What expert value investors does best is estimation of intrinsic value of stocks.
But there are 5,000+ stocks in market. They calculate intrinsic value of all stocks? No.
This exercise will be too futile.
They first shortlist good stocks.
How they shortlist their stocks? They use a suitable stock screener.
When we invest in stocks, focus should be on long term growth.
Stock investing is not for making quick-bucks.
Hence it is important not to fall into the trap of “day trading” while dealing with stocks.
Essential is to pick the “right stock investment strategy”.
Which strategy is right? Value investing.
Why value investing?
Because this is one strategy which is going to survive even the worst market debacles (like that of year 2008).
Value investing is not only about making money. It helps its investors to build wealth over time.
I first read about value investing from a book called The Intelligent Investor.
This book was written by the Late Benjamin Graham in 1949. Benjamin Graham is the Guru to Warren Buffett.
Till today this book is treated as a Bible of Value Investing.
There is a chapter (No: 14) in book called “Stock Selection for the Defensive Investor”.
Majority value investor’s stock investment journey started after reading this chapter of the book.
It has powers to change ones whole outlook obout stock investing.
Also, what best this chapter can provide one is few great stock screening criteria.
Value investors are generally conservative investors.
The screening criteria provided in this book works as if it was tailor made for them.
How conservative investors invest in stocks?
They buy stocks with objective of holding it for lifetime.
They do not buy stocks for selling it the next month/year.
Hence, their stock selection criteria are different than others.
What type of stocks, conservative investors would like to include in their investment portfolio?
Stocks of solid companies yielding assured capital appreciation over time.
How this can be achieved? By learning to value stock the right way.
How one can value stocks?
One can apply the following two steps:
- Apply a screening criteria.
- Estimate the intrinsic value using DCF.
By applying screening criteria, most of non-value stocks gets eliminated.
The balance what remains are 10-15 quality stocks
On these screened stocks, apply the DCF method.
Let me tell you the stock screening criteria suggested for value investors.
#Screen 1 – Size of company
Bigger companies are safer for investing compared to smaller ones.
Price of bigger companies are comparatively more stable. Why?
Because of profit/EPS of bigger companies show less volatility.
How to quantify the size of company?
- Sales above Rs.10,000 Crore.
- Total Assets above Rs.5,000 Crore.
#Screen 2 – Financial Health
Value investors will not buy stocks of even biggest of companies till their financial health is acceptable.
How to check if the financial health is good or not?
- Current Ratio > 2.
- Debt Equity Ratio < 2.
These 2 ratios are simple, but along with other financial ratios, works as a great indicator.
What they highlight?
How well placed are the companies finances to take care of their current liabilities.
High Current Ratio and Low Debt/Equity ratio means, companies is not in danger of bankruptcy.
#Screen 3 – Stable profits
In value investing, a lot of weightage is given to companies which has stable and predictable profits.
How to judge a company in terms of its profit stability?
Just look at their last 10 years PAT.
If in all last 10 years, the PAT has been positive, it indicates at profit stability.
One can also judge the profit stability in terms of its variance from the mean.
#Screen 4 – Dividend friendly
Value investors love companies which pay dividends to its shareholders.
The affinity will further grow if the dividend payment is predictable.
How to judge this predictability?
By looking at the dividend trend in last 10 years. What to look at?
- In all 10 years, the dividend has been paid or not.
- In all 10 years, the dividend payout ratio has been uniform or not.
#Screen 5 – EPS Growth
It is also essential for companies to grow their “effective profit” at least at a rate more than inflation.
What means by effective profit?
From shareholders point of view, effective profit is EPS (earning per share).
For shareholders, absolute PAT is not as meaningful as EPS.
If EPS grows at a rate faster than inflation, it is a very healthy sign.
How to check EPS growth?
Take EPS growth (CAGR) for 5 years and 10 years time horizon.
Both should be greater than inflation rate prevailing in the country (for those periods).
A rule of thumb can be, both the CAGR more than 9.0% per annum.
#Screen 6 – Price Earning Ratio (P/E) must be reasonable.
How to know which P/E ratio is reasonable?
To understand this we have to know what is P/E ratio.
P/E = Market price (P) / EPS.
P/E ratio says, how many time an investor is paying for a share (P) compared to its net profit per share (EPS).
What will be the inverse of P/E ratio?
How much profit per share a company generates per Rupee invested.
This is called earning yield of the stock.
How much should be the earning yield?
It should be at least greater than the interest offered by 10 year bank deposit?
Today (in 2018), one can earn at least 7.0% on a 10 Year Bank FD.
It means, Earning Yield (EY) of stocks must be at least 7% (say).
What is the inverse of 7%? 14.5 (100 /7).
[Inverse of earning yield is P/E ratio]
It means, today a reasonable P/E ratio of a stock must be 14.5 or below.
#Screen 7 – Price to Book Value Ratio (P/B) must be reasonable.
A reasonable Price to Book Value Ratio (P/B) must be 1.5.
What does it mean?
An investor should not pay more than 1.5 times of book value per share to buy a stock.
Like market price of stock is a function of EPS, it also has relation with “book value”.
Hence it is only prudent to check market price of stock compared to its Book value (net worth).