Value investing for layman - Part 1

Value pick, valuation gaps, fundamental analysis, etc. So many words for finding investment stocks. Many times I hear people saying that company is fundamentally strong, or good ratios. But if I ask u what should be good for you if you wanna buy shares for earning??? Of course its stock for which there is potential to rise. Stocks for which value is not yet realized. Such stocks where people are not yet buying aggressively to take it to new highs or rather stagnant and range bound for long time or in downtrend. I call them sleeping tigers. I have the habit of finding such stocks which are not yet in focus but soon it will be in news or people will buy in madness. 

People are scared about fundamental analysis as they think they are poor in understanding balance sheet, income statement, etc. But layman can adopt basic things to identify their own value picks without much knowing finance terms. One can easily understand what is net profit, operating profit margin, sales, etc. This much basics are okay. First let us understand basics terms in this session required for analysis. Then in next session, we will switch to method of finding stocks for investment. 

Brush up on basic Sales related terms:

Don't consider sell of scraps, or income from rent/lease to the company or even income from investments. Sales consider revenue from core business for which the company is established. Rest just comes under other incomes. So beware when company posting huge profit but major portion is other income. Example as follows

Suzlon

Just check June 2015 quarter results

Sales                     -         2605.81

Expenses                -        2415.46

operating profit        -        227.62

so operating profit margin (OPM) comes out to 

227.62 divide by 2605.81 multiplied by 100 equals 8.74%

layman generally have the habit of calculating profit divide by cost/expense. but let me clarify here that profit divide by cost is return on investment or profit percentage. to calculate profit margin, we need to check how much margin is there for company of sales value, that's why checking OPM is important.

But if you check net profit, it is shown as 1047.41 because net profit also includes 1329.83. 

Suzlon’s return to profitability in the quarter ended June 30, 2015, is attributed to a windfall gain of about INR 13.14 billion related to its disposal of German sector player Senvion to Centerbridge Partners LP. The Indian group noted that the particular transaction was completed at the end of April 2015, which means that its consolidated financial results for Q1 fiscal 2015/16 are not comparable with the prior period presented.

so if we deduct other income from net profit to remove the effect of windfall gains, we get net loss. But market actually cheered this huge net profit after this result was out without even noticing this other income concept and many retail investors might have got trapped by buying it at higher price and waiting for that price to come again. 

Sales is steady but net profit showed huge growth. Reason was other income. Common people tend to see net profits growth directly and specially when they have stock in study in their portfolio. It makes person biased and they see only positive things. But we should be  cautious enough as other income surge is not good sign as its not sustainable. It generally implies windfall gains. Our main focus should be how much company is earning with its core business which is showed only in sales heading.

OPM also called as operating profit margin denotes how efficiently company is working. To know what percentage OPM is good , we should have idea of business. You may also see OPM more than 100% which is practically impossible. But its just accounting method. Here a person should just focus on how company is earning money and what is ideal OPM. It may happen that other companies in that industry are having more OPM and stock under study is having less OPM then our stock under study is not good. It may be improving its profit margin quarter on quarter, maybe company is in expansion mode or any constructive reason. One can take efforts to find the reason. Thumb rule is don't just stick to numbers on financial statements. Try to built story as what company might be doing and how company might be utilizing its resources. It doesn't need big shot finance knowledge. A person can just select stock of the industry he understands better. And check whatever company has published on financial statements is in sync with what information is available to you???

Bottom line is select the stock from the business a person understands better. Try to built the company story with available numbers. How to use this will be explained in further write ups. 2 most important technical that I would like to elaborate here are PE and EPS

PE and EPS at glance

EPS is earnings per share. It indicates how much a company is earning for shareholders. Like 10 EPS is company is earning 10 Rs for each share after paying all expenses and taxes. Even dividend issued will reduce EPS as its an outflow for the company and that much amount has already been realised to the shareholders. Its like earlier it was 10 EPS. Means company should pay 10 Rs to each shareholders per share. But it pays only 1 Rs as dividend and retains 9 Rs for business. So revised EPS should be 9. This should actually reduce the stock price as EPS is considered in final stock value. So whenever you focus on financial statement, focus on EPS growth rather than net profit. And observe reason for EPS growth if its because of core sales or other income. 

Next very common term being discussed is PE. You may find many people discussing low PE stocks. There are few amateurs who always focus low PE stocks as undervalued stocks. But remember, Nifty with 22 PE was recently said to be overbought. Same Nifty at 22 PE was said to be oversold just 4 months back. So PE is actually a matter of perception of investors to be considered overbought or oversold. PE is simply price per earnings

It simply means how much price you are ready to pay to earn 1 Rs in that company. Like 20 PE indicates, an investor is paying 20 Rs to earn just 1 Rs from that company. It may look strange but its a fact. Why should we pay higher price to earn lower money. So basically it just denotes expectations. Expectations that company earning 1 Rs today will earn 20 Rs in future. It is only the expectations of the people from the company that makes stocks move up and down. Technical analysis call this demand and supply. If stock is expected to earn more in future then it will be in demand and price will surge. Bear in mind that EPS remains constant unless company has declared fresh results. Once results are out, new EPS will be considered and that should factor in stock price. One may think this as a simple trading opportunity. But experienced traders might have observed that results are mostly factored in stock price before it is out. Or many cases when results are outstanding, stock locks in upper ciruict with no sellers or vice versa with bad results. So nothing comes easy

People always compare company PE with industry PE or with PE of other companies. And many layman considers it as valuation gap for investment. But one should bear in mind that people should consider PE only as future expectations of earnings. Let me give 1 classic example

Experienced investors might have seen rally of kitex. It quadrupled ( 250 to 1000) within just 1 year. Kitex was trading around 20 PE when it was 250. In that case, kitex should have been considered fairly priced. But still it made excellent rally in a year to make it 4 digits stock. Suddenly what could have happened that even with 20 PE, kitex rallied to give 300% returns. If one goes through company presentations or google few analyst coverage or report then it can be found that Kitex has planned for expanding its capacity to double their sales with just 20% increase in cost. Now doubling the sales means doubling the earnings. But without much increase in cost means improvement in profitability thereby more than triple increase in net profits. So this statement from management increased its earnings expectations, which ultimately reflected in stock price. But today financial statements indicates sales are not doubled but 70-80% surge in 2 years with increase on OPM from 20% to approx 34%. It means management really took efforts in increasing their sales while making sure not to increase their cost proportionately. But couldnt achieve their target as promised. So even if for a layman, results are consistently good, it is not as per expectations for which, stock price took rally from 200 levels to 4 digits. And stock price fall which is now trading below 700 Rs. Many people are curius about stock price behaviour after results. Its  difficult for layman to understand that why stock fall inspite of good results and why stock surged inspite of bad results. So they should just keep in mind that company performance is already discounted. So again bottom line is that stock price is the factor of expectations which is indicated by PE. So many investors have basic question like why few stocks are trading at high PE or few trading at low PE. So i guess they might have got answer. 

Kitex is a past story. Now its obvious to know that readers are curious to know upcoming story. Its simple now. Just keep surfing through management commetries on their company performance. And also test the credibility of management commitments from their past performance. If you feel that management does what they says and they have made bullish statement on their growth then grab it for long term. 1 stock that I can suggest will be Vakrangee. I am personally invested in Vakrangee long back when it was trading at 132. I grabbed it because promoters are increasing there stakes and it was sleeping tiger since long. Management had set their vision upto 2020 and are aggressively approaching to complete their targets on time. recent announcement of strategic alliance in Ricoh India will improve their network and help vakrangee to achieve sales growth of 30-35% CAGR for next 5 years. Those who want to understand importance of 30-35% CAGR, they should divide 72 by 30 to see in how much time frame will the sales double.

72/30=2.4

Means sales will double in max 2 years 5 months as per company expectations. 

Now thinking about cost??? Of course doubling the sales requires expense to be proportional. But let's understand vakrangee business model. If you open their website, you will see invitation of franchise and amazon advert on top(vakrangee also have strategic tie up with amazon). Right now vakrangee is aggressively focussing on selling franchise. For franchise they are asking franchise owner to invest and vakrangee will give all back office support. For these support, vakrangee will get 20% share of the revenue earned by franchise. Now back office already exists. Infrastructure is already set up. Apparently Vakrangee don't need to put up additional cost for these revenue growth. Rather more the franchise, more will be the cash inflow without marginally increasing the cost. Sounds like kitex situation??? Kitex vision was just for for 1-2 year and vakrangees vision is for 5 years. Do your own research before investing and reading these numbers. 

A glance at CAGR

CAGR stands for compounded annual growth rate. Means 100 Rs invested today at 10% CAGR will increase as follows

1st year      110

2nd year     121 (10% increase over 110)

3rd year      133.1 (10% increase over 121)

4th year      146.41(10% increase over 133.1)

5th Year      161.051(10% increase over 146.41)

6th Year      177.1561(10% increase over 161.051)

7th Year      194.87(10% increase over 177.1561)

and so on.

Now its easy for us to understand that, with simple interest, money doubles in 10 years with 10% rate. but it takes only 7 years and few days to double with 10% CAGR. Now applying formula of 72. 

72 divide by 10 equals 7.2. 

so, instead of calculating, when our money will get double with defined rate, we can directly find out dividing 72 by our expected CAGR. That's the magic of compounding and number 72.

Finally combining EPS and PE

EPS multiplied by PE gives current market stock price. 

EPS X PE = CMP

As discussed before, EPS will be constant till fresh EPS out with results and PE changes according to stock price.

Hope I am able to explain basic points with investing point of view. This terms may not be new to investors traders or even layman who never traded. But my aim was to make readers think same term with respect to value investing. This session was just introduction to the basics of terms. In next part, will introduce you one method by which you can select which stocks to select for investment. 

I call them sleeping tigers