Spotting Undervalued Stocks: A SIMPLE APPROACH

There are lot of proven companies like Reliance Industries, Bajaj Auto, Infosys technologies and so on. But they might be fully valued. The whole market is watching their business activities and news relating to any change that may be positive or negative for those companies. Market quickly reacts to such information and as such their value would reflect their perceived business prospects at any given point of time.
The prices of such stocks may take a random walk on the basis of certain general news which affects the overall market sentiments but having no effect on their prospects. Those kind of situations give opportunity to get into such great stocks at a price below the normal valuations. Such events and news won't often come. Even if they occur also how will one know what is the right price to enter a stock. Volumes have been written on how to value stocks and volumes remain to be written on the subject. This is because the circumstances keep on changing and new valuation parameters are designed and employed to meet changing circumstances.

Methodology Issue
Though there are many complex valuation methods we need to have a holistic analysis that the company is doing well on all counts and not just valuation. Let us try to look into a methodology which can help an investor adjust the limits of his parameters based on his overall outlook. The methodology is more of quantitative in nature to eliminate subjectivity and requires good amount of past data regarding their balance sheet,
profit and loss account and cashflows to pinpoint undervalued stocks. This step by step approach can help you try and find a few good undervalued stocks. But sometimes you may not find one also. Yes finding
undervalued stocks are like finding oyster pearl from deep inside the sea! The analysis involves 5 basic factors and selects only those which satisfy all the parameters used for each

Stability
Stability can be attributed to the stable income generation capacity of the company and its potential to grow. The current sales should be more than a particular limit. For e.g. let us say that the current sales should be more than Rs.100 crores. This kind of limit is required as many companies won't be able to grow fast unless they achieve a critical mass in revenues. They need enough money to expand rapidly and revenues are the primary source for that. Hundreds of small companies remain small because after meeting the regular business expenses they won't be left with enough cash flow to grow. The second parameter is that the sales should be growing continuously. If the sales are up in one year, down in another and the pattern is repeated then there is some serious problem in the overall management of the business or the nature of the business. It is better not to buy shares of such companies. The growth in sales shows the demand for the products and services of the company and its continuity represents either the growth in market for the company's products or services or the company's ability to stay on top of competition. Reasonably you should look for a company whose sales are growing above 20% year on year.

Profitability factor. It is up to you whether to relax a parameter because some other parameter is so good so that it will negate the weakness of the other parameter. The 5 factors to analyse the stocks in the market are Stability, Profitability, Capital Structure, Management and Valuation. The first 4 factors except Management are quantitative factors and Management is qualitative factor.
Profitability means different things to different people. For a lender the total cash flow generated out of operation is very important. But for an equity investor the Net Profit Margin (NPM) is more important.
Because his cash flows in terms of dividend or increase in investment value through creating additional reserves can be done through the net profit only. If the NPM is very low like 2-3% then a small negative change in the sales would see that the company turns into red. Ideally you should look for companies which can generate NPM of 10% or more, continuously. The continuity factor is very important because it shows that the company is not growing at the expense of margins. NPM is calculated as Net Profit After Taxes divided by the Net Income. When we consider the stability factor also into account the minimum Earning Per Share (EPS) of double the face value would be ideal. This shows that the company is able to generate good money for the shareholders. The higher EPS reflects the fact that the company is in the business for long and the resources are under full utilization. The company should also give a reasonable Return on the Networth (RONW). This is nothing but the share capital plus reserves. The consistency or continuous growth of the RONW signifies that the assets are employed in good manner. The more the RONW the better the business is doing. It would be good to look around for a company which gives RONW above the expected equity returns.

Capital Structure
Capital Structure needs to be analyzed in 2 ways. One is with respect to the equity and debt combination and the other is in terms of the share holding pattern. Companies used to borrow money for expansion of business in order to grow. Ideally a company should not have more than 2 times the equity capital as debt. The advantage of borrowing is that the company expects to earn a higher return than the cost of interest thus increasing the net profit available to the shareholders. But if the borrowing is too high, in a down market company when margins are under pressure the company will find it difficult to generate enough profit to be shared with the shareholders. Before deducting interest and taxes, if the company's profits are more than 5 time the interest liability then we can fairly assume that the company is fairly placed. More the interest coverage ratio, better the ability of the company to survive in adverse conditions. The interest coverage ration is calculated as Profit Before Interest and Taxes divided by the Interest Paid. Secondly you have to see whether the promoters have substantial stake in the company and also whether any institutional investment is there. If the total of promoters and institutions as shareholders is more than 50% it may be considered as good.

Management
Management's integrity, accountability and honesty to shareholders and other stake holders should play a vital role in deciding whether to select the stock or not. There are notorious promoters who siphon out money through accounting juggleries and also take decision on diluting equity without considering the interest of other shareholders. The existing shareholders would not get any benefit in such scenarios. If a company pays good dividends, issues bonus shares or rights shares to existing shareholders it can be fairly considered as investor friendly. Also the management's approach to the labour force, promptness in meeting regulatory requirements, relationship with vendors and customer satisfaction are factors to be looked into. As this is a subjective analysis you should be trying to get as much news material on the company by surfing the internet or going through old business news papers or business magazines.

Valuation
By going through all the above steps you may find few good companies but now you need to find their valuation also. Here the simple way is to check the Price to Earnings (P/E) Ratio and the Price to Earnings Growth (PEG) Ratios. P/E ratio should be ideally below 14.2 if the opportunity cost is 7%. This means that if you can get a return of 7% from bank deposit which you are foregoing by investing in the stock, the stock should minimum generate earnings which would equal to the bank interest. P/E is calculated as Price per share divided by EPS. But P/E does not reflect the earnings growth over the future years and hence is very conservative. So you need to also look into the PEG Ratio. PEG ratio is calculated as P/E divided by the Annual Earnings Growth. So if you expect the net profits to grow by 30% then the PEG ratio for a stock with P/E of 14.2 will be 14.2/30 = 0.473 (You should not take the percentage into account in calculating this). A PEG ratio of less than 0.5 is a good sign of undiscovered value. There are a lot of methods for valuation. You can also calculate the discounted value of the free cash flows over the expected time horizon of your investment. But most of these involve tedious calculations. Many of the things like sectoral outlook or business model analysis are not considered in this methodology. But it is sure that there won't be many stocks which could qualify on all counts. So you need not worry about it. The stocks you find can be considered as stable with growth prospects, having good profitability, with low default risk, having good investor participation, fair management and at a price which is intrinsically higher than its currently quoted price.