Updated on 27 December 2016
On 1 December 2016, Sunil Hitech issued 10:1 stock split and 1:1 bonus issue shares. For the purpose of this article, consider Sunil Hitech price as 20 times of its current market price.
If you have been reading my posts or of any other fundamental stock analyst, you would have noticed that typically they focus on 2 areas of research – qualitative & quantitative (i.e. financials).
Before I proceed, let me reiterate the importance of qualitative research i.e. that pertaining to quality and integrity of management, state of the industry, and future prospects of the business model.
Quantitative research deals with an analysis of financial data and accordingly the results are somewhat predictable. All future predictions here rely on a certain level of guess work about future growth, discount rates etc; most of which is based in part upon past growth. In other words, the idea is to look at past growth levels and adjust future growth a few notches up or down based on those levels.
Before you check the fair value of a stock on the basis below, keep in mind that:
- Past performance is no indicator of future results – Instead of using a standard growth rate or discount rate for future (based on past rates or otherwise), the better way to research is to anticipate future events and accordingly give growth predictions.
- No full proof system – There are many valuation techniques and those many improvisations made by analysts in their efforts to predict the future better than others. What you will find below is an easy to check the fair value of stock based on quantitative aspects.
Fair Value Calculation
For the purpose of this example, I will take 2 stocks for my base calculations –
a) Sunil Hi-tech Engineering – we recommended this in our Multibagger portfolio on 18 November 2013 @ Rs 51 and exited from this stock on 2nd January 2014 @ Rs. 128; and
b) National Steel & Agro Industries – never recommended
Fair Value Based on Price Earnings (P/E) – It is easy to calculate the price earnings ratio of any stock by simply dividing its current price with its reported EPS of the last 4 quarters (take consolidated EPS). The best way to assess the PE is by comparing it to industry PE and with the historic PE of that specific stock.
At the current price of Rs 138 (as on 9 September 2014), Sunil Hi-Tech’s trailing 12 month PE comes to ~ 7.6 which is at a 15% discount to its 10 year average PE Multiple. It is another way of saying that the fair value of this stock should be Rs. 162 and you are getting it at Rs. 138. This is far below the industry PE (i.e. Power transmission and equipment; PE = 15).
At the current price of Rs. 24 (as on 9 September 2014), National Steel and Agro’s trailing 12 month PE comes to ~ 3.27 which is slightly higher than its 10 year average PE Multiple. However, it is far below the industry PE (i.e. Steel Sheets; PE = 20).
At these prices and based purely on PE analysis, Sunil Hi-Tech can be bought with a potential 15-25% year on year appreciation, with modest growth targets. For now, I would avoid buying into National Steel on these basis, unless there are any other strong external reasons to buy into this stock (which I may not be aware off).
Other factors affecting fair value of stock
That was a very basic (yet effective) way of arriving at some sort of fair value for a stock. 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?
To give you an example, MTNL stock has declined by nearly 90% over the last 6 years. With cellular service providers (like bharti Airtel, Vodafone and Reliance) gaining ground, was it justified to rely on the past financial performance and the wide pan-India reach of MTNL 6 years back? Go back a decade and it may be harder to answer this. At that time it seemed unreal that someone would eat into MTNL’s market share so quickly.
Also, you must define for yourself – the discount (in relation to fair value), at which you will be happy to buy a stock. 20 – 30 – 40%, i.e. your margin of safety or your margin for going wrong.