Tuesday, August 2, 2011

Selecting Stocks for Long Run - Value Investing

The markets have been languishing at sub 19k levels for some time now after a home run. Though timing the market is not something that is recommended, this could be a decent time to enter the market cautiously with a long term view in mind. The points I have mentioned below are primarily from my understanding of stock selection based on value investing methodologies espoused by Benjamin Graham & Warren Buffet. 
1.Use a free custom stock screener such as Capital 4 or Askkuber to filter stocks that meet certain criteria such as 
·         Price/Earnings ratio < 18
·         Price/Book ratio < 3
·         Return on Net Worth > 15%
·         3 Yr Earnings Growth > 15%
·         Debt/Equity ratio < 1


2. Once you get a list of companies which meet the above mentioned criteria , go to moneycontrol or any other such site and enter the company name to get details of the stock & company. Go to Co financial section and then to Ratios. Check the EPS ( Earnings per share) for the company for the past 5 yrs.Is it consistent and showing an upward growth ?

For example :

 Year
2006
2007
2008
2009
2010
EPS
2.6
3.2
4.1
4.8
6.2


Most of the companies get eliminated in the second stage itself :- ) For those that survive , move onto to step 3.

3. If you can analyse whether the company has a strategic advantage compared to its peers and/or has high entry barriers which might desist competition or delay new players from coming into the market and eating up the market share , fine. Shortlist those companies. 

4. Use an earnings growth formula/excel worksheet to predict earnings growth for the company 5 yrs down the line. One major factor is to ensure that you you use only a weighted Avg ROE for 5 to 10 yrs and also use only a historic PE in order to calculate future value of the share price. If and only if the compounded growth rate of value for the stock is > the cost of capital which is measured by Beta of the stock, should we consider further analysis.

5. If the investment in the stock is projected to give you sufficient returns, then the next step is to look at the price.Is the price of the stock high in relation to its fair value ? How do we determine the fair value of a stock ?
DCF or the Discounted Cash Flow is one of the best valuation methodologies used in order to determine the fair value of a stock. It discounts the future value of cash flows of a firm to its present value. Cash flow is a true measure of value of any firm in the long run.

6. Once we have calculated the fair value of a stock , we can compare it to the current market price at which the stock is selling. If there is adequate margin of safety which is more or less subjective based on your risk appetite , you can go ahead and invest in the stock. As per Benjamin Graham , the ideal margin of safety ( Difference between current market price of the stock and its fair value) should be in the range of 40-50%. Warren Buffet, the most famous disciple of Graham, however did not mind investing in stocks at a fair value provided he was confident about solid future earnings growth for the company.