Value investors estimate the intrinsic value of stocks more accurately. But there are more than 5000 listed stocks in the market. Even the experts cannot go about calculating the intrinsic value of all stocks. What do they do? They apply stock selection criteria, to shortlist potential stocks.
[Note: I got the inspiration for this article from the book written by Benjamin Graham, The Intelligent Investor – Chapter 11, 12, 14, and 15.]
In this article, we will talk about the stock selection criteria one can use to prepare their own shortlist. But before that, an essential disclaimer for newbies.
- It is essential to diversify.
- The investment portfolio must consist of at least 50% risk-free instruments like bonds, deposits, and debt funds.
- Before buying individual stocks, beginners must start with investments in index funds, Index ETFs.
- The third stage will be to start buying the stocks directly. Beginners must buy a basket of good stocks. But while buying stocks, it is essential to ensure that a high price is NOT paid to acquire them. Suggested reading: About Stock Basics.
- Long term holding (> 5 years) of the index funds, ETFs, and basket of stocks is essential.
The Basic Concept
These stocks are shortlisted based on the stock selection criteria we will discuss in this article. There is a basic concept based on which these selection criteria have been developed. Each stock that one purchase must give the investors a minimum benefit in terms of quality and quantity.
- Quality: The past performance of a company must display a minimum criteria. The present financial position must also be acceptable.
- Quantity: For every Rupee paid to buy the stock, it must display a minimum level of profit and assets.
Stock Selection Criteria – A Fundamental Analysis For Beginners
In the long term, a retail investor can easily earn returns higher than bonds or bank deposits simply by buying an index fund or index ETF. But if the desire is to earn even higher returns, divesting into direct stocks will be required.
Direct stock investing is good but it also has its disadvantages. It will expect the investor to give it full attention. The investor must remain aware of the movements in the stock’s fundamentals and price. The investor must also be aware of how to analyze stocks.
If someone is okay with this limitation of direct stock investing, they can add them to their portfolio. The below stock selection criteria will be a part of learning the skills of stock analysis.
Minimum Ifs and buts: As this article is for beginners, there will be minimum ifs and buts. Wherever possible, I’ll try to give a clear number as a selection criterion, without stating any exceptions. But in real-life investing, exceptions exist. For example, a stock that is yielding a 10% dividend might still not be a good buy. How? If it has reported a negative PAT, or its EPS is falling year after year.
But for the moment, let’s not bother about the exceptions.
Let’s look at our selection criteria:
#1. Minimum Size: Total Revenue
It is easier to find value stocks in smaller-sized companies. But as this article is for beginners, large companies are more suitable for them. What is a large company? One that has a minimum revenue number.
- A private enterprise whose average total revenue, in the last 3 years, is greater than 850 crores.
- A government enterprise whose average total revenue, in the last 3 years, is greater than 500 crores.
The purpose here is to filter out the smaller companies. Why? Because they are more susceptible to the negative effects of competitive pressures.
#2. Minimum Financial Position: Current Ratio & Debt
Investing in a financially healthy company is any investor’s priority. How to quantify a company’s financial position? A beginner can perform the litmus test using a liquidity and solvency ratio. Read more about financial ratio analysis.
- The current ratio of the company should be at least 1.5. It means, the company’s current asset is at least 1.5 times as big as its current liabilities.
- The Long-term borrowing (debt) of the company should not be more than 110% of its net current assets (=Current Asset minus Current Liability, also called working capital).
- For a government enterprise, the debt limitation could be slightly higher. If its debt to equity ratio is less than two (2), it is within the acceptable limits.
#3. Stable Profits
For beginners, it is more important to invest in a company with stable profits. How to judge if a company’s profits are stable or not?
- Note the operating profit and net profit of the company in the last 10-years. If for all the years, the number is positive, it is acceptable.
#4. Uninterrupted Dividend Payment
Investors love companies that pay dividends. The affinity further grows if the dividend payment is predictable. How to judge this predictability?
By looking at the dividend history of the 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.
#5. A minimum Earning Per Share (EPS) Growth
A listed company must exhibit a minimum growth rate of its EPS. Benjamin Graham has a particular way of calculating the EPS growth rate. What shall be considered as today’s EPS and 10-Yrs back EPS is different.
An average EPS number must be considered, as starting and ending values (as shown below).
Once today’s EPS and 10-Yrs back EPS is known, annualized growth rate (CAGR) to be calculated. Suggested Reading: How to measure return on investment.
A minimum annualized growth rate of 7.0% per annum is expected.
Why have I considered only a 7.0% per annum growth rate for EPS? Because a 10-Yr fixed deposit in India will yield these returns. I’m expecting that a business, in a 10-Yr time horizon, must yield at least this much-earning growth for itself. Else why the owners of the business will care to run the business if a risk-free bank FD may fetch him/her better returns?
#6. A Maximum PE Ratio (Valuation Metric)
A PE ratio of 13.5 or lower is acceptable. What is the logic behind the 13.5 number?
The inverse of 13.5 is 7.5%, also called earning yield (EPS / Price). To understand the significance of PE-13.5 (or 7.5%), let’s take an analogy.
Suppose we bought an FD of Rs.5000. At the end of the year, it yields a return of Rs.335. What is the rate of return? 6.7% (335/5000). In terms of the prevailing interest rate, an ROI of 6.7% from a bank FD is acceptable, right?
So as a stock investor, our return expectation from our shares will surely be more than 6.7% (FD’s returns). Let’s say we expect it to be a moderate 7.5%, a risk premium of only 0.8%. The inverse of 7.5% earning yield is 13.5.
So you can see, an Indian stock trading at a PE multiple of 13.5 or lower is trading at attractive valuations.
Just a note of caution about the PE ratio. It is always better to calculate the PE ratio by oneself. Do not believe the numbers published by even the best of web portals.
How to calculate the PE ratio? Use this formula:
#7. A Max “Blended Multiplier” (Valuation Metric)
What is a blended multiplier? It is a product of the PE and PB ratio. According to Benjamin Graham, a maximum blended multiplier of 22.5 is acceptable (PE 15 x PB 1.5). In our article, we have considered an acceptable PE ratio of 13.5 (instead of Graham PE-15). Hence for us, our blended multiplier will be 20.5.
But I feel that a blended multiplier of 22.5 is already a very stringent valuation ratio. Hence for our stock shortlisting, let’s keep the limiting number of 22.5.
How did Benjamin Graham arrive at a value of 22.5? PE of 15 multiplied by PB of 1.5.
In most cases, you will find that the blended multiplier of good stocks is much higher than 22.5. Only some government enterprises or fading companies will match these criteria.
Hence, Benjamin Graham suggests another selection criteria which is less stringent. The price of stocks not being higher than 1.2 times the net tangible assets.
What is net tangible asset?
Net Tangible asset = Tangible Asset – Long Term Borrowing – Short Term Borrowing – Account Payables.
What are tangible assets? Look into the company’s balance sheet. Following line items will qualify as tangible assets:
- Property, Plant, and Equipment.
- Inventory (work in progress, & finished goods).
- Account Receivables.
- Raw materials.
Here are the seven financial metrics we have considered to shortlist potential good stocks available for investing. Though these metrics may individually look flawed, in combination, they are reliable. The above-listed stock selection criteria are like a starters guide to a more detailed fundamental analysis. For people who want to indulge in a detailed fundamental analysis, please check the link.