For the value investor a rising market poses problems. Whatever filters or screens you use to make value picks, the quality of stocks thrown up by them deteriorates as the market heads into expensive territory. (By contrast, a similar exercise during a bear market throws up many index stalwarts). What does one do in times like the ones we find ourselves in currently, when the market has been rising for five straight quarters and the Sensex is trading at a rather elevated PE of around 21 (12-month trailing)?
A fund manager has to beat the index, the category average, his peers, and what not. As an individual investor, you do not face any of those pressures. You have the luxury of holding on to your cash till a truly exciting opportunity comes along.
While you hold on to your cash, continue with your basic job of prospecting, i.e., studying the fundamentals of stocks. That means reading annual reports and reports of management's recent interactions with analysts (available at company web sites).
You may also read the reports put out by brokerage houses, but use them only for the information they provide about the company, and not for their “buy” or “sell” recommendations or for the price targets they suggest. On those issues you should think independently.
If you like a stock, you need not buy it right away. Besides the fundamentals, the stock's price must also be right. Fix a price target at which you would like to buy it using a method suggested by Timothy Vick, author of How to pick stocks like Warren Buffett. Now put this stock in your inventory. Only if the stock touches the price target you have set should you buy it.
It is said of legendary investor Warren Buffett that he studied the silver market for more than 30 years before investing in that metal. And when he bought it, silver was trading at a 650-year (inflation-adjusted) low! Display similar patience.
The methodology
Here is a method that you can use to determine a price target at which, according to your calculations, the stock would become an attractive buy. According to Vick, Warren Buffett uses it to set price targets for the stocks that he likes fundamentally and which he would like to buy, provided the price becomes right.
There are certain premises on which this method is based. The first: it requires that the stock should provide at least a 15 per cent rate of return. And the second: it assumes that a stock's long-term track record (over a span of 10 years) is a reasonably accurate predictor of its future performance. To ensure that this turns out to be true, one should, however, mostly apply this method to stocks whose EPS has grown at a consistent rate in the past.
The calculation
· Current price of the stock = Rs 140.
· Latest EPS = 3.50
· EPS growth rate (average from the past) = 13 per cent
· Average PE (over the past 10 years) = 18
· Dividend pay out ratio (historical) = 20 per cent
· Minimum return required = 15 per cent
Using the current EPS and the average growth rate in EPS over the past, one can project what the stock's EPS will be 10 years hence. Similarly, by looking at the stock's dividend payment record in the past, one can calculate its average dividend payout ratio in the past. By multiplying each year's EPS with the dividend payout ratio, one can get the dividend payments that the stock is likely to make over the next 10 years. Add and get the sum total of the dividend payments made over 10 years.
Now, we have obtained the stock's estimated EPS for 2019 and we also have its average PE of the past. Multiplying the two, we get the stock's estimated price in 2019. To this we add the total dividend paid out by the stock to get total return
Now, using the total return from the stock, a discount rate of 15 per cent and a period of 10 years, we obtain the price at which we would like this value buy the stock currently. If this value is lower than the current price, then we should buy the stock. If not, we should wait for it to decline to that level.
This article was originally published on June 14, 2010.
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