[Updated: 27-Feb-2021] One day I got a call from my former colleague. He questioned me about the best stocks to buy today. On the face of it, the question looks simple. But a very deep analysis is required to answer it. Why? [Check: list of best stocks]
Because to answer this question we must first define, what it means by best stocks? From the perspective of investors, these are stocks that will yield the expected returns.
So for example sake, let’s assume that our expected return is 15% per annum. Any stock which has a potential to yield returns of 15% or more will be our best stock.
What we mean by “potential” of a stock? How to identify the potential in a stock? Keep reading to know more…
List of best stocks
|SL||Name||Price (Rs.)||M.Cap (Rs.Cr.)||Income (Rs.Cr.)||PAT (Rs.Cr.)||Size||GMR Score|
|2||United Drilling Tools||260||520.78||118.19||36.66||Small||27.02|
|3||Alkyl Amines Chemical||5,039.90||10,359.45||1,095.07||251.95||Mid Size||26.86|
|7||Tata Elxsi||2,659.35||16,375.28||1,746.65||335.04||Mid Size||25.91|
What is Potential Stock?
Stock which has the ability to yield expected returns are the “potential stocks”. Such stocks can also be broadly classified as undervalued stocks.
How to know if a stock is set to give the desired returns? Simple explanation: Suppose there is a stock whose intrinsic value is say Rs.100. Let’s also assume that its current market price is @Rs.85.
- Discount to Intrinsic Value: Our example stock is currently trading at a 15% discount to its fair price. At current price levels, the stock has a strong tendency to go up by at least 15% soon (say in next few months).
- Future Earnings Growth: Further more, suppose this company is also able to grow its earnings (EPS) at rate of 12% per annum for next five years. In this case, an investor who bought the stock at Rs.85 per share may also see an additional price appreciation of at least 12% per annum for next 5 years.
This way we can say that, our example stock has a potential to earn 12%-15% per annum returns in next 5 year period.
Undervalued and Overvalued Stocks
Not all undervalued stocks will yield the same returns. There will be a group of stocks which can yield like less than 10% returns. Another group may yield higher returns. So one thing is for sure, for a stock to earn the tag of being the “best”, it must first be undervalued.
An overvalued stock can never be the best one. Why? Because stocks bought at overvalued price levels has strong affinity to shed its price in times to come – resulting in negative returns.
Talking about overvalued stocks, there are two types of stocks which often trade at overvalued price levels:
- First, are stocks of those companies whose business fundamentals are weak. These stocks tend of have an intrinsic value which is substantially lower than its current price.
- Second, are stocks of those companies whose fundamentals are super strong. Hence their stocks are always in high-demand (like blue chip stocks). Current price of such stocks trade at levels higher than its intrinsic value (overvalued).
So when the search is for “best stocks”, we are indirectly referring to shares of strong businesses trading at undervalued price levels.
Strong Business Fundamentals
Best stocks invariably represents business which are strong. But again we must define the term strong business. Different people may use different parameters to confirm business fundamentals of company. In the process of developing our best stocks screener we’ve used the following parameters:
- #1. Company Size: Large company also represents a large market share. Suppose there is a hypothetical market which has 100 consumers, and four companies operating in this space. Out of these 4 companies, one company serves about 40% consumers. In terms of size (market share), fundamental of this company is stronger. Read: Blue chip companies.
- #2. Profitability: What is profitability? It is a measure of how much profit a company is generating for every Rupee it is spending. Suppose there are two companies (A & B) spending Rs.100 to run its business. A & B generates a profit of Rs.5 and Rs.8 respectively. In terms of profitability, fundamental of B is stronger. Why? Because for the same Rs.100 (cost) B is generating more profits than A. Read: Profitable companies.
- #3. Growth Rate: A growing company is every investors favourite. No matter how small is the company today, but if its growth attributes are visible, investors will bank on them. In fact growth is such an important factor that even highly profitable companies tend to underperform (in stock market) as compared to growth stocks. Read: Fast growing companies.
- #4. Price Valuation: Ultimately everything boils down to price. True investor will never buy an overvalued stock. Ultimately the size, profitability, and future growth rate should justify the buy price. How to know if the price is justifiable? By looking at its financial ratios or by estimating it’s intrinsic value.
Finding Best Stocks (Screener’s Logic)
Based on the above listed parameters, we’ve written a mathematical algorithm. Our screener uses this algorithm to give it a score (GMR Score). The higher is the score the better.
Few more insights into how the screener’s mathematics works. The screeners works in levels. Let me show you how:
- Level #1: Market Capitalisation, total revenue and net profit of a company is considered to judge its size. A weighted average of these three numbers works as the first screening layer. Special care has been taken so that very large market cap companies (like RIL, TCS, HDFC, HUL etc) should not get unnecessary leverage over other companies.
- Level #2: The screener gives more emphasis on the company’s profitability. A small but highly profitable business may score higher than a large companies like RIL, SBI etc. Profitability is measured w.r.t ROE, RoCE, Operating margin and net profit. More weightage is given to a company which sustains higher profitability for long periods of time.
- Level #4: A company which shows faster growth of its revenue and earnings, earns a higher score. But again, emphasis is more on sustainable growth instead of short term growth. Talking about earnings, consideration is on Earning Per Share (EPS) instead of gross or net profit.
- Level #5: The best measure of price valuation is the intrinsic value. But it is difficult to estimate it using screeners. Hence I personally use my stock analysis worksheet to estimate intrinsic value of my screened stocks. Our best-stock screener instead uses ratios to judge a company’s valuation. P/E ratio, P/B ratio, Dividend Yield, and PEG ratio is used score a company based on price valuation.
Our screen ranks stocks based on the algorithm called ‘GMR score’. But we have taken our screener one step further. There are sub-screeners which users can apply from their end. These sub-screeners can further customise the best stocks list based on the users preference.
Here are sub-screeners:
- Sub-screener #1: Based on Market Capitalisation (M.Cap), the list can be further shortlisted. All companies trading in NSE/BSE, are classified into five sub-categories: (a) Very Large, (b) Large, (c) Mid-Size, (d) Small, and (e) Very Small. As a user you can use this sub-screener to find best stocks within these five sub-categories.
- Sub-Screener #2: Another filter of Return on Equity (ROE) can also be applied. As a user you can shortlist your stocks based on their ROE numbers. All companies can be grouped into three sub-categories: (a) ROE>10, (b) ROE>15, and (c) ROE>20.
- Sub-Screener #3: Like ROE, the companies can also be filtered based on their Return on Capital Employed (RoCE). I personally love shortlisting companies based on their RoCE. Why? Because I think this is the most accurate measure of company’s profitability. The sub-screener can be used to find group of companies whose RoCE is as follows: (a) RoCE>10, (b) RoCE>15, and (c) RoCE>20.
Important Final Step
I personally do not halt my analysis after screening best stocks. I prefer to take it one step further. How I do it? By estimating the intrinsic value of my screened stocks. There are two ways I like to do it.
- First, I do it myself by doing manual calculation based on method like (a) NCAVPS, (b) Residual Income and, (c) DCF model.
- Secondly, I prefer it this way. Why? Because we have spent lot of man-hours in developing this tool. It can estimate intrinsic value of stocks with click of few buttons. We call this tool “stock analysis worksheet“. The tool has been built to do a complete fundamental analysis of its stocks.
I hope you found this article and our best-stock screener useful. Frankly speaking there are no easy answers to finding a best stock for investing. The longer and most accurate way of doing it is through fundamental analysis of business.
An easier way is through our articles and tools. Using our tools the aim is to unearth ‘top stocks’ as accurately as possible.
A stock investor’s aim should always be to buy a fundamentally strong stock at undervalued price.
But a practical problem with this theory is that, our market consists of more than 5,000 number stocks. We cannot do fundamental analysis of all stocks. What is the way out? I use our best-stock screener to first shortlist stocks, and then use stock analysis worksheet to check its fundamentals more deeply.