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Does your stock measure up? - Views on News from Equitymaster
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  • Nov 10, 2005

    Does your stock measure up?

    The markets appear as strong as ever, again. Despite the October month fall, which saw the Sensex lose over 1,100-points from its all-time high of 8,800+ (nearly 13%), in November, the up trend appears to have resumed. At the current levels, the Sensex trades at a price to earnings multiple of 16.2 times trailing 12-month earnings. If we assume a reasonable 15% growth in earnings of the Sensex companies until FY07, this comes to a valuation of around 12.2 times FY07 estimated EPS, which appears to be quite reasonable.

    However, we firmly believe that in this market, a bottom-up approach to investing would serve investors the best. Unless, of course, you would like to be a passive investor, in which case it would be advisable to probably go for an index fund. But now, with the current bull market around two-and-a-half years old, the days of strong returns across sectors are well and over and it is in such a market where the stock picking skills of investors are truly tested.

    While we would not give a specific list of stocks we believe will be winners from these levels, we give here, a checklist of quantitative factors that any investor must take into account while judging his or her investments, current as well as prospective.

    Topline and bottomline growth, past and present: While this may sound like repetitive advice of sorts, we believe that the importance of these factors cannot be overemphasized. If a company has been able to maintain a reasonable degree of consistency in its performance, it reflects its ability to grow even in difficult conditions. To substantiate with an example, Infosys grew sales and profits consistently even after the tech bubble burst, even as hundreds of 'fly-by-night' players and companies with weak business models went bust virtually overnight. Some of these companies are struggling even today, even as the demand environment for offshoring appears to be stronger than ever before. Therefore, this is undoubtedly a factor of prime importance. We believe that it is necessary to view the past four to five years CAGR and then take a call.

    Of course, it should also be understood that one must note the industry in which that particular company operates. For example, steel is a cyclical industry and just because Tata Steel does not grow well in one or two years does not necessarily make the stock a bad bet. Although it may increase the risk profile of the stock, this factor should not be considered in isolation.

    Operating margins: Margins reflect a company's operational performance and efficiency. The ability of a particular company to improve the selling price of goods/services and effective cost management determine the level of margins. Taking Infosys as an example again, the company's margins in FY05 stood at 32.8%, the highest in the industry. This is a combination of factors, such as premium billing rates that Infosys receives relative to competition and good control over major cost heads.

    Financial ratios: Financial ratios are a very important tool to judge the performance of any company. Important ratios would include return on capital employed (ROCE), which shows the value that a firm is able to create for all its stakeholders, including creditors, and return on net worth (RONW), reflecting value created for shareholders. Companies with higher ratios should be considered as candidates for investment.

    Industry-specific metrics: Depending upon the industry in which the current or potential company is operating, it is always advisable to compare ratios that are important in that particular industry. For example, in the software industry, ratios such as revenues per employee, geographical diversification, client concentration, revenues from high-end services and cash flows generated are key metrics for comparison before considering an investment in any software company.

    Quantitative metrics: Who's the best?
      Infosys TCS Wipro Satyam
    Revenue CAGR (FY01-FY05) 39.2% 33.6% 27.6% 25.6%
    Profit CAGR (FY01-FY05) 31.7% 27.4% 24.8% 28.0%
    Operating margins (FY05) 32.8% 29.3% 25.1% 24.7%
    Return on Net Worth (FY05) 43.7% 70.6% 36.0% 23.9%
    Revenues per employee (Rs m, FY05) 2.3 2.6 2.3 2.1

    Valuations: And of course, not to forget, the kind of valuations that the stock is trading at. If it has run ahead of itself and factors in two to three years of growth in earnings, then one must avoid the stock. Of course, if one is considering an entry into such a stock, then that investor will 'by default', become a long-term investor, as he or she will have to wait for a longer period of time in order to earn decent money on that stock!

    There are numerous stocks that trade at such high valuations in this market and one must be very careful while picking and choosing. One must juxtapose the expected growth rate with the current valuations and then take a call if the company can justify its valuations by its earnings growth and more importantly, the sustainability of this growth.

    It should be noted that all the above quantitative factors must always be considered on a relative basis. That is, one should compare the peer group and then arrive at a decision. We believe that companies with superior metrics will be able to better withstand any downturn in the business cycle and also any downturn in the stock markets. As long as the fundamentals are strong and there is indeed a solid growth story behind the company, regardless of whether it is a bull or bear market and regardless of whether FIIs are buying or selling, these companies will outperform their peers in the long term.

    Of course, an investor must also consider qualitative factors in his or her analysis of the company, like management quality, reputation, vision, social responsibility and so on. Inevitably, the winners turn out to be the ones with the most credible and visionary managements. Therefore, as a long-term investor, one must always have such companies in one's portfolio or certainly consider having them at a future date.



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