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How to screen value stocks?

Picking stocks is fun. When it comes to wealth building, there is no more popular investment vehicle than stocks. But stock investing is also risky.

The trick to be successful in stock investing is to pick good stocks. Pro investors do not mention ‘good stocks’ as only ‘good’, they call it as ‘value stocks’.

If one can find a way to screen value stocks, it will present him/her a great buying opportunity. In this article we will talk about how to screen value stocks.

I present to you 8 essential checklist/steps based on which a stock can be screened for its true value.

The approach should be like this, suppose you decide to buy stocks of say Reliance Capital (BSE: 500111). What details you must check before you arrive at a decision that Reliance Capital is a good buy?

The checklist/steps that we are going to discuss here will give this answer.

It is true that these 8 checklist points are not out of the Bible. Its not fool proof.

These 8 checklist I have figured out myself. Based on my investing experience, I have found these checklist to be reasonably effective.

Lets discuss how to identify a value stock.

Step 1. Check EPS health

A company which is not able to grow its profit over time is not good. But looking alone at PAT (Profit after Tax) is not enough. EPS effects market price of stocks more directly than PAT.

What to check in EPS? Earning per share (EPS) alone does not say much about a stock. But historical EPS speaks a ton about the fundamentals of the company.

Note last 10 years EPS of Reliance Capital.

Basic EPS (Rs.)
Rs.38.67 (Mar’16)
Rs.30.77 (Mar’15)
Rs.16.67 (Mar’14)
Rs.26.95 (Mar’13)
Rs.21.14 (Mar’12)
Rs.09.33 (Mar’11)
Rs.13.79 (Mar’10)
Rs.39.32 (Mar’09)
Rs.41.52 (Mar’08)
Rs.27.14 (Mar’07)

What does these historical EPS values tell its investors?

Reliance Capital has been able to grow its EPS steadily since last 10 years (except for Mar’09, Mar’10, Mar’11 & Mar’14). We can rate Reliance capital based on its growth stability as 3.5 out of 5.

The growth rate of EPS in last 10 years (from Rs.27.14 to Rs.38.67) is 3.8% per annum. Assuming that, average inflation in India for next 10 years will be close to 6%. Growth rate of 3.8% is quite low. We can rate Reliance capital based on its growth rate as 2 out of 5.

On an average, Reliance capital earned rating of 2.75 out of 5 for its EPS health.

[Note: The same company will earn a rating of 4.5+ if evaluated with only last 5 years data. But in value investing, 10 years data gives more reliable results]

Step 2. Check liquidity levels of company

Companies liquidity is like blood running in the veins of the company. When blood flow will stop, the company will start dying.

Maintaining sufficient liquidity in company is a must for its managers.

How to check companies liquidity levels?

Comparison of current assets and current liabilities of company will highlight the level of liquidity that a company maintains.

As a rule of thumb, ration between current asset and current liability should be more than 2.

Note last 10 years current assets and current liability levels of Reliance Capital.

Current Asset / Current Liability / Ratio
07,897 / 09,278 / 0.85 (Mar’16)
10,819 / 08,857 / 1.22 (Mar’15)
08,736 / 12,623 / 0.69 (Mar’14)
08,551 / 09,593 / 0.89 (Mar’13)
07,098 / 08,249 / 0.86 (Mar’12)
06,245 / 08,850 / 0.71 (Mar’11)
09,184 / 02,779 / 3.30 (Mar’10)
11,932 / 05,598 / 2.13 (Mar’09)
11,607 / 01,070 / 10.85 (Mar’08)
04,245 / 00,206 / 20.61 (Mar’07)

Average ratio of last 10 years is 4.21. This is considered very good. But the problem with Reliance Capital is its liquidity levels in last 6 years. Average liquidity ratio has been less than 1 in last 6 years. This is not a good sign for company.

Rating of Reliance capital based on its liquidity level is as 2.5 out of 5.

Step 3. Check debt levels of company

Good companies keeps debt levels to bare minimum. There are some companies who works with zero debt. But here the idea is not to limit our search for zero debt companies. Focus will be on low debt companies.

How to identify low debt companies?

The easiest way to analyse debt levels of companies is to check its debt equity ratio.

As a rule of thumb, companies having debt equity ratio of less than 1 (D/E<1) is considered good for investing. The lower is the D/E ratio the better.

Note last 10 years debt equity ratio of Reliance Capital.

Debt / Equity (D/E) Ratio:
1.31 (Mar’16)
1.42 (Mar’15)
1.62 (Mar’14)
1.44 (Mar’13)
1.30 (Mar’12)
2.23 (Mar’11)
1.72 (Mar’10)
2.02 (Mar’09)
1.55 (Mar’08)
0.27 (Mar’07)

Average debt equity ratio of last 1o years is 1.488. This indicates a debt levels which is on a higher side. If we see even last five years D/E ratio, the value is close to 1.41. The value that attracts a value investor is D/E<1.

Rating of Reliance capital based on its D/E ratio is 3 out of 5.

Step 4. Check P/E ratio of stocks

Looking only at P/E ratio is not enough these days.

In good old days we used to consider stocks trading at P/E ratio below 15 as good-buy.

But I will recommend my readers to take one step more. It is not easy to find good stocks below the magic value of 15. The reason can be, Sensex itself has jumped close to 8,000 points in last 36 months.

So, it is better to evaluate price value of stocks compared to Sensex levels.

Note P/E ratio of Reliance Capital. As on today, P/E ratio of Reliance Capital is 9.91.

Similarly, P/E ratio of Sensex is 20.5

Compared to Sensex, Reliance capital is trading at price earning ratio at discount of 50%. Hence it is considered good.

Ideally a stocks which is trading at two-third of PE of Sensex is considered a good buy.

Rating of Reliance capital based on its P/E ratio is 5 out of 5.

Step 5. Check PEG ratio of stock

Price Earning ratio in isolation does talk about if a stock is really undervalued. Stocks of fast growing companies can afford to have higher P/E ratio.

How to identify if a stock is worth a buy based on its growth potential?

One must calculate its PEG ratio.

PEG can be calculated by this formula:
PEG = PE Ratio / EPS growth rate.

Lets calculate PEG ratio of Reliance Capital.

P/E ratio = 9.91
EPS Growth Rate in last 10 years (%) = 3.8

PEG = PE / EPSG = 9.91 / 3.8 = 2.6

As a rule of thumb, a stock which has PEG of less than 1 is considered a good buy.

Rating of Reliance capital based on its PEG ratio is 1.5 out of 5.

Step 6. Check P/B ratio of stock

These days, investors do not use the P/B ratio a lot. But for me it still works fine.

Price to book value ratio (P/B) compares stocks price with respect to its net worth (book value).

Higher will be the book value, lower will be P/B ratio.

As a rule of thumb, P/B <1.5 is considered good. But this is a very old analogy.

I will request my readers to check P/B ratio of Sensex and then compare it with stocks P/B ratio.

Lets do it for Reliance Capital.

P/B ratio of Reliance Capital = 0.78
P/B ratio of Sensex = 2.72

A good stock must be available at a discount (two-third) to Sensex P/B ratio.

Both in terms of Sensex comparison (2/3×2.72 = 1.81) and thumb rule (1.5), Reliance capital scores well in terms of P/B ratio (0.78).

Rating of Reliance capital based on its P/B ratio is 5 out of 5.

Step 7. Check Dividend Yield of the stock

To screen value stocks, one cannot forget to utilize the dividends. Value investors love dividends.

But this can be slightly tricky. Dividend yield of most stocks in India is pretty low.

It becomes more confusion if for some year a company pays high dividend, then for remaining year dividend becomes scarce.

Ideally, dividend yield of a stock should be two-third of the yield of India Government Bond 10Y.

Lets see how Reliance Capital fares on this screener.

Dividend Yield of Reliance Capital = 2.3%
Yield of 10Y GOI Bond = 6.4%
Two third of 10Y GOI Bond = 4.2%

In terms of dividend yield comparison, Reliance capital’s fares very moderately (2.3% < 4.2%).

Rating of Reliance capital based on its dividend yield is 2.8 out of 5.

Step 8. Calculate Intrinsic value of

This is final litmus test for stocks. To be frank, it is not as common for general public to compute intrinsic value of stocks on their own.

Expert investors cannot think of investing in stocks without estimating its intrinsic value. But for majority, its complicated.

I understood this limitation and have developed and easy to use stock analysis worksheet for my readers. This worksheet not only helps users to learn estimating intrinsic value but it also gathers other meaningful data about the company.

Using this worksheet, intrinsic value of Reliance Capital comes out between Rs.2,000-2,500/share.

As a rule of thumb, market price of stock should be two third of its estimated intrinsic value.

Rating of Reliance capital based on its intrinsic value is 5 out of 5.

Conclusion

Rating of Reliance capital based on its EPS Health is 2.75 out of 5.

Rating of Reliance capital based on its liquidity level is as 2.5 out of 5.

Rating of Reliance capital based on its D/E ratio is as 3 out of 5.

Rating of Reliance capital based on its P/E ratio is 5 out of 5.

Rating of Reliance capital based on its PEG ratio is 1.5 out of 5.

Rating of Reliance capital based on its P/B ratio is 5 out of 5.

Rating of Reliance capital based on its dividend yield is 2.8 out of 5.

Rating of Reliance capital based on its intrinsic value is 5 out of 5.

Average rating of Reliance capital based on above 8 screening points is 3.44 out of 5 (68%).

A stock which earns >85% (4.2 out of 5) points can considered a good buy.



Stock investing made easy by worksheets"

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Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyze all securities before investing in one.

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