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There is a heated debate going on amidst the investor community on whether the domestic stock markets will fall further or not. Many analysts who were optimistic till a few months ago have now thrown in the towel. The sign of decline in the domestic macroeconomic environment has disappointed even the most optimistic investor.
There is a sense of resignation that the stock markets will do nothing for sometime or worse may fall further. Which ever side of the debate one belongs to, the common opinion is that most stocks listed in the stock markets are available at mouth-watering valuations.
Best time for value investing
The question that then arises is should investors pick up some stocks at the current valuations knowing fully well that their stocks can have some downside if the markets correct. The answer obviously is yes.
Long-term or value investors with an ability to withstand some erosion in the nominal value of their portfolios should probably start investing is a staggered fashion in their favourite stocks.
Become a value investor
Value investors rely on fundamental analysis for stock picking. Some of the world's best-known investors use fundamental analysis to choose stocks. Fundamental analysis implies understanding the company thoroughly by dissecting its past performance and on that basis trying to predict its future performance, and its stock price.
Analysing a company's financial and operational data is indeed a time consuming long-drawn process. An easier way to understand a company would be to focus on its numbers. A company's financial numbers - earnings per share (EPS) and price to earnings ratio - can help an investor short list stocks that are worth looking at for value investing.
Some of the metrics that can help an investor pick stocks are:
P/E ratio
This is a valuation ratio of a company's current share price as compared to its per share earnings. A higher price-to-earnings (P/E) ratio indicates that you are paying more for the company in anticipation of high growth. This can work both ways.
If the investors' expectations are not met the stock price can come down sharply. Hence, a value investor goes for stocks that have lower P/E, indicating that the stock in underpriced in comparison to its performance. Today, most blue-chip companies in the domestic stock markets are quoting at lower P/E ratios.
Dividend yield
A stock's dividend yield is expressed as an annual percentage and is calculated as the company's annual cash dividend per share divided by the current price of the stock. Ideally, a higher dividend yield indicates safety.
Income investors value a dividend-paying stock, while growth investors have little interest in dividends. Value investors, on the other hand, look out for high dividend yields in a stock as a measure of safety.
Low debt
Debt and equity financing are two different financial strategies adopted by a company. Debt means borrowing money for business needs. Equity shows the extent of stakeholders' cash in a company. A higher debt in a company is a danger sign because in tough times like these the company could have trouble repaying it.
Value investors prefer companies with low debt as such a company is a safe one to invest in.
Free cash flow
A company's earnings almost never equal the amount of cash it brings in. Companies report their financials using accounting principles, leading to a mismatch in the reported profits and actual cash a company has generated. So, while a company could be reporting a huge profit it could be making very little cash.
Therefore, it may be a good idea to look for companies with a positive free cash flow. As with the debt-equity ratio, this metric gains significance in tough times.
Returns on capital
Returns on capital employed (ROCE) is the rate of returns a business is making on the total capital employed in the business. Capital will include all sources of funding (shareholders' funds and debt). Ideally higher the ratio the better it is.
This ratio indicates how well a company is using its capital. It makes sense to use this ratio on companies along with their peers to get the correct picture.
Qualitative factors
Stock picking cannot be done on the basis of ratios alone. Qualitative factors such as management matter in a company's valuation. The ratios mentioned are good starting points to identify stocks that are fundamentally-strong for longterm investing. They can start you off on a journey to discover stocks that could be multi-baggers in your portfolio.
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