In this article, I am going to share the secret tools and techniques that Wall Street fund managers and legendary investors like Warren Buffet, Charlie Munger, and Peter Lynch use for the purpose of stock valuation.
At the end of this article, I will share my personal favorite which I have used in my short tenure of working as an associate fund manager.
I will explain these tools with simple yet effective examples so that you can understand it practically.
I bet you will no longer need any stock research tools to understand the stock valuation
Long term investors including value investors use a set of analytical and fundamental tools for understanding and calculating the fair value of a share or the market as a whole. Stock valuation tells you whether the current market price of the security you want to buy is fair or not as per the performance or the fundamentals of the company.
Let’s understand stock valuation with a simple example
Consider a person who went to buy vegetables from the local vegetable market. He asks the shopkeeper the price of tomatoes. The shopkeeper says $4 per kg. He then went to another vendor who is selling tomatoes at $3 per kg. So, the second shopkeeper is selling the same commodity at a lower price. So, from which vendor will the person buy?
Simple, the second seller is selling at a cheaper price. Not that simple
We don’t simply consider the price while shopping. We also inspect the quality of the product that we are buying. If our first vendor is selling premium quality tomato compared to the second vendor then we won’t have any problem in buying the product at a comparatively higher price. So, the price is not a single variable that determines the value of a product.
The same thing applies to a stock. Stock valuation not only considers the price of a stock or a company. It also considers the quality of the company by judging its earnings. So, stock valuation helps us to find profitable stocks at bargain prices
Buffet Indicator — Market Capitalization / GDP of the country
The Buffet indicator is calculated as a ratio of the cumulative market capitalization of all listed companies in the country to the GDP of the country. Hence, this indicator shows us the big picture or the valuation of the entire stock market. Warren Buffet uses this indicator for investing in countries across the globe.
The implication of this indicator is pretty simple to understand. The stock market must be correlated with the overall performance of the economy. We often see that the stock market is behaving irrationally in accordance with economic growth. There are periods where economic growth has been negative but the stock market has shown a positive momentum.
For the US Markets
Buffet Indicator > 120 = Overvalued
Buffet Indicator > 150 = Highly Overvalued
100 < Buffet Indicator < 120 = Correct Valuation
Buffet Indicator < 100 = Undervalued
For the Indian markets
Buffet Indicator > 80 = Overvalued
Buffet Indicator > 130 = Highly Overvalued
80 < Buffet Indicator < 120 = Correct Valuation
Buffet Indicator < 80 = Undervalued
So, I personally invest only when the ratio is less than 80.
Now, we shall see the empirical evidence of the famous Buffet Indicator. I will show you where we are currently standing during the COVID crisis. I shall also show you how Buffet Indicator predicted market valuations during historic falls and recessions.
Indian stock valuation using Buffet Indicator — A Blast from the Past
So, we can clearly see that before the 2008 global economic recession, Indian stock markets were in a highly overvalued zone. Historically, for Indian stock markets the long term average has been nearly equal to 80.
We can also see that the return post-correction has been magnificently high. So, we can conclude that the greater the magnitude of the fall, the higher will be the return post correction
During the dot com crash in the US, the Indian benchmark equity index BSE Sensex was trading at an all-time high. So, the stock valuation was high compared to economic performance. It generated a return of more than 400% within 3 years after the crash
Similarly, during the historic slump of the Sensex during the global economic crisis, Sensex dropped 30% from its highs in 2007. It then went on to generate a 387% return after 3 years in 2011. Earnings Yield — My personal favorite Stock Valuation Calculator
We will not use the typical P/E ratio also known as the Price to Earnings ratio for calculating stock valuation.
Earnings Yield is the reciprocal of P/E. It is calculated by dividing the Earnings Per Share (EPS of the company) with Price per share
Let’s take a quick example to make you understand the concept of Earnings Yield
Suppose “Company X” has a chain of 10 stores and it earned a “Net Profit” of $1.2 million in FY 2020.
Now, consider that Company X has divided the ownership into 1 million equal shares.
Therefore, we can say that each share is entitled to earn $1.20. We get this result by [ dividing Net Profit / Number of outstanding shares]
This is known as “Earnings Per Share” or EPS.
Next, we shall see the price at which Company X’s share is trading in the stock market. We are looking at the LTP or Last Traded Price. Suppose the shares are trading at $12 per share.
Hence, based on the FY 2020 earnings, Company X gives us a return of ($1.2 / $12) on our investment.
Therefore, we are getting a 10% return on our investment. This 10% is known as the Earnings Yield of the Company.
It shows how much investors are getting back for the price they are paying for purchasing a share in Company X.
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