DCM Shriram Inds. Ltd.136.50.010.070.079.954.050.547.33
7Indian Oil Corpn. Ltd.155.250.10.160.189.66.81.326.12
8Polyplex Corporation Ltd.422.550.010.030.4535.058.460.531.66
9Star Paper Mills Ltd.159.70.010.060.1617.314.580.611.57
10Rural Electrification Corpn. Ltd.100.750.380.420.2428.474.240.559.59
11Tata Power Co. Ltd.72.050.040.050.084.897.861.31.81
12Tata Chemicals Ltd.691.650.050.120.1610.557.261.591.59
13VLS Finance Ltd.64.750.020.070.1316.97100.891.54
14JK Paper Ltd.108.650.030.120.2916.737.431.171.38
15Joindre Capital Services Ltd.240.030.140.2328.275.570.583.12
16Lycos Internet Ltd.4.150.060.010.0226.330.490.080
17PNB Gilts Ltd.27.950.030.340.26240.4313.760.573.58
18Shreyans Industries Ltd.132.250.030.260.0920.625.831.181.37
19Vivimed Labs Ltd.59.40.030.120.2412.056.290.540.67
20Vardhman Holdings Ltd.2841.60.010.040.176.644.810.520.18
21Gujarat Narmada Valley Fertilizers & Chemicals Ltd.415.60.040.380.6222.78.111.431.21
22Vakrangee Ltd.57.40.250.210.069.878.932.341.74
23DCM Shriram Ltd.310.20.230.180.258.287.531.661.87
24Indiabulls Real Estate Ltd.149.70.110.160.1510.263.3710
25EID-Parry (India) Ltd.227.350.010.171.537.9915.731.351.76

2 thoughts on “What stocks to buy? What are undervalued stocks?

  1. Sohan Reply

    I like your valuable a d genuine recommendation. 2 years back in 2017 you have recommended SYNGENE INTERNATIONAL, TODAY THEY DECLARE BONUS SHARE

    • Mani Post authorReply

      Thanks, but I do not really recommend shares. I just share my analysis. But it’s good that it helped. Thanks a lot for giving your feedback. Readers like you keeps me going. Ciao

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