First of all, let me be clear, there is no sure shot way in the world to pick the best stock. Yet, many of us fall in the trap of sly stock brokers or investment planners suggesting us to buy the next Apple. However, we can surely use a few techniques to figure out intrinsic value of a company. And that is a very strong indicator of how good the stock is. So let us look at the way to calculate intrinsic value of a company that will help you answer how to pick best stocks. The way to calculate intrinsic value that I explain below is something that I have learnt from another blog article by Mani on Getmoneyrich. In the last section, I shall summarize how I go about picking the best stocks.
What are good stocks?
There are two aspects that make a stock good: 1) Good business and 2) Undervalued stock price.
- Good business: What is a good business? There are many contributing factors like sector it is in, profit margin, competitive intensity etc. But the one factor which works as the best indicator is ‘free cash flow‘. A good business has high free cash flow.
- Undervalued stock price: This is simple enough. Think about a company which has intrinsic value per share of Rs. 1000 but its current market price is at Rs. 100 per share. Hence, this is an undervalued stock. We shall be primarily discussing how to figure out intrinsic value of the stock in this post.
Why is it difficult to identify the best stock?
I have only mentioned two of the several factors above to figure out how to pick best stocks. And I am sure you are already wondering how can I know what is the free cash flow and intrinsic value of a company. Is it easy to figure out?
It is definitely very hard to figure out the free cash flow and intrinsic value accurately. However, it is far easier to figure out an approximate intrinsic value. And that can be a helpful indicator when combined with other market knowledge (like sectoral growth, buy recommendations etc.). Remember if market price of stock is less than the intrinsic value, then it is a strong indicator that the stock could be a good buy. Of course, nothing is 100% accurate in stock market. But being better equipped increases our probability of success.
So, let us look at the key steps involved to figure out intrinsic value.
Steps involved to figure out intrinsic value
One of the most common method to figure out intrinsic value is the Discounted cash flow (DCF) model. Which is essentially figuring out how much money a company would generate in the future at today’s value. However, what we will be using is a hybrid of DCF and dividend discount model.
We will estimate intrinsic value in four steps:
- First step: Calculate present Free Cash Flow to Equity (FCFE)
- Second step: Forecast FCFE growth rate for the next year
- Third step: We would need to assume expected return
- Fourth step: Calculate intrinsic value of the company.
First step: Calculating FCFE
Before we calculate FCFE, only a stock that shows a positive FCFE is worth proceeding with to calculate intrinsic value. If FCFE is negative, then intrinsic value will also be negative.
Following is the formula for calculating FCFE, and don’t get overwhelmed I shall explain how to calculate each variable in the formula:
FCFE = PAT – [Net Capital expenditure] – [increase in working capital] + [net long term debt]
Here, PAT = Profit after tax. Net capital expenditure is capex – depreciation and amortisation. You might be wondering how to get these. The first thing you have to do is download the latest annual report of the company you are trying to figure these things out. Next up you would need to search for a few terms in the annual report as mentioned below:
Where to find different line items in the Annual report?
- PAT: You would find ‘PAT’ or ‘Profit After Tax’ in the ‘profit and loss account’ section. Note the numbers mentioned against ‘net profit after tax’ or something similar.
- CAPEX or Captial expenditure: You can find this in the cash flow statement. In that, you need to go to ‘Cash from from investing activities’. Not down values of ‘Purchase of capital assets’ and ‘Sale of capital assets’. CAPEX will be = Purchase of capital assets – sale of capital assets. Also, note that any or both of these values can be zero in an year and that is fine.
- Depreciation & Amortisation: Again go back to the profit and loss account section and note the numbers mentioned against ‘Depreciation and amortisation’.
- Increase in working capital: In the balance sheet, you would notice two sections namely, ‘Current Assets’ and ‘Current liabilities’. Below is the formula to calculate increase in working capital:
- Increase in current assets = Current assets (this financial year) – Current assets (last financial year)
- Increase in current liabilities = Current liabilities (this financial year) – Current liabilities (last financial year)
- And thus, increase in working capital = Increase in current assets – Increase in current liabilities
- New debt: In the ‘cash flow statement’, go to ‘cash flow from financing activities’. Note the number mentioned against ‘Proceeds from borrowing’.
- Debt repaid: Again, in the ‘cash flow statement’, go to ‘cash flow from financing activities’. Note the number mentioned against ‘Repayment of borrowing’.
Do note, if the FCFE of a company is positive only because of new debt, every year, then that is not a good sign. Additionally, when companies are expanding their CAPEX will be high and thus reducing FCFE. If it is a good company then it will lead to higher FCFE in times to come, keep monitoring it.
Example Excel calculation
Second step: Forecast FCFE growth rate (Fg)
As a next step, we have to estimate how much FCFE will grow next year. The ideal way is to calculate FCFE for last 5 years. See the trend to assume the growth rate for next year. However, it might be cumbersome to look at annual report of 5 years.
Hence, as a quick check you can assume that the growth rate is 5%. Reason being, traditionally inflation in India is around 6-7% and any good company in the long run would try to beat this. But in the short run assuming growth rate a percentage point or so lower than inflation is safe. You can also take multiple growth rates (like 3%, 4%, 6% etc.) and keep changing in the excel.
Third step: What is your expected return (Er)?
This is the return that you would expect in the next one year. Of course, in the long run in Indian equity market one can expect a return of 10-12% but in the short-term, next one year, it is safe to expect 7-8%. Let us say, our expected return is 8%. As we did for Fg, we can assume multiple expected returns like 6%, 8%, 10% etc. Do note, Er should always be greater than Fg.
You can take the following combinations of Fg and Er:
Fourth step: Calculate intrinsic value
One way to calculate intrinsic value is the Gordon Growth model. Which says:
Intrinsic value = Dividend/(Fg – Er)
Here, dividend is used as it is considered as the real earnings reaching the hands of investor.
In our hybrid approach we replace Dividend with FCFE, hence Intrinsic value = FCFE/(Fg-Er)
The reason to replace Dividend with FCFE is, that FCFE has two uses: one part can be used to pay dividends and other part can be reinvested in business for future growth.
Suppose FCFE was Rs. 1000 crore. Er was 5% and Fg was 8%. Then Intrinsic value = (1000/(8%-5%)) Crore = 33,333 crore.
But what to do with intrinsic value?
In order to figure out if the stock is undervalued or not, we see intrinsic value per share. One last time, you need to refer to the annual report and find ‘number of shares outstanding (n)’.
Hence intrinsic value per share = Intrinsic value/n
Now if intrinsic value per share > share price, then the stock is undervalued and can most likely be a ‘Buy’ candidate.
Summary: Steps I take to pick best stocks
- First – Look for recommendations online, CNBC, blogs of well known investors. Make a list of stock that have most buy recommendations.
- Second – Calculate intrinsic value per share of these stocks and compare if they are undervalued or overvalued. Remove all those stocks from considerations whose current price make them overvalued.
- Third – For the remaining, read about the specific sectors those companies operate in. Understand the sectoral outlook, other competitors and key differentiator of your selected company.
Basis these factors take a decision to pick the stocks. This is how to pick best stocks. Please share other ideas in comments below that you think are useful in picking the best stocks.