Success in stock market investing almost entirely lies in the art of discovering discount in the value of stocks. Warren Buffett is a master of this art. But the secret behind it is quite simple. Even you and I can do it. This article explains the key tools in a simple way.
Before we talk about the discount and undervalued we need to know the real or intrinsic value of an object. Whether it is a stock or a product or commodity. But how to find the intrinsic value of a stock? What are the aspects on which the value of a stock depends?
There are two underlying aspects to the value of a stock. These are:
- Value based on underlying assets
- Value based on earnings
If a stock is trading on the stock market below the real value arrived at based on either assets or earnings, then it is undervalued – as simple as that.
Discount in the Value of Stocks based on the Underlying Assets
We can find the value of the share based on the underlying assets by adding up the values of assets. Then we have to deduct the value of all liabilities owed to outsiders other than equity shareholders. The result is the value of net assets owned by the company. Then we should divide the value of net assets by the number of equity shares. This will give us the value of net assets per share. It is also called the book value per share. Following example will make it easy:
After we have found out the book value per share we should compare it with the present market price of the share. If the market price is less than the book value per share then the stock is available at a discount to the intrinsic value of the share as per the value of underlying assets.
Continuing the example above if the stock of SJVN Ltd. is trading at rupees 22.00 then it is available at a discount of 2.66 rupees.
Value-investing says that a price up to one and half times the book value is fair. This means if a share is available at a price below Rs.36.99 (1.5 x 24.66) it is available at a discount to its fair value.
Conversely, when we divide the market price by the book value per share we derive an important relationship called the Price to Book Value (P2BV) Ratio. In the SJVN situation if the stock is available at Rs.36.99 then dividing this by the book value per share of Rs.24.66 we get a P2BV Ratio of 1.50. So at this price the stock just available at the fair price. There is no discount or premium involved. However, if the SJVN share is available at Rs.22, then it is available at a discount of Rs.2.66 compared to the absolute book value of the share and Rs.14.99 compared to the maximum assigned value as per value-investing norms.
Discount in the Value of Stocks based on the Earnings
Benjamin Graham said that we can pay up to 15 times the earnings as the fair price of a share. If a stock is available in the market below the 15 times the earnings then it is trading at a discount. If not the stock is trading at a premium.
The earnings of an individual share are found by dividing the total net profit earned by a company by the total number of equity shares of the company. This is also called earnings per share (EPS). Continuing with the example of SJVN Ltd., following table shows how EPS is derived:
In the above example, the EPS of SJVN Ltd. is rupees 4.05. Value-investing prescribes that 60.75 rupees (15×4.05) as fair. If the share is available at a price below Rs.60.75 then it is said to be trading at a discount to its fair value.
Conversely, when you divide the current market price by EPS you get the important relation called the price to earnings ratio. The price to earnings ratio is also popularly called the PE Ratio and PE Multiple. In the SJVN example supposing the market price is Rs.40.50 when we divide it by EPS of Rs.4.05 we get a 10 as the price to earnings ratio. Since this number is less than the accepted multiple of 15 there is a clear discount.
What if the stock is available at a price above fair based on underlying assets and below the fair price as per earnings?
Such a situation arises often. In fact, our example of SJVN Ltd. poses the same question. Suppose SJVN stock is trading at a price of Rs.40.50 is it available at a discount or premium? For based on the value of the assets the price is above the fair Rs.36.99 and based on the earnings it is below the allowed Rs.60.75?
The answer is that yes it is expensive based on the assets criterion and available at a discount as per the earnings criterion.
Now the next question is can we buy the share of SJVN Ltd. at Rs.40.50?
Well, If I am conservative I will wait for the price to correct to below Rs.36.99. However practically I overcome the dilemma by adopting a different approach. Every month I allocate my investment equally among the two criteria. Then I let a group of 14 stocks selected after a thorough analysis and finding a place in the Portfolio2K15 to compete for the funds based. Each stock will get funds based on the extent of discount obtained under each criterion.
In the above table, you can see that the stock NMDC has a PE number of 13.98. This number results in a discount of 1.02. If we add up all the real discounts (positive numbers which represent discount available) the sum is 40.87. The discount enjoyed by NMDC of 1.02 translates into a 2.50% of the total discount of 40,87. Hence NMDC gets an allocation of 2.50% of the total investible of Rs.5000, that is Rs.125.
However, under the aspect of assets NMDC does not enjoy any discount as the P2BV ratio is 1.81 which is greater than the maximum 1.50 accepted by value-investing norms.
On the other hand, the stock NALCO enjoys discount under the assets criterion but not the earnings aspect.
SJVN qualified under both the criteria.
Real Investment Example
In this article, I have explained two broad categories evaluation the stocks. However, in real life I add two more aspects as follows:
- Combined or Products of PE and P2BV Ratios: The value-investing norms prescribe an additional combination ratio with a maximum permitted number of 22.5 (1.5*15). If number obtained in the case of a stock is more than 22.50 then the stock overall is supposed to be expensive even though there is a discount under one of the aspects. In such a situation the stock should not be bought.
- Dividend Yield: Dividend yield measures return on investment from a stock. I have set a hurdle rate of a minimum of 4.0% per annum. I allocate funds to stocks that have yields above 4% per annum.
To see a real allocation of Rs.20,000 based on these four aspects, please read at Stocks Recommendation for November 2017.
Successful stock market investing needs us to unearth discount in the value of stocks available in the stock market. Therefore we should always buy stocks at their fair value or below. Sometimes a small premium may be justified. But W\we should never buy stocks at a big premium.