How to make money in the stock markets

There comes a time in your life when decision-making becomes a bit tricky. Like the current situation where the Indian stock markets are again close to their all-time high and you, as an investor, are wondering which stocks to buy.

If you need to make money, then you need a clear rationale and a tool by which you can decide if the markets hold long-term promise. Imagine if you had a simple formula that gave you an idea about what to do in the stock markets.

This is precisely what Dr Benjamin Graham has given us.

You might wonder who Benjamin Graham is. He's the man who taught Warren Buffet, the second richest man in the world (after Microsoft's Bill Gates) who earned a lot of his wealth from stock markets around the world.

Dr Graham taught Buffet basic and sound principles of investment. Graham has given a very simple formula that one can use to find out the market's expectation from a particular stock. Now, if I know what type of growth rate markets expects from a particular stock and I have an exactly opposite or similar view, then I can always buy or sell that stock.

The formulae is: Value= EPS (8.5+2g), where

Value = Value of the stock in rupees (if you are investing in India)

EPS = Earnings Per share in rupees (if you are investing in India)

g = Growth rate in per cent

For instance, assume that a stock like TCS' value as of today is Rs 1,240 and its EPS is Rs 57.65. Now, these two figures can help us arrive at a growth rate in terms of percentage at which the company's profits need to grow to sustain a price of Rs 1,240.

Let us calculate 'g' for TCS by substituting the assumed values in Graham's formula.

1,240 = 57.65 * (8.5 + 2*g)

Therefore, 1,240/57.65 = 8.5 + 2*g

Therefore, 21.5 = 8.5 + 2*g

Therefore, 21.5 – 8.5 = 2*g

Therefore, 13 = 2*g

Therefore, g = 13/2

Therefore, g = 6.5.

So according to Graham's formula, for TCS to sustain a price of Rs 1,240 every year, its net profits need to grow at a rate of 6.5 per cent every year.

Now let's see what this formula means to an average investor like you and me.

We know that the price of all stocks that are bought and sold in the Indian markets can be obtained from any financial daily or even on this site itself in the stocks section.

EPS, simply, is nothing else but earnings per share. As the term suggests, it can be calculated by net profits of a company divided by total number of outstanding shares. If you think this is too difficult to calculate, you can even get this number directly in the stocks section of this site.

Now, the only unknown in the above formula is 'g'.

'g' indicates the rate at which a company's profits need to grow to sustain the current market price. So, long as a company maintains this growth rate, the value of the share's price is justified.

Using the above step-by-step calculations, I have calculated the 'g' for five stocks below. Even you can do it if you have a company's market price on a given day and its EPS, both of which are available in financial dailies. The prices mentioned in this example, however, are not actual prices.

Now let's try and analyse these figures.

While TCS needs to grow at 6.5 per cent for next 7-10 years to justify its stock market price of Rs 1,240, Tata Steel needs to grow by a mere 0.2 per cent for next 7-10 years to sustain its respective price.

Do you think a huge company like Tata Steel will grow only at a mere 0.2 per cent? Of course not. It is a promising company with a sound management that can propel the company to much higher growth rate than 0.2 per cent.

Normally, a company that is expected to clock higher growth rates than 'g' is considered as a good buy. But this should not be your only tool to identify a stock could increase in value in the future.

In the case of Tata Steel, if you think the company can grow by more then 0.2 per cent for next 7-10 years, just don't go and buy the stock.

The above formula will assist you in making the 'buy' or 'sell' decision. However, you should not make this the sole reason why you invest in a stock. Do some more research about the company. Check if other fundamentals that affect the company's performance are sound. Then make your decision.

You should always try and buy a stock cheap, and this formula is one of the best and the simplest method to know if the stock is cheap enough to buy.

A lower 'g' would normally mean a cheaper stock as it is easier for companies to grow at, say, a 'g' of 2 per cent year on year. More so in India where the country's gross domestic product is showing an average annual increase of 7-8 per cent for the last couple of years.

There is one more method to find out if a stock is cheap or not. But it is very complicated and is known as DCF or discounted cash flow method. DCF can only be done by experts in the field of finance; this is not a feasible option for general investors.

DCF and Graham's formula give you a similar output with a minor variation.

Discliamer

Readers should take professional financial help before making any stock market investment. The above article is for educational purposes only and readers should refrain from making their buy/sell decision based on the same.