What stocks to buy? What are undervalued stocks?

What stocks to buy for profitable investing?

Investor should try to “buy fundamentally strong stocks which are undervalued“. Why undervalued?

Because undervalued stocks can fetch higher returns in long term.

Why fundamentally strong stocks?

Because fundamentally strong stocks represent those companies which are doing good business. Higher returns are only the result of good business practices.

People get confused about which stocks to buy. To clear the confusion, there is one sentence:

Buy only fundamentally strong, undervalued stocks.

If we can keep our investment understanding as simple as these 6 words, we will be sorted.

No matter how complicated is the decisions, one must stick to this simple rule.

People who practice short term trading in stocks, do not follow this rule. They will rather buy anything. Why?

Because they believe in profiting from momentum investing.

But this is not the investment practice which I promote in this blog.

How to know if the stock is undervalued?

When market price of stock is less than its intrinsic value, it is undervalued.

So to know if the stock is undervalued, one must know how to estimate its intrinsic value.

The other easier way of knowing if the stock is undervalued or not is wait and watch method.

The easiest time to find undervalued stocks in India is in a falling market.

How to know if the market is falling or rising?

Tracking stock market index will give this answer. Observing main indices like Sensex, Nifty, Nasdaq etc is better.

But it is not sufficient to see index movements alone.

To get a more meaningful idea, look deeper into the index’s PE & PB ratios.

[P.Note: Sensex’s PE & PB ratio can be found by visiting bseindia’s website.]

Index Sensex Levels P/E P/B Dividend Yield Date
SENSEX 28,500 18.63 3.09 1.22 Apr’15
SENSEX 34,000 24.95 3.09 1.14 Dec’17

It is interesting to observe index in terms of its PE, PB. I maintain a historical PE and PB database of Sensex. This gives me a general idea about the present valuation of stocks.

In above table you can observe the following:

  • Sensex jumped from 28,500 to 34,000 levels in 2.7 years (up by 15%).
  • PE of Sensex jumped from 18.63 to 24.95 levels in 2.7 years (up by 25%).
  • PB of Sensex remained same.
  • Dividend Yield of Sensex is down by 5%.

What these data tell about the market?

PE up by 25%, when the index is up by only 15%, is a strong signal of overvaluation.

PB remaining same means the companies are increasing their net worth at the pace of the market, which is very good.

Dividend yield coming down can mean two things, either overvaluation or, company holding more of its profits. When Net worth of company is growing fast, it is more likely that Sensex companies are holding more of their profits.

As a general rule of thumb, stocks having PE more than 15 may be overvalued. Similarly, stocks having PB more than 1.5 may be overvalued.

Though it is an outdated rule, but it still gives investors a feel about the price valuations.

Sensex Verses Individual Stocks

Price Earning (P/E) Ratio of Index represents average valuations of stocks listed in stock exchange. Presently P/E ratio of SENSEX is 24.95. Applying a rule of thumb, P/E above 15 hints at overvaluation.

In last 24 months, Sensex has risen by more than 8,500 points. This is the reason why P/E of Sensex is trading at 24.95 levels today.

When Sensex is rising it means its P/E ratio is also increasing. It implies that stocks may be getting overvalued too.

In this uptrend of Index there are some good stocks that gets left-behind.

Investors intention should be to track those fundamentally strong stocks which are undervalued.

Let’s take an example of Tata Steel to see how we can compare individual stocks with Sensex and derive a conclusion:

What Stocks To Buy? What Are Undervalued Stocks?This type of comparison of SENSEX with individual stocks gives insights about the market.

Lets see what we can decode about Tata Steel from above table:

  • Sensex rose @9.5% in last 5 years.
  • Tata Steel’s share price rose @8.95% in last 5 years. This growth is almost at par with Sensex.
  • But Tata Steel’s EPS fell @ -7.41% in last 5 years. This growth is not at par even with inflation.
  • PE ratio rose at a massive rate of 17.67% per annum. This indicates overvaluation.
  • This overvaluation is the result of falling EPS.
  • Dividend per share growth is almost at par with Sensex growth.
  • The dividend yield has almost been consistent in last 5 years. But it is on very lower side.

What we can conclude from this table?

As EPS of Tata Steel is falling, it indicates problems in its business fundamentals.

But as because this company has a very strong Management, it is still taking care of the shareholders interest in terms of market price appreciation and dividend earnings.

So does this make it a good stock for investing?

No, because it does not stand up to our basic investing rule (buy only fundamentally strong, undervalued stocks).

Tata Steel’s fundamentals may not be strong (falling EPS). It may also not be undervalued (increasing PE ratio).

To get a deeper understanding of Tata Steel we can use the stock analysis worksheet, but prima facie it doesn’t look too good.

This kind of understanding is possible when we compare Sensex movements with individual shares.

PE Ratio speaks much more…

PE ratio gives a broad idea about market whether it is overvalued or undervalued.

In years 1920, 1950, 2001 & 2008, stock market across the world saw its worst crisis. During these moments of turmoil the average PE ratio of stock market was at its rock bottom.

Investors who bought stocks during these times made handsome profits.

But this is only one side of the story.

There were investors who bought stocks only when stock market got revived. Like in year 2010. PE ratio of the market was at all time highs.

Buying stocks when market has already peaked is bad.

So does it mean that now, when Sensex is at 34,000 levels, market is overvalued?

Just because of the fact that Sensex is at all time high, does not make it overvalued.

Hence to answer this question we will have to look deeper (PE ratio) into historical data of Sensex.

What Stocks To Buy? What Are Undervalued Stocks?

What you see in the above table is last 20 years Sensex data obtained from bseindia’s website.

I have indicated three points as “Max” in the above table. Out of these 3 points, 2 are those years when market peaked and subsequently crashed.

What was the PE ratio in those years? 23.89 (year 2001) and 22.61 (year 2002).

What is the PE ratio of Sensex today? It is 23.60.

Looking at this historical data, possible Sensex correction looks very probable any time soon.

But what Sensex patterns has to say about – what stock to buy?

If Sensex is tending towards overvalued levels, it does not necessarily mean that individual stocks are also overvalued.

But when Sensex becomes overvalued, market may crash.

When market crashes, stock price will also fall very rapidly.

Hence, it is better to wait for the possible stock market correction and then buy stocks.

[P.Note in the above table: After the indicated stock market crashes, the PE of Sensex fell close to our rule of thumb of 15 and then bounced back again]

Keep a watch on inflation…

In countries like India, investors must also look into inflation.

PE ratio is effected by inflation rates. How?

High inflation rates effects the sentiment of the market. Buyers/Customers feel the pinch of soaring prices.

Companies expenses goes up rapidly resulting in less profits.

When customers are buying less, and companies are making less profits, EPS is bound to fall.

When EPS falls PE ratio increases, making stocks overvalued.

This further pushed the investors away from investments.

Controlled inflation is good for the economy. But erratic and stubbornly high inflation rates are worrisome.

Having said that, it must also be noted that stock market do not work well in economies having low inflation rates.

Please see the below table to correlate the performance of Sensex with prevailing inflation in India.

What Stocks To Buy? What Are Undervalued Stocks?

Between year 2000 and 2011 (11 years)

Inflation was rising rampantly in India. It rose from 4.84% (year 2000) to 12.11% levels (year 2011).

In the same period, Sensex rose from 5001 (year 2000) to 19,445 levels (year 2011).

The growth in Sensex was amazing at the rate of 13.13% per annum.

Between year 2011 and 2017 (7 years)

Inflation was falling in India. It fell from 12.11% (year 2011) to 2.19% levels (year 2017).

In the same period, Sensex rose from 19,445 (year 2011) to 33.848 levels (year 2017).

The growth in Sensex was decent at the rate of 8.24% per annum.

Could you get the pattern?

Between the periods when inflation was soaring (2000-2011), Sensex did better.

Between the periods when inflation was falling (2011-2017), Sensex still performed well but not as good as previous years.

What does it mean?

It does not mean that high inflation is better. But for a growing economy, too low inflation rate is also not good.

This is where our RBI needs to keep a proper check. Inflation should neither be too high nor too low.

So what it means for stock investors?

Investors must not feel scared when inflation is rising (in a controlled way). Market may perform better in those times.

So when one has to buy stock, keep a look at the varying inflation charts. If it is showing a downtrend, future growth may not be as great.

Look for fundamentally strong stocks

In addition to index, it is equally important to look at business fundamentals of individual stocks.

No matter how undervalued are the stocks, but if their fundamentals are weak, it will not be a good buy.

Many stocks trade at low PE & PB levels. But majority of them has weak fundamentals.

One must buy only fundamentally strong stocks.

Looking at the following parameters in stocks can give an idea about its fundamentals:

  • BALANCE SHEET (5 Year Data)
    • Share Capital – Ideally it must be constant.
    • Reserves – Ideally it must grow faster than inflation.
    • Net Block (fixed assets) – Ideally it must grow faster than inflation.
    • Current Asset / Current Liability Ratio – Must be above one (1).
  • P&L ACCOUNT (5 Year Data)
    • Sales – Ideally it must grow faster than inflation.
    • EBIT – Ideally it must grow faster than inflation.
    • EBIT Margin – Ideally it must grow with time.
    • Net Profit (PAT) – Ideally it must grow faster than inflation.
    • Dividend per share – Ideally it must grow at rate of PAT growth.
  • CASH FLOW (5 Year Data)
    • Net Cash Flow from operations – Must always be positive.
    • Growth in Net Cash Flow from operations -Ideally it must grow faster than inflation.
  • DERIVED RESULTS
    • Current Market Price < Intrinsic Value.
    • Piostroski F Score > 6.
    • Altman Z Score > 2.6.
    • Future Growth prospects – Ideally it must be more than inflation.
    • No bankruptcy threat.
    • Management must be efficient.
    • Overall financial health must be stable.
    • etc….

I know, this checklist can be endless.

Different people will use different parameters to evaluate their stocks. I use these parameters for my decision making.

If you want to avoid going into so much self calculations, you can use my stock analysis worksheet to get instant answers. Though it is not a stock advice tool, but it works.

Quick Tip: Check for potential investors:

A quick comparison of companies “Enterprise Value” and its “Market Capitalisation” gives a nice first hand idea of whether a stock may be undervalued or overvalued.

This is again one of the easier ways to identify undervalued stocks in India.

Stocks whose enterprise value is less than their market capitalization can be assumed to be trading at undervalued price levels.

How?

Enterprise value = Market Cap + (Debt – Cash)

Suppose there is a company which has huge cash reserves. Its cash level is so high that it can pay-off its total debt from its cash reserves only (cash > Debt). This is a rarest of rare case.

In such a case, using the above equation, the companies enterprise value will be less than its market cap.

Such companies can be assumed to be undervalued.

Undervalued Stocks in India (Enterprise Value < Market Capitalisation)

(Updated as on Apr’2018)

  1. Hindustan Petroleum Corpn. Ltd.
  2. Indian Oil Corpn. Ltd.
  3. NLC India Ltd.
  4. Mangalore Refinery & Petrochem
  5. Chennai Petroleum Corpn. Ltd.
  6. Rural Electrification Corpn. Ltd.
  7. Balrampur Chini Mills Ltd.
  8. SJVN Ltd.
  9. DCM Shriram Ltd.
  10. Bharat Petroleum Corpn. Ltd.

Check this link to find P/E, P/B, PEG, Dividend Yield of 25 undervalued stocks…


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-analyse all securities before investing in one.

5 Comments on "What stocks to buy? What are undervalued stocks?"

  1. Give your thoughts on Orchid Pharma. Though orchid has been included in the second list and the outcome will be later than
    April 2018 would you give us the case study taking into account intangible assets in the company. Since it’s inspection FDA has never put the company under the watch list and the Annual FDA audit was carried out in May 17 and has certified the Company.
    The Companies strength in it’s R & D if reflected in bringing out on commercial stream of the
    Generic TAZOBECTUM with in 60 days from the date of getting
    ANDA approval. The recent ANDA approved drug both in 10 Mg and 20 Mg tablets market is almost
    600 Million USD. With MKT cap of 158 Crores and total Debt at
    3500 Crores the notional Enterprise value is Negative.
    But as per Sept17 balance sheet, the EBITDA is around 11%
    and the sales at 1200 Crores.
    The valuation by empherical means is at 10 times EBITDA and
    @ 2 times the sale. Taking the former,the valuation comes to
    1100 Crores together with the sweetner of 50%=haircut the net
    Debt is around 1750 Crores. With the implementation of 5 / 25 scheme the prospective buyer
    Would be getting a FDA approved
    With a strong human resources and a pool of 70 ANDA in it’s kitty is a serious buy. The transfer of ownership would give the prospective buyer a clean 26% of the equity and if the Company valued at 1100 Crores at a revised equity of
    100 Crores the notional value pegged at 100/share the upfront payment towards equity is 228 Crores.

    • If ethically wrong donot do it. Make sure
      Your interest should protect small investors and educate
      Investing Public .
      Though I donot indulge in the market I keenly watch the market since
      1969. Kindly strike delete button and let us not discuss about it for I value your judgement and after all the platform is yours and not mine.
      Wish you all the best.

  2. Thanks a lot for the analysis and listing it down.
    Request to update the list.

    Thanks

  3. KEEP it up
    very GOOD WORK

  4. Simple and very informative blog….a good initiative…thanks

Your comments fuels me to write better...