Indian Share Market | What a long term investor must check in stocks before buying it.

Which are the best stocks currently trading in the stock market? How to evaluate the future potential of such stocks?

In this blog post, we will discuss what a long term investor must check in stocks before buying it.

1. WHICH ARE BEST STOCKS?

Best stocks are ones, which represent a “good business”, and are also available at “undervalued price” levels for investing.

• Good business: Which is good business? There can be several contributing factors, but what works best is ‘free cash flow’. Read about blue chip stocks.
• Undervalued Price: What is undervalued price? For this one must know the ‘intrinsic value’ of a stock. When market price less than its intrinsic value, stock is undervalued. Read about low PE stocks.

A good business will always generate high free cash flows. High free cash flow will eventually lead to high intrinsic value. Check free cash flow based calculator.

When intrinsic value is high, there are more chances to find it at undervalued price levels.

So what is the takeaway from here? Look for stock with high free cash (FCF).

See how good business builds its intrinsic value (use MS Excel to estimate intrinsic value)

2. WHICH ARE UNDERVALUED STOCKS?

Suppose a stock is trading at a market price of Rs.100/share. Upon estimation, its intrinsic value comes out to be Rs.120/share.

As market Price is less than intrinsic value, stock is said to be undervalued.

To identify best stocks, the essential ingredients are the following:

• Free cash Flow (FCF), and
• Intrinsic Value (IV). Read more on IV formula.

How to identify best stock? FCF will help you to estimate IV.

Then one can compare the current market price with its estimated intrinsic value to check undervaluation. Read more on undervalued stocks.

3. COMPLICATION TO IDENTIFY BEST STOCKS

It is not possible to accurately 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 financial 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 a solution for it.

4. THE ULTIMATE SOLUTION

Why I’m calling it ultimate? Because the solution lies within us. How?

Learn to estimate intrinsic value of stocks by self.

From my experience, I can say three things about intrinsic value estimation:

• First: Estimating an approximate intrinsic value of stocks 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?

But some might say that estimating intrinsic value estimation is tough – how to learn it?

This is where my stock analysis worksheet can be helpful. How? You can actually see for yourself the financial reports data being converted into intrinsic value.

Reading this article, and using my excel worksheet can give huge clarity about intrinsic value estimation even to a novice.

A few days of practice can clear a lot of cloud about intrinsic value.

So lets process and try to learn how to estimate free cash flow and intrinsic value of stocks…

5. WHAT BUILDS INTRINSIC VALUE?

Before we get into the math part of intrinsic value, let’s understand what are the steps involved in estimation of intrinsic value.

There are several methods of estimating intrinsic value of stocks. One of the most reliable method is discounted cash flow model (DCF). You can read this post to know more about it.

But here what I will show you is a hybrid method of “dividend discount model’ and DCF.

In this hybrid model, there are three steps which ultimates helps us to build the intrinsic value:

• Step #1 (FCFE): Calculate the present Free Cash Flow to Equity (FCFE).
• Step #2 (FCFE Growth): Forecast FCFE growth rate for next one year.
• Step #3 (Expected Return). Quantify your ‘expected return’ (say 5%, 8%, 12% etc).
• Step #4. Calculate intrinsic value. 

5.1 HOW TO ESTIMATE FREE CASH FLOW (FCFE)

A stock must show a positive free cash flow (FCFE). If not, then its intrinsic value will also go in negative.

Only if the FCFE is positive, the stock may stand a chance to become undervalued.

How to estimate free cash flow? Free cash flow formula is like this:

To estimate free cash flow, get the following values from the company’s 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:
  • CA (Increase) = CA (Y2018) – CA Y(2017)
  • SL (Increase) = CL (Y2018) – CL (Y2017)
  • WC (Increase) = 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.

Note the ‘Formula‘ column. This way, one can arrive at ‘free cash flow‘ numbers for a stock.

5.2. HOW TO ESTIMATE FCFE GROWTH (G)?

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 grow 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 5% (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 we can settle 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 go the difficult way. Downloading annual reports, searching data in the reports, preparing the excel sheet will take time. If you afraid of losing the interest, begin with the easy way. If after the calculation, the stock looks attractive, repeat the process using the difficult route. Another option can be, use my stock analysis worksheet.

5.3 WHAT SHOULD BE THE EXPECTED RETURNS (K)?

This step will be easy.

But important Note: K must always be more than g. Here as well, 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:

5.3 WHAT SHOULD BE THE EXPECTED RETURNS (K)?

This step will be easy.

But important Note: K must always be more than g. Here as well, 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:

	1	2	3	4	5
g	3%	5%	7%	9%	12%
k	6%	8%	10%	12%	15%

5.4 CALCULATION OF INTRINSIC VALUE

What we have in hand till now?

• FCFE.
• 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. 

Intrinsic value = Dividend / (k – g)

But in our hybrid formula, 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?

In the Gordon Growth Model, dividend is taken in consideration as its ‘real earnings’ reaching the hands of investors. In other words, it is the dividends which is creating real value for the shareholders.

The real value generator (dividend) in turn is determining the intrinsic value of the stock.

Similarly, free cash flow has powers to create real value for the shareholders. How? In two ways:

• One: A part of FCF can be used to pay dividends to the shareholders.
• Two: Another part can be reinvested back into the business to fund future growth (resulting in capital appreciation).

The real value generator (FCF) in turn is determining the intrinsic value of the stock (using the hybrid formula)

Examples of intrinsic value calculation:

6. BEST STOCKS ARE UNDERVALUED

How to check if the above stocks are undervalued or not? Just follow the below 2 steps:

1. Calculate IV/share (N): What is IV per share? Intrinsic value 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.
2. 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.

Now matter how strong is the underlying business, a stock cannot become a good buy till its market price is ‘undervalued’.

7. NECESSITY OF STOCK ANALYSIS

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 have 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 people undertake the process of intrinsic value estimation of a stock, they are actually following these 2 screening criteria:

• 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.