Jul 10, 2012|
Don't pay more than book value for these firms
How would you define a minimum expected rate of return? Well, there is no universally true answer for this. The number would mostly depend upon the inflation rate prevailing in a country. And also the asset class under consideration.
Source: Ace Equity, BSE 500 universe, standalone numbers
For e.g. a five percent return on an investment in India would be considered grossly inadequate by Indian investors. For it does not even cover the rise in inflation, that until recently was as high as 9%-10%.
However, the five percent return would be more than satisfactory for a person in the US where the official inflation figures are barely above 2%-3% or may be even less.
Secondly, a return of 10% on a bond investment in India can be considered good enough. But if the same return were expected of a stock, it would again be inadequate we believe.
Stocks are riskier than bonds and hence, to cover the extra risk, the expected returns should also be higher. Something in the range of 12%-15% will be more appropriate for stocks we believe.
This isn't a very complicated rule to follow, isn't it? But we routinely encounter cases in stock markets where people price stocks in such a way that returns expected of them end up being much lower than bonds.
Take the example of the firms in the table below. Assume for the sake of this article that your expected rate of return from a stock is 15%. Thus, what book value multiple would you be willing to give to a stock where ROE (Return on Equity) has averaged not more than 15% over the past five years? A maximum price to book value of 1x, isn't it?
* Price as on 6th July 2012
(Banks, holding companies and firms with negative numbers have been excluded)
Anything more than that and your effective returns will come down to less than 15%. Of course, one would argue that the higher multiple is justified because unlike bonds, earnings of a firm keep growing.
But this is a flawed assumption to make. Please bear in mind one of the most important tenets of investing. Growth in earnings is meaningful if and only if the return on equity of a firm is higher than the investor's expected rate of return. In other words, for firms those have a maximum ROE of not more than 15%, growth in earnings is not meaningful as the expected rate of return is also 15%.
Thus, the maximum price to book value multiple that one would be willing to pay such firms is at the most 1x. This is the case irrespective of the growth in earnings. Investors, like the ones invested in the companies mentioned above are making a grave mistake by assigning higher multiples to stocks where average RONW over the past five years has not exceeded 15%.
Of course, they would be under the delusion that RONW could go up going forward thus justifying their investments. But the effort of investing in companies that consistently earn ROEs above the returns expected of them, i.e. 15% in this case, is paid off much handsomely in the future we believe.
||Rahul Shah (Research Analyst), Managing Editor, Microcap Millionaires has led the team from the front in developing some of our most stringent and rewarding research processes. As per his own admission, the turning point in Rahul's life as a financial analyst came a few years back when he got introduced to the works of Warren Buffett and Charlie Munger. From Buffett, he understood the value of investing in good quality business with powerful moats and strong management teams. Charlie Munger on the other hand inspired him to be a lifelong learner and use mental models in order to arrive at the crux of matters across most disciplines. Rahul firmly believes that in order to be successful at investing, you have to do the big things right and possess a great temperament and a contrarian streak.
More Views on News
Jun 10, 2017
Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.
Aug 19, 2017
Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.
Aug 18, 2017
Buying the index now will hardly help make money in stocks even in ten years.
Aug 18, 2017
Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.
Aug 17, 2017
PersonalFN simplifies the mutual fund account statement for you.
More Views on News
Aug 7, 2017
The data tells us quite a different story from the one the government is trying to project.
Aug 10, 2017
Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.
Aug 8, 2017
Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...
Aug 12, 2017
The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.
Aug 7, 2017
Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...
Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement. LEGAL DISCLAIMER:
Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here
. The performance data quoted represents past performance and does not guarantee future results.SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.
Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: firstname.lastname@example.org. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407