Value Stocks at Fair Price: Avoid Overpaying Ever Again with this Simple Method!

Be it a veteran or a first-time investor, it is common sense that if you are buying a stock, you should obviously buy it at the lowest price possible.

Of course, a step before that is identifying a stock worthy of your hard-earned money. But while we know there are great companies out there like say, Tata group's Tata Consultancy Services (TCS) or HDFC Bank amongst others, does a good company necessarily mean a good investment?

No doubt, one of the prerequisites of any investment strategy is to buy the stock of a good company. However, a good company may be a bad stock to buy if it is bought at any price.

While it may be uber cool for a person to boast of buying a painting or vintage car by outbidding others, you would probably have never come across any individual who will go around beating his chest about buying a stock at its peak.

On the contrary, one will often hear investors, youtubers, financial gurus and the list goes on... talk about how they were able to identify a winner at rock bottom prices (even if it's a lie!)

Let's be honest... no one ever wants to admit they overpaid for anything. Last week, I hated to admit to my wife that I overpaid for a kg of apples!

But yet, every investor at some point in their life will surely end up overpaying for a stock.

Personally, I have done it more times than I can count and while I am hoping that with age, I'd become wiser, in the mean time there is the next best thing - using a method to actually figure out what a stock is worth.

And before you go about saying that I am just talking through my hat, this method was not 'created' or 'invented' by me.

Rather, it is a method prescribed by the American investor, Philip Town in his best-selling book - Rule #1: The Simple Strategy for Successful Investing in Only 15 Minutes a Week! - published in 2006.

Ever since, I came across this method, I often use it to value stocks and I like to believe that it has helped me avoid a lot of pain in the markets.

But do remember, this is not a trading strategy or a quick tip for making short term money. The method is strictly for long term investors looking for good quality stocks at reasonable valuations.

So, let's dive in to find out more about this method and use it to derive the fair value of a popular Indian stock as an example.

What is Rule #1

Before we talk about Town's method, lets briefly understand what Town's Rule #1 is about.

Rule #1 is an investment strategy that involves finding high-quality companies trading at a discount to their intrinsic value and investing in them for the long term.

It's based on the idea that the best way to invest is to focus on the fundamentals of a company, rather than on short-term market trends or speculation.

The strategy involves identifying companies with a competitive advantage that will protect them from competitors over the long term.

These companies should have a predictable and consistent business model, strong financials, and a history of increasing earnings over time.

Town believes that diversification ruins investor returns.

Hence, he suggests that investors identify a few good businesses, analyse them using this simple method and invest into these companies instead of diversifying unnecessarily in multiple businesses.

Once these companies are identified, the investor should determine their intrinsic value, or the true value of the company based on its financials and potential for growth.

If the current market price of the company is below its intrinsic value, the investor could consider buying shares in the company.

The idea is that the market will eventually recognize the true value of the company, and the stock price will increase accordingly.

Using Rule #1 to Calculate the Intrinsic Value of HDFC Bank

For the purpose of this exercise, we decided to pick a blue-chip company, HDFC Bank which has over the years proven its mettle.

For this method, there are five inputs required to be calculated as shown in the table below -

Earnings Per Share (EPS TTM)

Growth Rate %

Minimum Return on Investment %

Future P/E

Margin of Safety %

As per Town's method, Rule #1, we start off by taking the EPS TTM (Earnings per share for trailing 12 months period) for HDFC Bank.

Earnings per share or EPS is an important financial measure, which indicates the profitability of a company. It is calculated by dividing the company's net income with its total number of outstanding shares.

So, essentially, we need to know how much has HDFC Bank earned over the last 12 months per share. We can get that information from any credible financial website like say the Equitymaster's Screener.

The EPS of HDFC Bank as per the website is Rs 78.8.

Next, is the tricky part. We need to enter the growth rate that's expected of HDFC Bank for the next few years.

As per Town, he says you can either use the past 10 years equity growth rate or use current analysts estimates, whichever is lower.

As an investor, one can always modify such inputs as what may make sense to one might not to another or one could be more bullish on prospects of a particular company or sector as compared to another investor.

Considering this is a variable that requires some kind of prediction, I like to use a slightly modified version of it.

First, I use the historical data to calculate the rate that the company has grown over the last 10 years.

Next, I try and find the company's earnings call transcripts or interviews of top honchos of the company to determine if the management has provided some kind of guidance for the next few quarters or years ahead.

And finally, I also look up estimates provided by analysts, although I don't particularly place too much importance to it. Rather, it's an additional step to check if there is a very big variance between their estimates and my calculations.

For our example of HDFC Bank, let's start with the first step - using the historical equity growth rate, which on a per share basis is the book value per share.

HDFC BANK BOOK VALUE PER SHARE (In Rupees)
Year	2013	2014	2015	2016	2017	2018	2019	2020	2021	2022
Book Value Per Share	154.0	184.1	252.0	293.9	358.2	422.3	564.3	321.6	380.6	446.0
Growth % in Book Value	N.A.	19.5%	36.9%	16.6%	21.9%	17.9%	33.6%	-43.0%	18.3%	17.2%
	AVERAGE BOOK VALUE PER SHARE- 15.4%

Source: Equitymaster

If we take the average growth rate in book value per share for the 10-year period, we arrive at a figure of 15.4%.

Now, for anyone who has been tracking HDFC Bank, it is a well-known fact that the company has been able to grow consistently over the years to become India's largest private sector bank by assets.

If one was to go back and see, between 2000 and 2010, the bank used to grow at a compounded annual growth rate (CAGR) of 25% which over the years has reduced to around 15-18% as the bank has become bigger and bigger.

This is normal for any company as the phenomenon is called 'The Law of Large Numbers."

In an interview last year, Sashidhar Jagdishan, CEO of HDFC Bank had mentioned that he expects a growth rate of 18-20% and profits almost doubling to US$15 billion in 5 years after the merger with HDFC Ltd.

And if one was to look at analyst estimates, it is in line with the above. The average growth estimate by analysts for the next 5 years is 19.9%.

But, while the merger may bring in many positives for the bank, let's be conservative as always and assume that as an even larger entity post the merger, the growth could possibly moderate going forward.

Hence, I am going to assume a growth rate of 13% instead of the historical average of 15.4% and management / analyst estimates of 18-20%

One thing to note here is that this method of valuation would work only with stable companies with a strong track record of growth and profitability.

This would not be the right way to value a cyclical stock or a high growth business as there is a calculated assumption being made and hence, there is room for error.

The next step in the method is entering a minimum rate of return. Town suggests that we use 15%

Currently, debt investments such as AAA rated fixed deposits generate an assured return of 7.5% to 9% return.

Hence, as an equity investor, if one is taking a risk with his or her capital, a minimum return rate of 15% would seem reasonable.

So, we are going to use the same rate as prescribed by Town, i.e., 15% as the minimum rate of return.

The next input for our calculation is the future P/E ratio. For this, Town suggests that investors should simply double the future growth rate that we got earlier, or one can use the five-year average PE that the company has had in the last five years.

If we double the growth rate of 13% that we estimated earlier, we would have a future P/E of 26%.

HDFC BANK - PE Ratio (x)
2018	2019	2020	2021	2022	Average 5 Year PE
24.1	25.7	20.6	21.3	22.0	22.7

Source: Equitymaster

On the other hand, if we were to look at the historical PE ratios of HDFC Bank for the last 5 years, the average 5 Year PE is 22.7%.

Again, being a conservative investor, I am going to take the lower number, i.e., 22.7% as the future PE for our calculation.

The final input used to calculate the fair value of a stock using this method is what Phil Town calls the Margin of Safety.

Warren Buffet once said, "The 3 most important words in investing are margin of safety."

What it simply means is always pay less than the actual value of something.

The Margin of Safety is the discount rate you can buy a good business at as an investor. Town suggests we use 50% off the fair value of the company's share price, once we derive it.

In our case, we are going to stick to 50% as the margin of safety for HDFC Bank.

Hence, once we work out the fair price of the stock, we are going to discount it by 50% so that it offers us great protection in case of a downside, simply because it means we would be buying something that we think is worth Rs 100 for just Rs 50.

And on the other hand, when prices move higher, our return on investment would be much greater as we would have purchased the stock at half its intrinsic value.

Alright, now that we have all the inputs, lets summarise it in the table below and then derive the fair price for HDFC bank, at which investors could consider the stock.

HDFC Bank Ltd
EPS TTM (In Rupees)	78.8
Growth Rate	13.0%
Minimum Return on Investment	15.0%
Future P/E	22.7
Margin of Safety	50.00%

Source: Equitymaster

Now, the first step to calculate the value is forecasting the EPS for the next 10 years. We have the current figure, i.e., the EPS TTM which is Rs 78.8.

Assuming our growth rate of 13%, i.e., if HDFC Bank continues to grow at 13% per annum, then the EPS would grow from Rs 78.8 in 2023 to Rs 236.7 in 2032.

2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
78.8	89.0	100.6	113.7	128.4	145.1	164.0	185.3	209.4	236.7

Source: Equitymaster

With this future EPS figure, we can now plug in the future P/E number, which is 22.7 according to our table.

So, if HDFC Bank has an EPS of 236.7 in 2032 and the market is willing to pay a PE of 22.7, it simply means investors are ready to pay 22.7 times for every rupee earned by HDFC Bank.

Hence, as per this logic, the share price of HDFC Bank should be Rs 5,373 per share (Rs 236.7*22.7) in 2032.

Now that we have figured out the future value of HDFC Bank, we can calculate backwards to find out what is the right price to pay for the stock currently.

For this, we use our input, the minimum return on investment (ROI). As per our table, we had decided on a minimum ROI of 15%, which means that if I invest in any stock or in this case, HDFC Bank, I need to make a minimum ROI of 15% per annum.

Hence, calculating backwards, I will reduce the future share price of HDFC Bank, i.e., Rs 5,373 by 15% and then each consecutive figure every year all the way back to the present year.

Doing this, I arrive at a fair value of Rs 1,527 per share of HDFC Bank as on today as against the current market price of Rs 1,684 per share.

Hence, as per this method, HDFC Bank is currently overvalued by about 10%.

However, there is still one last step to Town's Rule # 1 method, the margin of safety.

As a value investor, one would want to purchase stocks at a discount to the fair price. So, using the 50% margin, it means that the best price to buy HDFC Bank shares would be at Rs 763.

This means that at the rate of Rs 763, the stock would be extremely attractive with very limited downside risk and a huge potential for significant return on investment.

Again, this can be modified as per an investor's view on a particular sector or stock. For instance, I may be comfortable with only a 25% margin of safety, meaning I could be very interested in the stock at levels of Rs 1,145.

There you have it... Now you too can find the fair price of any stock using the Rule # 1 method.

Overall, the Rule #1 strategy emphasizes the importance of patience, discipline, and a focus on the long term. It requires careful research and analysis of companies and their financials, as well as a willingness to wait for the right investment opportunities to come along.

Conclusion

Phil Town's Rule #1 investment strategy is only one of many such methods to value a stock and find a potential winner.

While the strategy has its advantages, there are also some potential flaws to consider.

One of the key components of the Rule #1 strategy is determining a company's intrinsic value. However, this can be a challenging task, as it requires making assumptions about the company's future earnings and growth potential.

If the intrinsic value estimate is incorrect, it could lead to overpaying for a stock, resulting in lower returns or even losses.

Further, this approach can be challenging for investors who may not have the time or expertise to conduct thorough research on individual companies.

Finally, the strategy assumes that the market will eventually recognize the true value of a company, but this may not always be the case. Market volatility and unpredictable events can impact stock prices and company valuations, which could lead to unexpected losses.

As always, it's crucial to conduct your due diligence before making any investment decisions. Despite the favourable outlook, don't overlook the significance of sustained research.

Investing your hard-earned money should not be taken lightly, so make sure to conduct thorough research before making any commitments.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...