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Being shares of exceptional companies does not mean that they are also the best stocks to buy. We can get confused between a good company and a good stock. Share of companies like RIL, TCS, HDFC Bank, Apple, Microsoft, does not guarantee that they are the best shares to buy today.
- What are the best stocks
- Price valuation
- Identify exceptional companies
- Share price Vs. EVPS
- Estimating intrinsic value
What Are The Best Stocks?
What can make a stock good for investing? It will be a combination of the ‘quality of a 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 the idea should be to always buy shares of only quality businesses.
But after we have identified a quality business, its stocks cannot be bought straight away. We must also check its price valuations.
So as an investor, our aim should be to buy stocks of a strong business at an undervalued price.
There are methods to estimate the best buy price of shares. This buy price is justified by the business fundamentals of the underlying company. The difference between the market price and justified price builds a buying opportunity for the investors.
Considering the strengths and weakness of a business, a stock trading at (or below) its justified price tends to move up.
Pro investors are always looking for exceptional companies whose stocks are trading at a price below their justified price. A more niche name for the justified price is intrinsic value.
Being aware of the price valuation methods prevents people from falling into the value trap. Novice investors often fall for famous names. Two points to note:
- 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 using price valuation methods, the value trap can be avoided. This is what my stock analysis worksheet does. It estimates the intrinsic value of its stocks.
An Example of Overvaluation
Castrol is one of the blue-chip companies in India. 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 of Castrol. 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 this company, 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 gradually tumbling down. As of 6-May’21, its price is at Rs.125 levels.
People who had bought the shares in Yr-2015 must be wondering what is the problem with this stock.
With the benefit of hindsight, price valuation ratios hint at overvaluation in Yr-2015. People who did the price valuation analysis in 2015, must have stayed away from the stock.
This is an apt example of an exceptional company, not able to yield positive long-term returns for its shareholders due to expensive valuations.
Checking the price valuation of stock before a purchase is a non-negotiable requirement.
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 about its products, top managers, competitors, etc can give the insight.
Once a company looks good upon observation, further digging is required. What details to look for? Here are the five things to look at:
- 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, dividends, 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 management who run the business contributes to its strengths. Ethics, qualification, and aptitude of the top managers play role in the long-term performance of its stocks.
- Competitive Advantage: Suppose I’m competing in a sector where companies deliver ‘operating systems’ for laptops and desktops. Here my competitors will be Microsoft (Windows) and Apple (macOS). What are my chances of success? Very low, right? As I’ll be put against the two giants of business, my competitive advantage (MOAT) will be like zero. Read more about MOAT.
- Price Valuation: The above four factors justify if the underlying business of the stocks is good or not. But it is also essential to look at the price valuation of its stock. In this article, we learn to value stocks through their enterprise value instead of price (jump here).
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 alone cannot make the stock the best buy. If the shares are expensive, they will never reap the desired returns.
Best Stocks: Use of Share Price Vs. Enterprise Value Per Share (EVPS)
Now we know about two things, the concept of price valuation and exceptional companies. Together, they make a stock great. In this section, we will take further, the concept of price valuation.
Suppose we’ve calculated the intrinsic value of Castrol as Rs.90 per share (just for example). Suppose, 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 market price with intrinsic value to draw a conclusion about the valuation of Castrol’s share price.
But there is a better alternative than the market price, enterprise value per share (EVPS). Experts prefer EVPS over share price for comparison with the intrinsic value.
To get detailed info about enterprise value, please check the link. But we will briefly delve into it in this article as well.
We may not realize it but EVPS and market price are very similar numbers. How? For stocks, whose debt minus cash component is zero, their market cap and stock price will be the same.
Check this infographic to understand the relationship vividly.
We can 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 (know more here).
Hence if we have to compare the estimated intrinsic value, we must use EVPS instead of ‘current price’.
Example: Price Vs EVPS Vs Intrinsic Value
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 EVPS.
What we can conclude here? To identify the best stocks to buy in India, we must use EVPS instead of stock price. Comparing EVPS with the intrinsic value will give a better feel about the price valuation of the stock.
But we still have a bigger puzzle to solve. How to estimate the intrinsic value? Without knowing the intrinsic value, knowledge of EVPS will be worthless, right?
How to Estimate The Intrinsic Value?
Before we can understand the calculations behind the intrinsic value, we must realize few important concepts related to the intrinsic value.
Concept #1: Stocks Are Not Just Tickers
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 only Rs.115. Why this price difference? On one side, people are ready to pay Rs.84,000 per share for MRF, but only Rs.115 for Ashok Leyland. What is causing the difference?
The reason lies in the business fundamentals of the two companies. Let’s correlate one such business fundamentals and try to justify the price difference.
Both MRF and Ashok Leyland reported similar net profit numbers in the last five years. But still, MRF’s price is Rs.89,000 and Ashok Leyland’s is Rs.115. The difference is caused by EP. Check the infographics shown above.
Concept #2: Business Fundamentals Builds Intrinsic Value
Like the example of EPS shown above, there are other business fundamentals that have a direct or indirect impact on the stock’s intrinsic value, hence its market price.
A deeper analysis is required to unearth the strengths and weaknesses of a company. Such an analysis is called fundamental analysis. In this article, we will not go into those details. If one wants to know more about it, check the provided link.
Here, we will take a quick route to understand which business parameters shape the intrinsic value of 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 the rate of their growth.
The majority of companies build their value from contributions from the above two factors. But there are exceptions to this rule.
- Bluechip companies derive their value more from their current and past fundamentals. Their future growth rates are slow.
- Startups get value from their future growth potential. Considering that they are new companies, they have very thin past records.
#Concept #3: Intrinsic Value and Valuation Models
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 can calculate both: financial ratios and the intrinsic value of 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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