Category: Your Money

Stock Valuation Metrics

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Every company is different, they have their own culture, target market, processes, etc. In order to have a make relative value comparisons between them, it is useful to have a common set of metrics. Here are some of the key numbers and rations:

  • PE Ratio: the Price-to-Earnings Ratio simply divides the stock’s price by its earnings per share. It basically shows what investors are willing to pay for each Rupee of the company’s earnings. In inverse ratio: Earnings Yield indicates how much the company yielded in earnings for each invested dollar.
  • PB Ratio: the Price-to-Book Ratio divides the stock’s price by its net assets (less any intangibles like goodwill.) It basically indicates what investors are willing to pay for each Rupee of a company’s tangible assets.
  • Free Cash Flow: FCF tells the investor how much cash the company is left with after capital investments.
  • PEG Ratio: Price/Earnings to Growth ratio is a modified version of the PE ratio that takes the growth of the company into account. It is calculated by dividing the P/E ratio by the expected earnings growth rate in %.

So what would be an ideal investment? To get you started, you should aim for a PB < 1.5, a positive and growing FCF and PEG <= 1.0. Use the PE as a guide to compare a stock with industry peers. You can use our screener to shortlist stocks that meet your investment needs.

Remember: these metrics are only snapshots of a firm at a point in time. As an investor, you should look at how these numbers have evolved over time for a company. More on this later.

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GDP Growth vs. Stocks

World gdp growth rate and gdp growth rate of t...

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Quite often, the reasons that investors give to be bullish on Indian stocks are: millions of people are rising above poverty and are experiencing the joys of consumerism for the first time. Almost all of India is connected via mobile phones and cable TV is making inroads in the remotest of towns. So in effect, what they are saying is that the stock-market is going to rise with India’s GDP. Is that really the case? Are stock-market returns correlated with GDP growth?

A study by Peter Henry and Prakash Kannan seems to indicate not:

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This only reconfirms the theory that stock-markets are leading indicators of the economy, not the other way around. And somewhat counter-intuitively, investing in low growth countries actually yielded higher returns!

So what does this mean for Indian investors? The key take-away is to not get swayed by all the “India Shining” callouts and focus on the fundamentals of individual stocks. A rising tide lifts all boats but you only find out who is swimming naked when the tide goes out (Warren Buffett).

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Investing–getting started

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We instinctively know that to build wealth, we need to take control of our finances. But to get started investing is a daunting task. From pundits shilling stocks to brokers selling themselves on CNBC, it is easy to conclude that the deck is stacked against the individual investor. However, not all is lot. A volatile market like ours rewards patience, something that I see is in very short supply. The retail investor, and this is true across different markets, gets in too late and gets out too early. Call it the itchy trigger finger or the lack of courage in one’s conviction, retail investors often end up being contrarian statistics to institutional money. If retail is buying, sell, sell, sell!

Not all is lost. The waters might seem treacherous, but are navigable. The first step is to be in the right frame of mind. If you think of making money as a zero sum game, i.e., for you to make money, someone else has to lose it, then you will never make money! Wealth is created by the value creation process. So the first step is to understand that an infinite amount of wealth can be created because human ingenuity will always figure out a way to create value.

The second step is to distance yourself from what you can do with money, to what it actually is. It is nothing more than a piece of paper with a dead man’s picture on it. It is not really backed by anything other than your faith in its value (this is an entirely different post altogether). So try to be even minded whether you are making money or losing it.

The third thing is to write down 4-5 lines on how much risk you can take. Capital comes in two forms, one that is in your pocket and the other is mental. Mental capital is much more expensive than the notes in your pocket. If you can’t take the heat, stay away from the stove! Once you figure out what your risk appetite is, you can then start looking for investments that fit your profile.

Number four: valuation matters. We’ll get to what valuation is in future posts, but leave momentum chasing to the machines. Make sure that you buy stocks when they are cheap (fundamental) and have bottomed out (technical). Analyse, analyse, analyse. Make sure you understand what the company makes (how does it create value?), the regulatory backdrop and be prepared to change your stance if the situation demands.

And lastly, remember this: In “good times,” even errors are profitable; in “bad times” even the most well researched trades go awry. Be nimble, be smart and rely on process rathe than luck.

Good luck and stay tuned!

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