Understand this first, There is strong business behind every strong stock.
Second thing in the stock market, identifying a good business is not enough.
Buying the stock of that business at the right valuations is the most important.
Let us understand today what is the right valuation!
In my last email, I gave an example of how investing in Maruti Suzuki would have delivered a staggering 80X returns as the stock moved from Rs 125 to Rs 10,000.
Now, what if you had bought the stock at Rs 7000?
You would have made only 1.5x returns.
Maruti Suzuki was still a great company. The company still enjoyed brand power, customer goodwill, pricing power, wide distribution and highest sales.
You see, a great business will make a great investment only if bought at the right price.
That right price was Rs 125, Rs 200, Rs 500, and all the way up to Rs 1000.
Because even at Rs 1000, you would have still made 10X returns.
Now, once the market gets a sniff of a great stock like in case of Maruti Suzuki, it begins to realize its true potential and people start buying.
That is when the stock starts moving on an upward and becomes overpriced.
You wouldn’t want to buy/ invest in a stock at such high price since you will not make any meaningful returns or, even worse, you may lose money.
Rather you want to buy a business at a time when the stock is available at less than it’s intrinsic value i.e discount to its actual worth.
If the actual value of a business is Rs 400 per share then buy when it’s trading in the stock market at Rs 100 per share.
The stock will reach to its actual price in the future.
Let’s take Maruti Suzuki’s example again. The stock was trading close to Rs 9000 last year.
What if after latest analysis you realize that the stock is worth Rs 30,000. You would definitely buy it since there is a potential of more than 3X gains.
But what if your latest analysis says that the stock is worth Rs 6000 only. You would definitely stay away from it since the stock could correct in the future leading to a loss.
This is what valuing a business is all about. This is how you identify a good/bad business that makes a great/poor investment.
But, how do know the true value of a business?
How do you know whether to pay Rs 50, Rs 110, Rs 250, or whatever the right price might be for a business?
The answer lies in Intrinsic Value.
Intrinsic value is the fundamental or inherent value of a business. This value may or may not be same as the current market value.
If the current market value of the stock is above the intrinsic value, you can say that the stock is overvalued.
If the current market value of the stock is below the intrinsic value, you can say that the stock is undervalued.
Now, this intrinsic value of stocks can be estimated by two popular methods
- Discounted Cash Flow Analysis (DCF) or Present Value Method
- P/E Analysis or Relative Value Method
By the way, there is also a ready made formula using which you can easily estimate the intrinsic value of the stock.
More on that later.
The DCF analysis is based on Warren Buffett’s definition of intrinsic value as
“the discounted value of the cash that can be taken out of a business during its remaining life.”
Here cash refers to the free cash flow (FCF) of a company i.e the money that is left over after paying taxes on borrowings, any investments on new expansions, and accounting for working capital to support its day to day business activities.
If the company’s free cash flow is increasing and is high, that means the company has strong cash reserves, the ability to support its future expansion, and importantly be able to sustain itself in the business.
On the contrary, decreasing and poor free cash flow indicates that the company doesn’t have cash reserves to fuel its growth, may not be sustainable, and has to borrow a lot of debt to stay in the game.
Now, based on DCF analysis, intrinsic value can be defined as present value of the excess cash (free cash flow) that a business can generate over a period of next 10 years.
What this present value means is…
For example, if you put Rs 1000 in a fixed deposit today, the amount you will receive after 1 year is Rs 1080 at 8% interest rate.
Meaning the future value of Rs 1000, 1 year later, is Rs 1080.
The present value of that Rs 1080 you will receive an year later is Rs 1000.
Similarly, the intrinsic value of Maruti Suzuki or any stock can be known by calculating the present value of the future cash that the business will generate in the years to come say upto next 10 years.
That is you are calculating what the business is worth today (intrinsic value) by estimating its future cash flows and calculating the present value of that future cash flows.
In my article 7 smart steps to start investing in share markets, I have shared a resource on how to use the DCF model to arrive at an exact intrinsic value figure for any stock.
Another popular method that you can use to calculate the intrinsic value of the stock is the Relative Value Method.
In this method, one of the financial ratios you can use is P/E (price to earnings ratio).
In this ratio, you divide the per share price of the company with its per share earnings. For example, if the price per share is Rs 100 and its earnings per share (EPS) is Rs 5, the PE will 100/5 = 20.
This means that for each rupee of the company’s earnings you are paying Rs 20.
But, how do you know that this price is fair?
To find this, you must compare it with the PEs of the company’s competitors. If the average PE of the competitors is say 25, you are getting your shares for much cheaper. This is because, for a share of one of the competitors, you will have to pay on average Rs 25 per unit of earnings. For your company, though, you only pay Rs 20.
You can use this approach to calculate the intrinsic value of the stock using the below formula
Intrinsic value of the stock = P/E ratio * Earnings per Share (EPS)
If your competitor’s PE is 25 and your company’s EPS is 5 , then intrinsic value of your stock is
25 * 5 = Rs 125
This means that the fair price to pay for your stock is Rs 125. And if you are getting it in the market for Rs 100, it is a buy since you expect it to appreciate to this fair value.
In relative value method, you are using both the company’s own fundamentals as well as market trends to calculate the intrinsic value of a stock.
Beyond these two methods, there is a formula created by Benjamin Graham (the father of value investing) to calculate the intrinsic value. It involves very simple calculations to arrive at the intrinsic value of any stock.
Companies like EquityMaster have experts whose task is to analyse the stocks and stay updated with the latest news of industry.
We can’t match to their level of research but still we can do one thing better than those experts.
Holding on the right stocks for the longer period. Yes, those experts can do the math but a real investor have appetite to see the results.
Lastly, always remember these two things …..
It is more important to buy a great business at a good price, rather than a poor business at a great price.
Also sometimes, you come across businesses with attractive/cheap valuations. That doesn’t mean you should buy those stocks because the cheap valuations could be because of the bad fundamentals of the businesses.
Making such stocks ‘value traps’. Avoid them.
So, this was all about valuing a business. In my next email, I am going to talk about how companies with strong “Moats” (competitive advantage) can make for great stocks.
I will give you a clue of “competitive advantage” and give you some practice tomorrow.
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