Which are best stocks? Stocks which represent a “good business”, and are also available at “undervalued price” levels for investing.
How to know which is a good business? For this we will have to look at their ‘free cash flow’.
How to know if the if the stock is undervalued? For this we will have to look at their “intrinsic value’. A stock which available at a market price less than its intrinsic value is undervalued.
To calculate intrinsic value, we must know know the ‘free cash flow’ generated by the company.
So you can see how the loop is closing itself?
Example: Suppose a stock is trading at a market price of Rs.100 per share. Upon calculation, its intrinsic value comes out to be Rs.120 per share. Such a stock is said to be undervalued (Market Price < Intrinsic Value).
So, to identify best stocks, the essential ingredients are the following:
- Free cash Flow (FCF).
- Intrinsic Value (IV)
How to identify best stock? FCF will help you to estimate IV. Then you can compare the current market price of stock with its estimated IV. If current price is less than its IV, we can call it a best stock.
[I have used an easier screening criterial to compose a list of potential best stocks. Check this list here.]
It is almost impossible to identify best stocks without knowing their free cash flow and intrinsic value. Does this understanding make best stock picking simpler? Yes and No.
- Yes, because we now know what stock parameter must be looked at to pick best stocks. Otherwise we simply waste our time looking at less important stock metrics like ratios etc.
- No, because estimation of both ‘free cash flow’ and ‘intrinsic value’ is a special skill. Only gifted people can do it accurately.
So how a common man, who knows nothing about stocks can identify best stock? It is a tough task, but I have an easy solution for it.
The solution lies within us.
Like we need to learn to ride a bicycle, we must also learn to estimate intrinsic value of stocks.
From my experience, I can say three things about intrinsic value estimation:
- First: Estimating an approximate intrinsic value of a stock can be done by anyone. No special skill is necessary.
- Second: The more one practices estimating intrinsic value, the accuracy improves.
- Third: It is better to believe in the intrinsic value estimated by self, rather than buying stocks on others advice.
I am sure these points are making sense, right?
So lets process and try to learn how to estimate free cash flow and intrinsic value of stocks…
What builds intrinsic value?
Before we get into the math part of intrinsic value, lets understand what are the steps involved in estimation of intrinsic value.
- Step #1: Calculate the present Free Cash Flow to Equity (FCFE).
- Step #2: Forecast FCFE growth rate for next one year.
- Step #3. Quantify your ‘expected return’ (say 5%, 8%, 12% etc).
- Step #4. Calculate intrinsic value.
A stock must show a positive free cash flow (FCFE). If the FCFE is positive, the stock may be a good buy. A negative free cash flow means, the stocks intrinsic value is negative. Not a good buy. Free cash flow formula is like this:
To estimate free cash flow, get the following form the specified financial reports:
- PAT: Open the ‘profit and loss account’. Note the numbers mentioned against ‘net profit after tax’.
- CAPEX: Open the ‘cash flow statement’. Go to ‘Cash flows from investing activities’. Note the numbers for ‘purchase and sale of capital assets’.
- D&A: Open the ‘profit and loss account’. Go to the section where all ‘expenses’ are listed. Note the numbers mentioned against ‘depreciation and amortisation’.
- Increase in Working Capital (WC): Open the ‘balance sheet’. Note current assets (CA) and current liabilities (CL). The formula for change in WC will be like this:
- Increase in CA = CA (Y2018) – CA Y(2017)
- Increase in CL = CL (Y2018) – CL (Y2017)
- Increase in WC = Increase in (CA – CL).
- New Debt: Open the ‘cash flow statement’. Go to ‘Cash flows from financing activities’. Note the numbers for ‘purchase and sale of capital assets’. Note the numbers mentioned against ‘Proceeds from borrowing’.
- Debt Repaid: Open the ‘cash flow statement’. Go to ‘Cash flows from financing activities’. Note the numbers for ‘purchase and sale of capital assets’. Note the numbers mentioned against ‘Repayment of borrowing’.
Gather these values in your excel sheet and calculate the free cash flow (FCFE) as indicated below:
Important points to note about best stocks with respect to free cash flow:
- FCFE must always be positive.
- If a company is in expansion mode, its Capital Expenditure (CAPEX) will be high. High CAPEX often leads to lower FCFE. But such companies will eventually yield higher FCFE in times to come. The waiting time for FCFE to become positive can be 3+ years.
- Sudden increase in CA (compared to CL) will also lead to lower FCFE.
- A company relying too much on “long term debt” (year after year for longer duration of time) for enhancing its FCFE is not a good sign.
- Good companies rely less on debt. Their major cash comes from PAT & provisions of D&A.
2. FCFE Growth
In the above step we have estimated the Free Cash Flow (FCFE) of a stock. Now we must estimate the expected rate at which the above FCFE will growth in next 1 year time (g).
There are two ways to do it, easy way and the difficult way.
- Easy way: Assume it to be as g = 5% p.a. Logic, in India the average inflation over a period of last 10 years is close to 7.5% per annum. Over a period of time, a good company will make sure that its Free Cash Flow (FCFE) must beat the inflation rate. But this will happen only in long term. In shorter time horizon (like next 1 year), assuming a smaller growth rate (less than inflation) is better. Hence I have settled for FCFE growth rate of g=5%. If you want, you can repeat the calculation for other g values like 3%, 6% etc.
- Difficult way: Calculate the FCFE for last 5 years. See the trend and then make a safe assumption. But I will suggest that, initially do not do it the difficult way. Downloading annual reports, searching data in the reports, preparing the excel sheet will take time. People do lose interest this way. Better approach for a beginner is to use the easy way first. Assume 5% FCFE growth (1Y) and move head. If after the calculation, the stock looks attractive, repeat the process using the difficult route.
3. Expected Returns (k)?
This step will be easy. But important Note: K must always be more than g. Here as will I will suggest you to use a rule of thumb (k= 8% per annum).
Logic, in a long time horizon (5+ years), Sensex/Nifty can grown at a rate of 12% p.a. But at present we are making an assumption for next 1 year only.
Hence a smaller rate of return (w.r.t. 12%) shall be assumed. Hence I have settled for rate of return of g=8%.
My suggestion will be to repeat the calculation with the following combination of “g & k” values:
4. Calculate Intrinsic Value
What we have in hand till now?
- FCFE Growth Rate for next 1 year (g)
- Expected Return for next 1 year (k)
With these values we can estimate the intrinsic value of any stock using a formula.What is the formula? It is called Gordon Growth Model formula.
Intrinsic value = Dividend / (k – g)
But in our case we have replaced Dividend with FCFE. This way our new formula looks like this:
Intrinsic Value = FCFE / (k – g)
What is the logic for this alternation? dividend paying companies, generally distributes their free cash flow as “dividend” to its share holders. But growth stocks retains their ‘free cash flow’ to fund future growth.
Examples of intrinsic value calculation:
5. Best stocks are undervalued
How to check if the above stocks are undervalued or not? Just follow the below 2 steps:
- Calculate IV/share (N): What is IV per share? Intrinsic value calculated in step four above converted to per share value. How to do it? Get the ‘number of shares outstanding’ of the company from its financial reports. IV/share = Intrinsic value / N.
- Compare: Compare the calculated IV/share with the current market price of the stock. If IV/share is more than current price, the stock is undervalued.
There are 5,000+ stocks currently trading in Indian stock market (BSE). Out of these, which are the best stocks? The answer is not easy. In fact, the answer is so unique that people who can find this answer, become millionaires.
We common men can find this answer? Yes it is possible. But we have to follow a procedure. We can use two basic screening criteria’s. This will help to identify best stocks among ordinary ones. What is this screening criteria?
When a person undertakes the process of intrinsic value estimation of a stock, he/she actually is following the above 2 screening criteria. How?
- Screen #1: Remove fundamentally weak stocks. How it is done? Only those stocks whose free cash flow is positive are fundamentally strong.
- Screen #2: Remove overvalued stocks. How this is done? Only those stocks whose market price is less than its intrinsic value per share are undervalued.
List of best stocks to buy in India in 2019
The table has been last updated on 09-May’2019.