In order to get multibagger returns one individual needs to follow one simple rule, “Find only fundamentally strong stocks which are undervalued and stay invested in them for the long term.”
Why long term?
Historically, the equity asset class has delivered better returns in comparison to other asset classes. Let’s make it clear with the help of the following example. Ace investor Warren Buffet picks those fundamentally strong stocks which have delivered a CAGR of 29%. Apart from the return, the most crucial factor is that he started an investment when he was 11 years old.
Just look at the following graph.
If you make a lump sum investment of Rs. 1 lakh at once and allow the money to compound at the rate of 15%, then you will get-
- 4 lakh after 10 years,
- 16 lakh after 20 years,
- 66 lakh after 30 years.
Why fundamentally strong stocks?
It is because stocks with strong fundamentals represent those companies which have these features,
- Consistent sales growth at a rate of 10%.
- Consistent profit growth at a rate of 15%.
- A debt-free company. If not so, the ratio must be low to 0.10 or 0.25.
- Strong business model.
- Sustainable competitive advantage in comparison to peer companies.
- Good dividend yield.
- Sustainable EPS growth.
Now after analysis of the above-mentioned points, retail investors are confused about how to pick undervalued stocks.
What are undervalued stocks?
Undervalued stocks are those stocks that trade at prices which are presumed to be below the intrinsic or enterprise value. An undervalued stock can be picked after analysis of the company’s financial status, fundamentals, valuation ratios, etc.
How to know if the stock is undervalued
The easiest way to pick undervalued stocks is to invest during the falling market.
The next thing is how to know whether the market is falling or rising.
Keep notice if the indices such as Nifty 50, Sensex, Nifty Auto, S & P BSE FMCG, etc. inches towards lower levels.
To get a better idea you need to check the Price-to-Earnings Ratio and Price-to-Book ratio of any index.
- Read also: Undervalued stock – Wikipedia
How to find undervalued stocks?
Apart from that Ace Investor, Benjamin Graham describes how to pick undervalued stocks in his famous book “The Intelligent Investor”. Here are the parameters you should keep in mind while picking undervalued stocks,
- Pick a stock that has got at least a B+ rating from Standard & Poor.
- Stocks with a lower price-to-earnings ratio in comparison to peer companies.
- Any stock with lower Price-to-Book Ratio i.e. less than 1.
- Stocks with a Current ratio of 1.5 or higher.
- Debt to Equity Ratio is Zero or less than 0.25.
- Healthy Dividend payout and stable Earnings-per-Share.
- The cash flow of the company.
- Current Inflation.
- Enterprise Value.
There are many rating agencies which are in operation like Crisil, Morgan-Stanley, and Standard & Poor, etc. You have to follow the rating given by these rating agencies. Generally, a B+ rating is an ideal investment grade in which you are free to invest your hard-earned money. The rating B+ indicates that the company is stable and likely to grow in the near future.
Let’s assume, a company has a net income of $ 10,000 per year. It Pays for $ 5,000/- in a preferred dividend to investors. It has 50 shares outstanding.
Now, if the stock currently trades at $ 1000, then
You need to choose such stocks that have P/E less than 9. But P/E varies from sector to sector. Lower P/E ratio of sectors does not mean that this sector is undervalued and is going to boom and deliver a multi-bagger return in the near future compared to that sector which has a higher P/E ratio. These sectors have higher valuation just because the market is bullish on these sectors and their future potential like Automobile, FMCG, Petroleum, etc. They are the core sectors of the Indian economy and have the potential to deliver a robust performance in the upcoming years.
You will find the book value of the stock in the balance sheet of the company.
Let’s assume, the stock currently trades at $ 100 and the book value per share is $ 10 then,
P/B Ratio = [$100/$ 10] = 10.
You need to pick such stocks that have a P/B ratio of less than one.
The ratio is the snapshot of the asset and liabilities of any company. You will find the assets and liabilities a company has in its balance sheet. Find such quality stocks that have a current ratio of more than 1.5.
Let’s assume, the current assets of any company is $ 1200 and current liabilities is $ 400 then,
Current Ratio = [$1200/$ 400] = 3.
Debt to Equity Ratio
An individual needs to analyze the total outstanding debt the company has to repay either in the long term or in the short term and the asset the company owes.
Preferably one individual should invest in those stocks which are either debt-free or have very marginal debt not more than 0.25.
Healthy dividend payout and stable Earnings-per-share
Let’s assume, a company has a net income of $ 10,000 per year. It Pays $5,000 in a preferred dividend to investors. It has 50 shares outstanding.
It is a good idea to invest your money in those stocks that regularly pay a dividend and deliver a Healthy dividend payout. The stocks which have delivered healthy dividend-paying must have following features
- Consistent dividend payout over the past 5 years.
- The high dividend yield for the last 5 years.
- Growth in dividend per share from time to time.
The cash flow of the company
To understand a company’s true economic condition one should check the free cash flow of the concerned company. Free cash flow actually reveals the profit the company makes. It implies a broader range in the company’s functioning in the overall business.
Whenever you check the free cash flow of a company, you should analyze from which source the company is gaining its capital for its day-to-day business. Usually, there are two sources, the first one is earning from running operation i.e., business and the second one is receiving debt from the market i.e., debt financing. If the company runs its operation from the profit earned by running operation you should stay invested with the company. But if the company runs its business by debt financing, naturally the debt will increase from time to time. So, stay clear of these types of companies or stocks.
Free Cash flow is one of the most reliable and widely used metrics among value investors, as it provides an accurate position of the company’s financial condition. In simple words, free cash flow is an account of how much cash a company is left with after paying for all expenses.
Companies that manage to generate consistently large cash flows without incurring much capital expenditure are always valued higher by investors. Negative free cash flows are a sign of the deteriorating health of a company.
In countries like India, you should watch out inflation because the P/E ratio is adversely affected by current inflation. Owing to inflation, retail consumers spend less and the expenses rise. This will decrease the earnings per share. When EPS falls, it, in turn, increases the P/E ratio making stocks overvalued. In addition, for a growing economy like India too low inflation rate also adversely affects the stocks. So, as an intelligent investor, you should analyze the following points,
- Reserves growth must be more than the current inflation rate.
- Asset growth must be more than the current inflation rate.
- Sales growth must be more than the current inflation rate.
- Cash flow growth must be more than the current inflation rate.
You need to analyze whether the enterprise value of any stock is less than its market capitalization. Usually when the stock’s enterprise value is less than the market capitalization, then it is considered that the stock is undervalued.
How to calculate the enterprise value of any undervalued stocks?
Enterprise Value = Market Capitalization + [Debt – Cash]
Suppose a company has a huge cash reserve. Its cash reserve is so enormous that the company may clear all the debt from the cash reserve only. But this is the rarest of rear cases. So, you need to pick those stocks which match the nearest one.
Note: This is the few lessons from the book which I discovered from Christopher Browne’s brilliant book ‘The Little Book of Value Investing’
Top 10 Undervalued stocks to buy in India
|Compounded Sales Growth
|Compounded Profit Growth
|Price to Earnings Ratio
|Power Grid Corporation Of India
|J Kumar Infraprojects
|LIC Housing Finance
|Indiabulls Housing Finance
Finally, you need to consider any specific sector which is cyclical in nature. This kind of sector tends to deliver better returns when the economy is booming. Spot any company after analysis of price fluctuations during the market correction or after a disappointing quarter or year. Then stay invested for the long term to yield better returns.
How Capitalante can help you
Are you confused about how to prepare an effective financial plan to achieve financial freedom? If yes, learn how to prepare effective financial planning.
- Read also: Cyclical Stocks Vs Defensive Stocks [With Infographics]
- Read also: Top 10 Best stocks to buy in India for long term
I hope, this article will help you to find undervalued stocks that can deliver better returns in the near future. If you have any questions feel free to comment so that we have a discussion. If you have found this post helpful feel free to share it with your loved ones.