[Updated: 08-May-2021] Buying shares of exceptional companies does not ensure that one has bought the best stocks. But people get confused between the two. Being a share of companies like RIL, TCS, HDFC Bank, Apple, Microsoft, does not guarantee that they are great stocks.
What can make a stock best for its investors? It will be a combination of the quality of business and the price valuation of its stocks.
Indeed, investors cannot buy shares of any company. Understanding a company is essential to judge its strengths. Why? Because one must buy shares of only strong companies.
But after we have identified a strong company, its stocks cannot be bought straight away. We must check further its price valuations.
List of best stocks in India
|SL||Name||Price (Rs.)||M.Cap (Rs.Cr.)||PAT (Rs.Cr.)||ROE-3Y (%)||GMR Score|
|3||Associated Alcohols &||418.2||753.99||53.62||24.74||74.59|
|9||Alkyl Amines Chemi||8,148.05||16,634.60||251.95||29.89||68.05|
|10||Navin Fluorine Intern||3,373.00||16,768.82||443.92||22.29||68.02|
Awareness For Price Valuations
Price valuation is a method to estimate a fair price for shares of companies. What is a fair price? It is a justified price of a stock that makes it a valuable purchase. Considering the strengths and weakness of a business, a stock trading at (or below) its fair price tends to move up.
Pro investors are always looking for exceptional companies whose stocks are trading at price below their fair price. A more niche name for ‘fair price’ is intrinsic value.
Being aware of the concept of price valuation prevents people from falling into the value trap. Novice stock investors often fall for famous names. How? First, a known name does not always mean that the company is strong.
Second, shares of famous/strong companies often trade at overvalued price levels. By sticking to the concept of buying stocks below their fair price can negate both the risks.
Let me give you an example.
Castrol India is one of the blue-chip companies we know about. The reason why the company has earned the tag is reflected in its financials. See these numbers:
Even the best of stocks will find it hard to match the profitability numbers shown by Castrol India. In the last five years, the minimum reported ROE was 41.21%. Similarly, the minimum RoCE was 54.56%, and the minimum ROA was 24.35%. These are par excellent numbers.
But allow me to show you another metric of Castrol India, its last 10-Yr price history.
In Yr-2009, the share price of Castrol was Rs.42. By Yr-2015 it rose to Rs.250 levels. But since then, the price is only tumbling down. As of date, its price is at Rs.125 levels. People who had bought the shares in Yr-2015 might be at loss.
In hindsight, seeing this chart hints at the stock price being overvalued in Yr-2015. People who did the price valuation analysis in 2015, must have stayed away from the stock.
Checking the price valuation of stock before a purchase is a non-negotiable requirement. [Check this excel sheet which can do intrinsic value estimation]
How to Identify Exceptional Companies
There are two stages to do this exercise. It starts with observing a company. Before one can go ahead and start reading and analyzing the financial reports, this is a must. What to observe? Seeing a company from a layman’s perspective to know its business goals, performance, competitors, etc can give insight.
Once a company looks good upon observation, further digging is required. What details to look for? Here are the four main parameters:
- Profit & Profitability: Nobody wants to invest in a loss-making company, hence profit is an important metric for investors to judge a company. But profitability is even more important. Ratios like ROE, RoCE, ROA, etc can highlight a company’s profitability. Read more.
- Future Growth: Guessing future growth numbers can be based on past trends. Looking at sales, profits, EPS, dividend, net worth, etc can give a reasonable idea. A profitable business that is also growing fast can be a good bet. Read more.
- Management: The quality of managers who run the business contributes to its strengths. Ethics, qualification, and aptitude of the top managers play role in the long-term performance of a company.
- Competitive Advantage: Suppose I’m competing in a sector where companies deliver ‘operating system’ for laptops and desktops. Here my competitors will be Microsoft (Windows) and Apple (macOS). What are my chances of success? Very low, right? Before the two, my competitive advantage (MOAT) is like zero. Read more about MOAT.
A profitable and growing company, run by great managers, having a wide MOAT are ingredients for an exceptional company.
But it is also true that a top score in these four parameters cannot make the best stocks. Why? Because if the shares are expensive, buying them at those price levels will be a mistake. It will never reap the desired returns.
Best Stocks and Enterprise Value
Now we know about two things, the concept of intrinsic value and exceptional companies. Together, they make a stock great. In this section, we will take further the concept of intrinsic value.
Suppose we’ve calculated the intrinsic value of Castrol India as Rs.90 per share (just for example). As of today, each share of Castrol India is trading at Rs.125 per share. This immediately tells us that Castrol’s share is overpriced.
What we are doing here is comparing the current price with intrinsic value to draw the conclusion about the valuation of Castrol’s share price.
But there is a better alternative than “market price”. Experts prefer it for comparison with intrinsic value. What is the alternative? It is called “enterprise value per share”. To know more about enterprise value, please check the link. But we will briefly delve into it in this article as well.
There is a strong link between the current price of stocks and enterprise value per share. For many stocks, both values are almost similar.
What is Market Price? We can also see market price as Market Cap per share. So what experts say that, instead of comparing price (market cap per share) with intrinsic value, use ‘enterprise value per share.’
What is enterprise value? It is equal to Market Cap + (Debt – Cash).
We can also visualize “enterprise value” as a “refined market cap”. It is a better metric than the ‘market cap’ to represent the market value of a company. Hence if we have to compare the estimated intrinsic value, we must use “enterprise value per share” instead of ‘current price’.
Castrol India has about 98.91 crore number shares in the market. Let’s assume the current price of its shares is Rs.125. Hence its market cap will be Rs.12,363 crores.
The company is debt-free (total debt = zero crores). The company has Rs.946 crores as “cash and cash equivalent’. Now, using these numbers we can calculate the enterprise value.
Enterprise Value = Market Cap + (Debt – Cash) = 12,363 + (0-946) = Rs.11,417 Crore.
Enterprise Value Per Share = 11,417 / 98.91 = Rs.115 Crore.
Now let’s see the comparison graphically. The company looks less overvalued by comparing the intrinsic value with ‘enterprise value per share.’
[Note: Generally speaking, a debt-free company is valued better than a company deep in debt]
What Gives Value To Stocks?
How often we end up buying shares without knowing much about its underlying company? It happens with most people. Buying stocks like this is like treating stocks as nothing more than a Ticker. For such people, shares are just numbers that go up-and-down the whole day.
But consider this example. Each Share of MRF is priced at Rs.84,000, whereas Ashok Leyland’s share is priced at Rs.115. Why there is a difference? The root of this difference lies in the business fundamentals. What are those fundamentals?
Generally, a very deep analysis is required to unearth the strengths and weaknesses of a company. Such an analysis is called fundamental analysis. But in this article, we will not go into those details. We will take a quick route to understand which business parameters build value for its stocks.
Generally speaking, every step of a business contributes in its own way to build the intrinsic value of its stocks. But in this article, we will limit our focus to the most important ones. Any company builds value for itself in two ways:
- Current & Past Fundamentals: The company’s current position can have a lot of say in its intrinsic value. The current size of net worth, debt, assets, net profit, dividend, and free cash flow are few important metrics. The past also has its say. The speed at which the company grew in the past-years is a crucial factor.
- Future Prospects: A company that is perceived as a fast-growing business will have a high value even if its current and past numbers are not so strong. The three most important parameters that build value are future profits, free cash flow, and rate of their growth.
The majority of companies build their value from contributions from each of the above two factors. But there are exceptions to this rule. Very large bluechip companies derive their value more from their current and past fundamentals. Whereas, startups get their value more from their future potential.
How to estimate the value of a business?
There are two ways to estimate the value of a business. The first way is through the use of financial ratios. In this analysis, people use ratios like P/E, P/B, PEG, etc to value a business. The ratio of a company is compared with other companies of the same sector. This is a rather simplified but superficial way of estimating the price valuation of stocks.
The second way is a more detailed approach. A company’s intrinsic value is calculated using valuation models like DCF, NCAVPS, Absolute PE, Residual Income Method, etc. Comparing the calculated intrinsic value with the ‘current market value’ (discussed above – enterprise value), gives a more certain conclusion.
My stock analysis worksheet provides both financial ratios and intrinsic value estimation for its stocks.
Identification of exceptional companies is only the first step towards learning the names of the best stocks of the market. The second step is to do the price valuation analysis. Buying stocks of even great business at overvalued price levels will only lead to losses.
A exceptionally good business available at overvalued price levels cannot qualify as a good investment. But stocks of an average business available at bargain price will be a better investment alternative.
Have a happy investing.
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