When selecting stocks, it is difficult to review the massive amount of data available from various sources for assessing equity fundamentals. Developing a good stock selection criteria for evaluating stocks can make this tedious task much less stressful. That being said, a bigger problem these days is to select a stock selection criteria. Just type the words – Stock Selection criteria and see how many results does Google throw up at you.
Each to their own: Figure out what works for you. Each person is comfortable with a certain set of principles and goals. However, keep in mind that the the exercise of filtering from the universe of companies has only one goal: to ensure that you do not end up buying good companies when they are overpriced.
Goal: It is easy to select good companies, but the goal really should be to buy good companies at great prices. The process of selecting stocks can be simplified by using five basic evaluative criteria:
[1] Evaluate Fundamentals
At first, consider a company’s fundamentals, including earnings, operating margins and balance sheet. Together, these factors will help you in understanding a company’s current financial health and future prospects of the company.
While evaluating, investors should consider how stable the earnings are and how they’re trending. Higher operating margins are typically more favorable than lower operating margins, in terms of measuring how efficiently a company operates. Reviewing the company’s balance sheet figures, specifically debt to equity metric, is helpful.
Below table will help you understand fundamentals of Nestle – Consistent revenue growth and profitability
| Nestle India | Mar-19 | Jun-19 | Sep-19 | Dec-19 | Mar-20 | Q-o-Q % | Y-o-Y % |
| Revenue (In Rs. Cr.) | 3,002.95 | 3,000.85 | 3,215.81 | 3,149.29 | 3,325.27 | 5.59% | 10.73% |
| EBITDA (In Rs. Cr.) | 752.70 | 697.30 | 751.43 | 677.87 | 793.31 | 17.03% | 5.40% |
| EBITDA Margin (%) | 25.07% | 23.24% | 23.37% | 21.52% | 23.86% | 10.84% | -4.82% |
| PAT (In Rs. Cr.) | 462.74 | 437.84 | 595.41 | 473.02 | 525.43 | 11.08% | 13.55% |
| PAT Margin (%) | 15.41% | 14.59% | 18.52% | 15.02% | 15.80% | 5.20% | 2.54% |
| EPS | 47.99 | 45.41 | 61.76 | 49.06 | 54.50 | 11.09% | 13.57% |
Now Consider, fundamentals of Century Textiles – inconsistent growth, declining profitability
| Century Textiles | Mar-19 | Jun-19 | Sep-19 | Dec-19 | Mar-20 | Q-o-Q % | Y-o-Y % |
| Revenue (In Rs. Cr.) | 938.76 | 874.35 | 885.30 | 876.87 | 786.21 | -10.34% | -16.25% |
| EBITDA (In Rs. Cr.) | 219.23 | 180.74 | 157.11 | 151.82 | 74.49 | -50.94% | -66.02% |
| EBITDA Margin (%) | 23.35% | 20.67% | 17.75% | 17.31% | 9.47% | -45.28% | -59.43% |
| PAT (In Rs. Cr.) | 141.10 | 67.10 | 187.34 | 41.51 | 79.88 | – | -43.39% |
| PAT Margin (%) | 15.03% | 7.67% | 21.16% | 4.73% | 10.16% | – | -32.40% |
| EPS | 12.63 | 6.01 | 16.77 | 3.72 | 7.58 | – | -40.00% |
[2] Valuation – PE Ratio works well for most companies
A good starting point will be to look for companies which are available at discount to their industry PE ratios and indeed to their own historic PE Ratio. Keep in mind that companies in some sectors will enjoy a high PE ratio in comparison to companies in other sectors. For example, FMCG sector has always enjoyed premium valuation as compared to other sectors like real estate or financial sectors.
In addition, within sectors, you may notice that some companies historically enjoy premium valuation as compared to its peers. For example, HUL and Nestle have always traded at premium as compared to ITC, Dabur or any other FMCG player.
[3] Return Ratio | Return on Equity (ROE)
ROE indicates the amount of profit which a company generates on capital invested by the equity shareholders (i.e. shareholder return). A company should generate healthy and consistent ROE. Keep in mind that certain companies with low equity base may report extremely high ROE’s and one must look for reasons for a high (or low) ROE.
How to use PE and ROE in Selecting Stocks?
PE/ROE – This ratio can be used to assess the valuation of the share. A high PE does not mean that the company is highly valued. Has to be seen in relation to what ROE the company is earning.
A high PE on a high ROE makes the company cheaper as compared to a high PE on a low ROE. Similarly, a high PE on a high ROE company is preferable to a low PE on a low ROE.
A company with a PE/ROE <1 and ROE > 20% is worth evaluating. If you apply this you will automatically find companies such as HUL, Colgate etc come out on top.
[4] Competitive Advantage and Future Prospects
Focus on companies that enjoy competitive advantages which in turn will help them in protecting their market share in the long term. For example, HUL and Colgate. Having strong economic moats is one of the most important stock selection criteria for any serious investor.
[5] Intrinsic Value or Fair Value of Stock
Often, the market price of well-established stocks with strong financial and business track records declines for little or prolonged period(s) due to difficult economic environment or due to a temporary setback in business. Investors seek to take advantage of these price movements to select stocks which are trading below (or may be far below) their intrinsic value.
The main purpose of any intrinsic value calculation is to help the investor in finding undervalued stocks which are fundamentally strong. While it is easy to discover such stocks, it is difficult to know when their market price will recover.
You can use Price Earnings (P/E) multiple to calculate a fair value – The best way to assess the PE is by comparing it to industry PE and with the historic PE of that specific stock.
For a detailed discussion on this, Read: A Simple Rule to Calculate Fair Value of Stock
LT Finance Holdings Limited – At its current price of Rs 60.80 (as on 12 June 2020), LT Finance’s trailing 12-month PE comes to ~ 7.17 which is at a 61% discount to its 5-year average PE Multiple. It is another way of saying that the fair value of this stock should be Rs. 157 and you are getting it at Rs. 60.80.
| 5-year Average P/E = 18.48 | |||||
| FY15 | FY16 | FY17 | FY18 | FY19 | |
| Price | 62.8 | 63.85 | 123.65 | 157.1 | 153.6 |
| EPS | 4.26 | 4.27 | 5.2 | 6.26 | 11.1 |
| P/E | 14.73 | 14.94 | 23.79 | 25.1 | 13.83 |
| CMP | 60.8 | ||||
| EPS | 8.48 | ||||
| Current PE | 6.18 | ||||
That was a very basic (yet effective) way of arriving at fair value for a stock. Keep in mind that there are many factors which may affect the fair value calculation. Future plans of the company, the general economic scenario, Industry specific news, are promoters buying or selling their holding?
Further, while the above-mentioned criteria will be helpful, it will not tell you if the stock is right for your portfolio. You should also check if the selected stock is in line with your investment strategy.
Selecting winning stocks with great consistency is extremely difficult. That’s why we should have a portfolio of around 12-14 stocks for diversification. A well-managed portfolio should be diversified to ensure safety of return on investment over time.
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