Low Price Shares

SHARDENDU PRAKASH

PGPSM(2017-18)-NISM(SEBI)
SECURITIES MARKET PROFESSIONAL

"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful." - Warren Buffett

So how find good low-price shares?

We all want to buy “low price shares”. But such shares must also be of a “good” company, What is a good company.? Which has strong business fundamentals. 

Low price shares of a “bad” company will be detrimental to our investment portfolio. If you are one who is building your investment portfolio from scratch, must know how to avoid stocks of bad companies.

No matter how low is the price , if the underlying company is bad, such shares are worth avoiding. In stock investing it is important to define ‘low price’.

General understanding is, Rs.100 is greater than Rs.50, right? But it can be different in case of stock investing.

Example: A stock which is trading at Rs.100 can be cheaper than a stock trading at Rs 50. 

How this is possible? It is a violation of the theory of mathematics, right? But this is what makes stock investing so interesting.

The puzzle of “low price” becomes even more interesting while dealing with penny stocks. Penny stocks are already low priced, but the bigger question is, are they also “good”?

What will make penny stocks good for investing? Their strong underlying business. 

There shall be one more filter here. What is it? The stock must also be undervalued. 

An undervalued share, of a good company, trading at “low price per share”, automatically becomes a good buy. 

Low price per share…

Why I am giving emphasis to “low price per share”? Because a high price per share of a stock may make it unreachable for common men. 

Lets see examples of few high price share of few Indian stocks:

• MRF Ltd: Rs.57,050 per share.
• Page Ind: Rs.22,218 per share. 
• Eicher: Rs.19,918 per share.

Even if these stocks represent great companies, may be they are trading at undervalued price levels, still less people can afford to buy even one share of them.

Why it is so? Because of their high current market price per share. They may be undervalued, but still unaffordable for a normal retail investor. 

To identify good shares to buy, we must use the following 3 filters:

• Filter #1: Low market price.
• Filter #2: Strong underlying Business.
• Filter #3: Undervalued price.

How to know if the stock has “strong underlying business”?

Let me rephrase my question. How to know if a business is good or not?

From point of view of investors, following will highlight if a business is good or not:

#1. Sales: Sales is growing fast enough? How to know?

Check last 5 years sales data in Profit & Loss Account. Then calculate sales growth rate (5Y-CAGR).

Sales growth matching inflation rate is considered moderate.

#2. Profit: Profit is growing fast enough? How to know? 

Check last 5 years net profit (PAT) data in Profit & Loss Account. Then calculate PAT growth rate (5Y-CAGR).

PAT growth matching inflation rate is considered good.

#3. EPS: EPS is growing fast enough? How to know?

Check last 5 years EPS data in Profit & Loss Account. Then calculate EPS growth rate (5Y-CAGR).

EPS growth more than inflation rate is considered great.

#3. ROE: Is the company profitable enough for its investors? How to know?

Check its ROE history, and if it is growing or not.

First, calculate the ROE ( = PAT / Net Worth).

A good company will either maintain its ROE, or improve it, over a period of time. 

Calculate last 5 years ROE. Then calculate ROE growth rate (5Y-CAGR).

Even if the ROE has increased marginally, it is outstanding.

#4. Debt: Is the company relying too much on debt? How to know it?

Check its Debt/Equity ratio history, and if it is growing or not.

First, calculate the Debt/Equity ratio ( = Debt / Net Worth).

A good company will keep reducing its debt dependency over time. It means, with time, its Debt/Equity ratio shall fall. 

Calculate last 5 years D/E ratio. Then calculate D/E growth rate (5Y-CAGR).

D/E growth in negative means, the company is doing good.

How to know if the stock’s price is undervalued or not?

We can use three financial ratios which will highlight if the current price of stock is undervalued or not.

Which are the financial ratios I am talking about?

• P/E ratio.
• PEG ratio.
• Dividend Yield.

#1. P/E ratio: This is price to earning ratio. 

P/E ratio can be calculated by this formula ( =Price / EPS). 

Calculating P/E ratio is easy. But I will suggest a better trick here. 

Calculate last 5 years P/E ratio and plot a curve. How to do it? Prepare this table first. 

Year	Price (P)	EPS (E)	P/E
Mar 18	934.80	45.17	20.70
Mar 17	1,028.65	44.13	23.31
Mar 16	380.90	32.55	11.70
Mar 15	325.50	20.35	16.00
Mar 14	130.75	21.74	6.01

If the P/E ratio is above 15, this is first sign of the stock being overvalued.  But better will be to compare the stocks P/E with its competitors P/E. 

The second check point in PE will be to check the PE trend in last 5 years.

How to check PE trend? By plotting the PE curve as shown above.

If P/E is only growing, it is hinting at overvaluation. While a falling P/E will hint towards undervaluation.

#2. PEG ratio: This is ratio between PE and “stock’s potential future growth rate“.

P/E ratio can be calculated by this formula ( =PE / EPS growth rate).

PEG is a very useful financial ratio for estimating price valuation of a stock. 

PEG less than 1, is a sign that the stock is undervalued.

It is always better to use P/E and PEG ratio together. Why?

• A stock with high PE, but low PEG (<1) is good. 
• A stock with low PE, but high PEG (>1) is not good. 

#3. Dividend Yield (DY): This is the ratio between dividend per share and price. 

DY ratio can be calculated by this formula ( = Dividend per share / price).

Dividend yield is a very reliable “value indicator“. Why?

Because a stock which will pass this test, will be undervalued for sure. 

How to do  this analysis? Again we will rely on a 5 years trend, instead of one year data.

Calculate last 5 years dividend yield, and plot a curve. How to do it? Prepare this table.

Year	Price	Dividend Per Share	Dividend Yield
Mar 18	934.80	15.5	1.66%
Mar 17	1,028.65	15	1.46%
Mar 16	380.90	10	2.63%
Mar 15	325.50	7	2.15%
Mar 14	130.75	7.5	5.74%

I personally consider a share yielding dividend more than 3%, as undervalued. 

But one must not reach this conclusion by seeing only one year data.

Better is to try and forecast the trend of dividend yield for next 3-4 years. How to do it?

Use last five years data and plot a curve.

The trend in last 5 years curve, will help to extrapolate the dividend yield trend in next 3-4 years.

Falling dividend yield is a sign that the share price is moving towards overvaluation. 

But falling dividend yield can also be due to falling “dividend per share” issued by the company. 

But in this case, “dividend per share” in last five years has more than doubled (see above table). 

What does it mean?

Dividend per share has increased, but still dividend yield has fallen from 5.74% to 1.66% in 5 years.

Moreover, as the present yield is below 3%, hence as per my assumption, this stocks looks overvalued. 

But it must also be noted that, no method is more certain to quantify share price as overvalued / undervalued, than calculation of intrinsic value.

I use my stock analysis worksheet to estimate intrinsic value of my stocks. 

Conclusion…

As an investor, one must buy only good stocks. Good stocks are one whose market price is low and also undervalued. 

The stocks underlying business should also be strong.

"Wide diversification is only required when investors do not understand what they are doing." - Warren Buffett

THANK YOU