How to get magical returns A simple formula, obtained by multiplying the PE and PB ratios, can help retail investors

shortlist stocks that are worth investing for the long term. NARENDRA NATHAN

After rallying briefly, the Indian stock market is on a downward spiral again. While this phase is likely to continue for the medium term, it offers investors a good long-term buying opportunity as the valuations have come down to the desired levels. Though the broader market is yet to reach the bear market valuations, several sectors and stocks have already hit rock bottom. It is these pockets of undervalued stocks that offer an opportunity to anyone who follows value investing. Value investing, however, is not easy because it involves an elaborate analysis to arrive at the intrinsic values of these stocks and then picking only the ones that are quoting at significant discounts to these values. This is because value investing doesn’t consider the current market price as a stock’s value. More importantly, value investors insist that the difference between the calculated value and current market price (also known as margin of safety) should be substantial. “The strategy should be to buy stocks that are quoting at 50-60% discounts to their intrinsic values,” says Raamdeo Agrawal, joint managing director, - Motilal Oswal Securities. Valuation ratios galore There are several ratios that can be used to identify stocks quoting at cheap valuations. These include price to earnings ratio (PE), price to book value ratio (PB), dividend yield, enterprise value to sales ratio, enterprise value to earnings before interest and tax (EBIT) ratio, etc. All these ratios are used under different circumstances and this is applicable even for the most commonly used ratios like PE and PB. For example, PE is a good indicator only for stocks with a relatively stable earnings stream, and PB is used where the company is

says a recent study conducted by EquityMaster. Will this multiple. it came to be known as Graham’s magic multiple.5. while the other shows that it is costly. the stocks with a lower multiple have significantly outperformed the stocks with a high multiple.reporting losses or the earnings stream is extremely volatile. therefore. As a value investor. He introduced a new multiple at a later stage to make life easy for investors who want to pick potential winners from a large number of stocks. Since this multiple combines the most important valuation ratios and gives a much clearer picture. Stocks worth considering . Magic multiple Graham spent decades analysing thousands of companies and documented the value investment framework. Since around 200 stocks from these 500 were listed in January 2002. which was introduced by Benjamin Graham. who is considered the father of value investing. This problem can be mitigated to an extent by using ‘magic multiple’. developed in a different set of circumstances. the universe of the study is restricted to these 200 stocks. he advised investors to concentrate only on stocks where the new multiple was less than 22.comamong the BSE-500 stocks. This means the biggest challenge faced by retail investors who want to practice value investing is to identify the most appropriate ratio. Graham was not comfortable investing in stocks where the PE ratio was more than 15 and PB ratio was more than 1. It also helps avoid the confusion when one ratio indicates that a stock is cheap. As is evident from the chart (see Impact of magic multiple).5 and. This multiple is arrived at by multiplying the two most commonly used valuation ratios. work in our market environment? Yes. PE and PB.

Bank of Baroda continued with its stellar performance in the second half of 2011-12 as well.Since there are several stocks whose magic multiple values are below 22. Bank of Baroda: Though the stock market is concerned about the health of all public sector banks at present. Its net profit during the quarter has grown by 14% on a y-o-y basis (compared to the second quarter of 2010-11) and 13% on a q-o-q basis (compared to the first quarter of 2011-12). we reached out to the market experts to select some stocks for you to consider. the company should have a decent size and some stock market activity. therefore. we considered only those stocks whose multiple value was less than 10. that is. the search universe is restricted only to the stocks that are part of either of the two broader indices—BSE-500 or S&P CNX 500. We also brought in additional filters. all loss-making companies and those with negative book values were automatically eliminated. To arrive at the magic multiple. Finally. First. So we decided to drop the stocks whose market capitalisation was less than 1. we decided to keep such companies.000 crore or whose average traded volume was less than 1 crore. This is possible because it could pass on the incremental cost of funds to borrowers in the domestic business and improve its net interest margin (NIM) to . we decided to restrict the selection. both PE and PB should be positive and. To make sure that the companies we shortlisted had good cash flows and had rewarded investors through dividends. Second.5 at present.

analyst.72.6%. The bank continues to grow in line with the industry average. with gross and net non-performing assets (NPA) of 1.” says Daljeet S Kohli. head of research. It has added 83 more branches in the second quarter.71 and PB ratio of 0.” says Kajal Gandhi.9% and net NPA is 1. respectively. “Bank of Baroda is expected to show a loan book growth of 25% in 2011-12. Maharashtra Seamless: With the company reporting lacklustre figures for the second quarter of 2011-12 as well.07%. The stock is currently quoting at a PE ratio of 3. the future looks bright. Bank of Baroda has an aggressive growth plan as well. Dena Bank: It has an 18% exposure to power sector (which is going through troubled times now) and the stock was beaten down recently for this. When a stock like this is quoting at cheap valuations.2%. especially considering the fact that it has been consistently reporting a return on assets of around 1% and return on equity of around 20% for the past 13 quarters. the bank has enough capital for its future growth. This consistent performance is despite the increased provisioning. With the capital adequacy ratio at 12. “The risk-reward ratio for Dena Bank is much more favourable now.13% in the first quarter of 2011-12). analysts continue to be bullish on it. This helped it increase its return on equity to 21% (up from 20% in the first quarter of 2011-12) and return on assets to 1. taking the total branch count to 3.” says Ankit Shah. that is the gross NPA is 1. its net profit in the second quarter grew by only 1% compared to that in the same period last year. So its valuation has reached a very low level. SPA Securities. Dena Bank has completed shifted all its accounts to the system-based NPA recognition method in the second quarter of 2011-12 and this should take care of a major concern about its uncertain asset quality. these are at manageable levels.492. This is because the high Brent crude oil prices have increased the interest in oil exploration and production.23% (up from 1.3. it is a steal. “Though the recent quarters have not been good due to higher raw material costs and taxes. banking analyst. ICICI Direct. thereby pushing the demand for seamless pipes. Though the shift has increased the NPAs slightly. its deposits grew by 20% y-oy and loans by 17%. This . India Nivesh Securities. While Maharashtra Seamless could post an impressive topline growth of 42%. However.41% and 0. the stock market has given it a thumbs down and this explains why it is quoting at such low valuations. The asset quality also remained almost stable.47%. an increase of 20 basis points on a q-o-q basis.

and domestic players are demanding it in India as well. has such low valuations. Its loan book should also continue to grow in the future because Power Finance Corp will be disbursing the loans sanctioned earlier. . Though the power sector is in trouble now. These longterm funding options will also help it to avoid any asset-liability mismatch. However. PFC plans to raise 16. market experts say the company needs to be regarded in a different light because it has been in this business for very long and has enough expertise to handle the situation. it is only natural that PFC. tax-saving infrastructure bonds and tax-free bonds in the domestic market. “We expect it to maintain its margins between 3.8%. says Kohli. Power Finance Corp: While the stock market is getting jittery with PSU banks that have an exposure to the power sector. Canada and Brazil are considering it.800 crore in the coming months through the issuance of medium term notes (MTN) in the international markets. the massive capacity addition of 1 lakh MW planned in the 12th five-year Plan is another factor that will push demand for steel pipes and tubes.” says Kohli.explains why the company reported continued export growth despite the global uncertainties.6% and 3. While China. This is another factor that will give a boost to Indian manufacturers like Maharashtra Seamless. These cheap sources of funding will help it maintain a spread in a high interest rate scenario like the present one. the US and Europe have already imposed antidumping duties on seamless pipes. with a 100% exposure to the power sector. “It is also prudent in getting resources.

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