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How to Find Cheap Stocks Using Fundamental Analysis?

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How to Find Cheap Stocks

Every investor dreams of building a portfolio of investments that would make him wealthy. But, the truth is that the average investor usually ends up burning his fingers in the stock market. That happens because investors chase stocks that are making media headlines rather than identifying stocks that are cheap but healthy, and have mid-term or long-term value.  The term ‘cheap’ should be interpreted in relative rather than absolute terms. Cheap stocks are ones that have a higher real value than their price in the market.

What is Fundamental Analysis

Fundamental AnalysisConversations around the office water cooler or at the lunch table often come around to the ‘fundamentals’ of a company that make its share a good buy. But what exactly do we mean by ‘fundamentals’? The fundamentals of a company are the attributes that give it long-term strength and value: financially resourceful promoters, savvy, progressive, forward thinking management, consistent sales growth, rising earnings, investment programs targeting future growth, better than peer performance, and brand equity. In the succeeding paragraphs, we will see how fundamental analysis can help cherry pick stocks that could turn into multi-baggers.

For this, we will track the actual performance of a company and its share price on the Bombay Stock Exchange. But, before that we must source data, understand value investing and determine the key criteria that come into play in reaching that ‘eureka’ moment.

Data Sources

The financial reports of a company: its balance sheet and profit loss accounts are one of the best sources for analyzing the track record of a company. Reading the directors’ report and the report of the auditors can prove rewarding, informative and influence thinking. Published data shared with stock exchanges, the web site of the company, and press releases are also reliable data sources.

The Market Size

There are 5,441 companies listed on the Bombay Stock Exchange (BSE) and 1,844 listed on the National Stock Exchange (NSE). First things first; from this universe of listed shares, we have to identify the companies that will come into our zone of consideration. How do we identify the stocks that have the potential to enrich us within a period of 5 to 10 years? Which are the stocks that hold hidden value for the future?  For that we turn to value investing.

Value Investing

value investingValue investing is a technique of stock selection with an eye on future appreciation.  This strategy targets stocks that are undervalued by the market in relation to the fundamentals of the company – its profit growth, market price to book value, price to earnings growth (PEG) ratio, dividend yield, leverage and liquidity. Merely because a stock is available at a cheap price does not make it a good pick.

For example, the current market price of a share of Maruti Suzuki Limited (Maruti) is Rs.3,749.15 and that of LML is Rs.7.05. Sure, the share of LML is cheap (you can buy 532 LML shares for the price of 1 share of Maruti) but would those shares have any genuine value. Perhaps not, given the losses incurred by LML for the past several years, its negative book value, low current ratio and generally dismal track record. Remember that when we invest, we invest not in a stock but in a company and its future.

Value investing is not

a get-rich-quick-overnight formula

A value investor looks to create wealth not by trading but by building a premium portfolio. The value investor’s focus is on the long term potential of the target company. Ergo, short-term market volatility and day-to-day price fluctuations matter little to the value investor who would ordinarily have a 5 years to 10 years horizon.

Making A Shortlist

SHORTLISTThe numbers that matter when selecting value-rich stocks are:

  • Debt-equity ratio of less than 1;
  • Current ratio of more than 1.33;
  • Quick ratio of more than 1;
  • Price to earnings growth ratio (PEG) of less than 1;
  • Stock price lower than Book value;
  • Operating profit growth of at least 10% for previous 3 years;
  • Dividend yield of more than 50% of AAA corporate bond yield / 66% of Government Securities yield

Free stock screeners that will help you to filter the good, the bad and the ugly are available online.

You could use the stock screeners of Google Finance, Reuters, Equity Master, Edelweiss, Screener, HDFC Securities, Ask Kuber to filter on the basis of the chosen criteria.

The stock screeners allow you to enter (+)/ (-) and (>)/ (<) symbols and add criteria from a drop down list. Let’s look at how well the selected criteria stack up in a real life scenario.

Case Study

The time horizon is 6 years from March 31, 2009 to March 31, 2015. The figures provided below are those of Cera Sanitaryware Limited listed on the BSE and NSE.

Parameter Standard As on March 31, 2009 As on March 31, 2015
Debt Equity Ratio < 1 0.52 0.17
Current Ratio > 1.33 1.15 1.16
Quick Ratio > 1 1.10 1.06
Operating profit growth (preceding 3 years) >10% 54.37%, 16.25%, 24.89% 41.15%, 26.01%, 23.81%
Price to Earnings Growth (PEG) <1 26.50/30.00 = 0.88 2495.15/30 = 83.17
Stock Price / Book Value <1 26.50/113.70 = 0.23 2495.15/270.42 = 9.23
Dividend Yield >66% of G-Sec yield Dividend yield = 2/26.50*100 = 7.55%

Government Security yield = 7.01%
(66% of 7.01% = 4.62%)

Dividend yield = 6.25/2495.15*100 = 0.25%

Government Security yield = 7.777%

SUCCESSThe stock ticked all the boxes except current ratio on March 31, 2009 which is acceptable. The likelihood of a stock fulfilling all the criteria is rare (akin to looking for a tomato without seeds). What is important is the overall picture that emerges. The value investor who purchased this stock at Rs. 55 in July 2009 would be sitting pretty even today i.e. February 17, 2016 as the stock is quoted at Rs.1626/- on the Bombay Stock Exchange and Rs.1646.65 on the National Stock Exchange.

What of the position of this stock as on March 31, 2015. The company performance continues to be impressive – with low indebtedness, healthy liquidity and robust growth of profits. But, the stock price has zoomed to levels that do not, per se, make it an attractive pick for future appreciation.

Due Diligence

The case study of Cera Sanitaryware Limited show cases the success that could be achieved through value investing. But, it is not intended to suggest that the parameters selected above are foolproof and guarantee wealth creation.

There is no substitute for thorough due diligence and painstaking research which are critical to stock selection. The savvy investor is one who knows that there can never be any magic formula to identify stocks that are certain to reach stratospheric heights.

Finding cheap stocks using fundamental analysis is possible. To say with certainty that the market prices of these stocks will increase five-fold or ten-fold would be foolhardy. Nevertheless.value investing is your best bet.

Like Damon Runyon said, “The race is not always to the swiftest, nor is the battle always to the strongest, but that’s the way to bet.”

(Disclaimer : This article provides general advice and recommendations and does not constitute personal advice. The opinions in this article are for informational and educational purposes only. I do not hold any stocks of Cera Sanitaryware Limited and the statements in this article should not be construed as advice to buy or sell any stocks.) 

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Randolph Rowe is a professional banker and former General Manager of Small Industries Development Bank of India (SIDBI). He brings with him the wealth of 34 years of all-round experience in the banking sector - comprising 12 years with IDBI and 22 years with SIDBI - which he combines with his flair for writing.

2 COMMENTS

  1. Another outstanding article by Randolph !!!! He has correctly emphasized on research and strategy making for profitable deals.He has provided with certain amazing pointers for helping the investors find the undervalued stocks.There is also a case study for understanding how these fundamentals actually work in real life cases.Emphasis given on due diligence and value investing will also prove to be an important asset while aiming for long term wealth appreciation.

  2. Thumbs up for making fundamental analysis sound so easy. The case study was beautifully presented. There is no shortcut for getting rich in share market overnight but then how do the share market scam occurs? The shortlist provided is a real good check. Now a days the free stock screeners is even a good option.

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