If you could get a Rs.100/- share at Rs.80/-, wouldn’t you buy it?
Value Investing being complex nature, it's generally used to figure out whether the stock is undervalued or overvalued for your portfolio. The idea is to get best bargains at reasonable prices. Before investing into a stock, we need to understand how the stocks become undervalued;
Here are some of the points:
Reasons for Undervaluation of Stocks
The main purpose of value investing is that the market misprices stock from time to time. There are many reasons for the stock to be undervalued.
1. Quarterly Earnings Expectations: If the results do not match with the analyst's expectations, the share prices plunge
2. Market correction: If the markets are in a downtrend or if the markets are in correcting mode, there is a possibility of identifying undervalued stocks.
3. Bad News: The stock market can have a jerk amongst investors if there is bad news at national or global level
4. Cyclical Fluctuations: Certain sectors are cyclical in nature. They work in accordance with economic cycles. E.g.: Automobile Sector is cyclical in nature. When the sector is in a downtrend, investors should look out for undervalued stocks.
Should investors look out for any specific sectors?
There is a very common mistake which every investor makes, and that is investing in every stock he comes across which is best for him. But the problem is the “timing” of buying the stock. He can buy it when the stock is overvalued.
Another very important thing a value investor should remember is to invest only in those sectors which he can understand. If you can understand its business and try to analyze specifically about each sector, you can flourish.
For E.g.: If a good understanding of Automobile, Auto Ancillary, Housing, FMCG or Real Estate, he would have all the stocks pertaining to this sector only. He would narrow down his portfolio to these sectors. The hunting of undervalued stocks would be from these industries. As he's unaware of different sectors like banking or NBFC sector, he would stay away from such sectors. But that does not mean there would be undervalued stocks which would not be of value to the investors.
The Key Metrics
There are many ratios which can guide the investor in identifying the undervalued stocks:
Price/Earnings Ratio (P/E): P/E Ratio is dividing Current Market Price to earnings, which is useful for comparing business in the same sector. A lower P/E means a stock is cheap.
Price/Book Ratio(P/B): Price to Book Value is simply calculated by Current Market Price by Equity per share. A book value less than states the stock is trading for less than the value of the business. Some investors use these metrics for Margin of safety.
Return on Equity (ROE): the company’s net earnings as a percentage of equity. This ratio helps investors to measure how efficiently a company is utilizing the invested capital to generate profits.
Debt-Equity Ratio: This ratio is calculated by dividing total debt by Total shareholders’ funds. A below .5 ratio would state the company has minuscule debt levels.
Current Ratio: This ratio is calculated by dividing Current Assets by Current Liabilities. This ratio states how easily can the company pay its short-term obligations.
When you start evaluating company using these metrics, it’s a good idea to develop your own criteria for selecting the stocks in your portfolio.
A good valuation for a company would mean a low P/E probably below average P/E ratio, a debt-equity ratio of .5 or less, ROE to be more than equal to 15%.
Apart from the above parameters, there are other parameters to look upon which could be
Products performance, earnings track record, management of the company, peer comparison.
What Next After Key parameters?
When an investor is looking at the above parameters to take an investment decision there is one more thing to look out for and that is “competitive advantage”. The company should be competent enough in the industry such that it can outperform in the worst conditions in the market as well as from its competitors. Companies like DMART have a competitive advantage over others as its market capitalization is highest in the sector. With maximum cash at the reserve and high net profits, it will undercut all other competitors and would be of higher value. This will help to build trust among the employees and stakeholders.
One rule for every value investor would be to stay calm. There would be situations where the markets would be trading expensively and none of the stocks would be giving value investment opportunity. You need to be patient and alert as well so that you can find the undervalued stock. You don’t have to rush to buy the stock in order to gain higher returns, as this can prove detrimental and would lead to a loss