Identifying good companies to invest

The equity value of a company is the present value of future cash flows. It’s a truism that value lies in the eyes for the beholder. Look at market fluctuations as your friend rather as your enemy profit from folly rather than participate in it. A legendary investor bought businesses that were high on growth, high on return on capital employed and he has achieved the status of a ‘legend’ and created wealth out of his investments.. When he bought Coca-cola many thought he had made a mistake. But he bought it because it had the capacity to do better than the stock market, due to its high returns potential.

Investors must seek value let us look at it another way. One metric by which equity value is determined is the P/E ratio. However can you, as an investor use it to spot hidden gems? Suppose you invested Rs 100 in a bank, at an annual return of 9% you get Rs 9 out of Rs 100. So the invested-to-return ratio is 100/9, or 11.1. It is the same way with stocks. You put in Rs 100 and the company has an earning per share of, say Rs 7. So its P/E is 100/7 or 14.29. In the bank FD, your risk is minimal and the payout is 9%. But in the case of equity the payoff is the dividend plus the potential for share price appreciation. Equity is risky hence the potential payoff must be significantly higher to make investing sense. So for companies that grow their profits significantly the stock price is higher, and dividend earnings lower. The latter is made up for in terms of greater appreciation in the stock price.

Another good guide is to identify fair evaluation in equity. This is referred as the PEG ratio. It is the P/E divided by the growth potential of the company. If that number is 1 or less the company is said to be fairly valued and if it is more, it is said to be over valued. Let us pick a company and check it out.

Birla Corporation has a market capitalization of over Rs 1,296 crore. The latest sales and net profit figures (year ended March 2008) are Rs 1,996.78 crore and Rs 393.57 crore respectively and have grown more than 11.27% and 20.64% over the previous year. EPS stands at Rs 51.1 and the estimate for FY09 is Rs 58.7 which represents 14.85% growth over the current EPS. The P/E for this company is 3.24. The PEG ratio is 3.24/14.85 or 0.22. That means you pay Rs 167 (current market price) for a share in Birla Corporation, and get an EPS of Rs. 51.1. This is a return of 30.86% — much better than bank FDs. And that’s not counting possible appreciation in the price of the stock. The company is not going to pay out the entire profit as dividend. But the intrinsic vale remains, which makes it a good stock to own.

Now, if the company is doing so well, why is the share price so low? There could be many reasons. Perhaps the company is heading for lower growth in future. Perhaps it is in an industry whose fortunes are cyclical. Competition could erode the margins or growth of the company. Indeed brokers agree in their estimate that the EPS will come down in FY2010 to Rs 52. Besides, the company has a troubled past, and has faced industrial relations issues throughout its history. This is where patience and diligence count. If one studies companies carefully, one can identify good value buys. Always look beyond to numbers and then decide.

That brings us to the next issue time. Is this the right time to buy? What’s important is not timing, but time in the market. If you find a good company at a good valuation the time is right. A time like this additionally presents an excellent opportunity to those who have the courage of conviction to buy now and hold on for later. So now could be the right time to buy good value stocks.

The value proposition is important. If you are convinced the company you are buying is good, it should not bother you where to stock market is going. For once you have bought a good stock its value does not diminish with the stock ticker’s oscillations.