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Home  » Business » A nine-step route to picking value stocks

A nine-step route to picking value stocks

By K V S S Narayana Rao
August 25, 2003 14:36 IST
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'Value stocks and growth stocks' are terms popularised by Professors Fama and French. They found that returns on value stocks were more than returns on growth stocks over a long period of time.

It was also found that in some periods of time growth stocks outperformed value stocks and in other periods value stocks outperformed growth stocks.

So what are value stocks? Simply put, stocks selling for a price less than their book value are value stocks; stocks selling at prices above their book values are growth stocks.

Why do stocks sell at prices below their book value? There must be problems concerning companies' operating performances. Their sales might have slumped, margins might have gone down, leverage ratios gone up and asset turnovers gone down some time in the past.

But if, as a group, value stocks outperform growth stocks, is there a way by which investors and analysts can pick the likely outperformers from the value stock population?

Fundamental analysis of equity shares involves the use of operating performance of the company in selecting stocks for buy-and-hold investment as well as short-horizon active investment.

The analysis can be value-based or non-value-based. In value-based analysis, analysts come out with a value estimate for the stock in question.

If the estimate is a present-value one, it is compared with the current price. If the current market price is less than the estimated value, the stock is recommended for purchase.

The return anticipated by purchasing a share at the current market price and selling it at a target price -- an estimate of the likely price in the future -- is compared with the required return of the investor for arriving at a decision to buy.

If the stock is expected to decline substantially, active investors make a short-sale decision by comparing the current price with the target price. In non-value-based analysis, only the direction of price movement is predicted.

Fundamental analysis can also be categorised as forecast-based and non-forecast based. In this method, analysts forecast the financial performance of the company for the next one or two years and, based on the forecast, give a rating as buy, hold or sell. Some analysts give a 12-month target price.

This article describes two methods of fundamental analysis. The first one is the model by Benjamin Graham, who is credited with systematising fundamental analysis, recommended for use by conservative investors.

Accordng to Graham's stock-selection criteria, the company must have an adequate size (Rs 100 crore sales may be taken as adequate size for Indian companies) and a strong financial condition.

To satisfy this criterion, the current assets should be at least twice that of current liabilities and the total debt-equity ratio should not be greater than 1:1.

The company should have paid dividends and earned profits for the last 10 years. There should be a growth in earnings per share of 10 per cent per annum over the last seven years.

The current price should not exceed 20 times the average EPS in the last seven years for companies with past seven-year growth higher than 20 per cent. For companies with past growth rates between 10 and 20 percent per annum, the multiplier has to be the growth rate itself.

The current price should also not be more than 1.5 times the book value last reported.

These prescriptions by Graham require 10-year data to pick stocks. But the method is unambiguous and uses a limited number of ratios.

Investors may complain about the 10-year data requirement; but they have to keep in mind that their hard-earned money has to be protected by committing it to companies with a good past record.

Professor Joseph Piotroski of the Graduate School of Business, Chicago, came out with a much simplified system of fundamental analysis based on the last two years' financial statements that can be used by active investors for picking value stocks with a one- or two-year horizon.

There are nine steps or tests in the model. The stock gets a point for every step/test it passes and a zero for any step it fails. Betting on stocks that score eight or nine points is recommended.

Test 1: Positive net income -  Net income, the bottomline after-tax profits, is the simplest measure of profitability. Score a point if the latest year's net income is positive; otherwise, a zero.

Test 2: Positive cash flow - Cash flow is arguably a better profitability measure than net income. Cash flow measures the money that actually moved into or out of a firm's bank accounts. Add one point if the latest year's operating cash flow is positive.

Test 3: Earnings quality - Many experts compare net income to operating cash flow to detect potential accounting manipulations. Cash flow normally exceeds net income because depreciation and other non-cash expenses reduce income, but not cash flow. Award one point if the latest year's operating cash flow exceeds the current year's net income.

Test 4: Decreasing debt - Piotroski rewards companies that are reducing their debt levels. He uses 'financial leverage,' which is total debt divided by total assets, to quantify debt. Award one point if the most recent annual figure is less than the value of the preceding year.

Test 5: Increasing working capital - Working capital, the difference between current assets and current liabilities, measures the cash available to run the business.

Piotroski prefers stocks with increasing working capital. Current ratio, which is current assets divided by current liabilities, is the usual metric for measuring working capital. Award one point if the most recent annual figure exceeds the preceding year's number.

Test 6: Increase in asset turnover - Award one point if the most recent annual asset turnover (sales revenue divided by total assets) exceeds the year-ago figure.

Test 7: Growing profitability - Return on assets measures overall profitability by comparing net income to total assets (net income divided by total assets). Award one point if the most recent annual ROA exceeds the year-ago figure.

Test 8: Issuing stock - Piotroski prefers companies that did not issue more stock to raise capital or to fund acquisitions. Award one point if the most recent number of total shares outstanding is equal to, or less than, the year-ago figure.

Test 9: Competitive position - Increasing competition often forces companies to cut prices, and hence profit margins, to maintain sales. Conversely, rising profit margins signal an improving competitive position. Award one point if this year's gross profit margin exceeds the year-ago number.

Piotroski's scoring system is easy to use. It was found to be effective over the period from 1976 to 1996 by Piotroski himself.

What are the risks associated with these methods? Investors have to remember that equity shares are categorised as risk securities. No amount of analysis can guarantee definite returns from equity commitments.

That is why investors are advised to invest only genuine long-term funds in equity shares. They are also told to commit only that amount of money that they can afford to lose in speculative or active investment deals.

Graham states that conservative investors have to be ready for an interim depreciation in their portfolios to the extent of 50 per cent even after buying at substantial discounts to the fair value determined according to his criteria.

Therefore, the risk to be taken by active investors is that much higher. But these analytical methods do provide systematic ways of committing funds to the share markets at either end of the spectrum and earning higher expected returns consistent with the risks undertaken.

(The author is professor of finance at S P Jain Institute of Management & Research, Mumbai.)

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