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Questions to ask yourself before buying a stock

Dec 7, 2010

Are you confused about whether or not to invest at the current levels? On one hand you may be advised to buy certain stocks. On the other, you are cautioned about the current valuations of some. Well, we hope this article will help you make your stop picking decisions easier. To some extent, at least.

One simple and quite effective method of doing so is to apply the widely used valuation metric - P/E ratio. Just to refresh your mind, P/E ratio is calculated by dividing the market price of the stock by the EPS (earnings per share).

EPS = Profit after tax / No. of shares outstanding

P/E Ratio = Current market price / EPS

In this article, we will not get into the details of what P/E a stock deserves, as it has been written about previously (link given below). But the main purpose of the method is to help investors do a quick check to see whether they are over-paying for a stock.

Let us take up an example to discuss this further.

Below we have laid out the historical financial performance of a hypothetical company - ABC Limited.

Parameter FY05 FY06 FY07 FY08 FY09 FY10
Sales (Rs m) 1,350 1,400 1,500 1,700 1,900 2,100
YoY change - 4% 7% 13% 12% 11%
EBIDTA (Rs m) 144 161 165 204 219 315
EBIDTA margin 10.7% 11.5% 11.0% 12.0% 11.5% 15.0%
PAT (Rs m) 68 78 79 101 106 166
YoY change   15% 1% 28% 6% 56%
PAT margin 5.0% 5.6% 5.3% 5.9% 5.6% 7.9%
Shares O/S (m) 10.0 10.0 10.0 10.0 10.0 10.0
EPS (Rs) 6.8 7.8 7.9 10.1 10.6 16.6

We assume that ABC Limited is a good company with a decent management, healthy balance sheet, has a stable historical performance with decent return ratios.

If we see ABC Limited's financial performance, its revenues have been growing at a steady pace. Operating margins have been stable, in the range of 10 to 12%. Profit margins have been stable too. If we see its FY10 performance, profits have grown by a strong 56% YoY.

It is quite often that the market values a company's stock slightly on the higher side on the back of a strong growth in the most recent earnings. Let us assume that ABC's stock is trading at a high multiple of 25 times its FY10 EPS. But here's the catch. And this is where most investors tend to overlook some important metrics and overpay.

In FY10, many companies reported strong operating performances. This was due to lower input costs in the form of lower commodity prices. Investors need to keep in mind that such a trend is not sustainable are nor are the high margins. So naturally, the expectation is that margins to return to normalised levels.

Let us assume that ABC Limited was also part of this group. And as such, its operating margins expanded to 15% in FY10. This is quite a high as compared to its preceding five year average operating margin of 11.3%. Thus, this company's operating margins may return to the normalized average to about 10 to 12%.

For the company to justify its current valuations it would need to grow its profits by at least 25% YoY (Price-earnings to growth ratio (PEG ratio) of at least 1 time). Now, if the company is able to maintain margins at levels of 15%, then the growth in revenues should be atleast 25%. But from the looks of it, such rate of growth in revenues seems to be difficult. This we say because it has not grown at such a sharp pace in the past five years (again, on the assumption that there is no significant increase in capex). Now since margins may eventually drop to 12% levels, for ABC Limited to clock a profit growth of 25%, it would need to grow its sales at a much stronger pace (higher than 25%).

Thus, the most recent memory often misleads investors about the ideal PE multiple that they would be willing to pay for a stock. To avoid this confusion try asking these questions to yourself:

- If I buy the stock at x times multiple, at what pace will its earnings have to grow?

-Is such growth possible given the historical average margins and growth rates?

Before we conclude, we could like to share a very simple yet apt quote by one of the most celebrated investors in the world, Peter Lynch. "If you remember nothing else about p/e ratios, remember to avoid stocks with excessively high ones. A company with a high p/e must have incredible earnings growth to justify its high price."


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5 Responses to "Questions to ask yourself before buying a stock"

vivekaditya

Dec 17, 2010

i want to invest in equity for 5-8 years which stock you advice also i want to start sip

Like 

Nikhil Shah

Dec 14, 2010

While comparing P/E between two companies, is it not equally important to pay attention to the paid up value of share?

Say Company A has a 10,000 shares outstanding with paid up value of Rs 10 and say Company B has the same number of shares outstanding, but with paid up value of Rs 1. They can both have the same P/E ratio if they have the same, say net profit of Rs. 100,000, and therefore EPS would be the same Rs. 10, and if their share prices are the same, say Rs. 200. Which one would you choose to invest based on these parameters only?

Analysis would say that Comp B is more profitable since it deployes less share capital compared to Comp A, because Comp A has earning per share capital of Rs. 1 whereas Comp B has earning per share capital of Rs. 10.

So I repeat the question: Is it not important to pay attention to the paid up value of share also?

Your thoughts please.

Thanks,

Nikhil H. Shah

Like 

venkataratnam

Dec 10, 2010

VERY GOOD ARTICLE. GRAHAM'S MULTIPLE MAY BE A BETTER BET. WHAT IS YOUR SUGGESTION?

Like 

Dayamaya Bhukta

Dec 9, 2010

This is a good suggetion for a investor.One can know how to buy a stock.

Like 

Savio

Dec 7, 2010

Very nice article, especially for the novice investor.

Way to go!

~Savio

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Equitymaster requests your view! Post a comment on "Questions to ask yourself before buying a stock". Click here!

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