Best Way to Identify VALUE Stock

There is an investment philosophy : “Price is what you pay, Value is what you get”. This holds good in every walk of life. It means that the price you pay should be worthy of the product. If the price at which you buy is less than the intrinsic value, then it is a Value Buy and if it is more – the stock is overvalued. This holds good in anything we buy – be it food / dress / electronics – we tend to check if we get more value for what we pay.

But the problem most investors face is – How to identify the value of a stock. Price is obviously quoted live in the stock exchanges. But only when you can find the value (loosely called as worthiness) of the stock, you would be able to judge if it is a cheap buy or an expensive stock. And in the long run, only if you buy at an attractive price (or even fair price), you can expect your investments to do well over the long run.

Following are few ratio’s used for arriving at the value of a stock:

• Price to Earnings (PE) Ratio
• Price to Book Value (PBv) Ratio
• Discounted Cash Flow
• Dividend Yield Ratio
• RoE : Return on Capital Employed / Return on Net Worth

While the first four ratios are easily understood by many, RoE is often viewed as a complex component.

Return on Equity:

• This is one ratio that can give a birds eye view on all the business activities of the company.
• It is an important number for shareholders, since it provides information about the returns generated by companies on capital provided by the share holders.
• RoE = (Net Profit – preferential dividends)/ (Paid up Equity capital + Reserves) *100
• And Paid up capital + reserve = Networth
• High RoE means – effective utilization of capital
• Better to exit companies with low RoE

Like in any ratio, RoE does have its own shortfalls:

• · Companies can sacrifice business growth (by raising less equity capital) to attain better RoE and please its existing share holders.
• · Borrowing (Debt) to fund growth: This can boost RoE if the borrowing cost is less than RoE. But this can work favourably when the industry is in Bull / upward cycle. When there is recession in the industry, leaverage can cause havoc – resulting in poor RoE.

Inspite of these limitations, RoE can be a good indicator for identifying / retaining good stocks. It can be a single vital parameter to make important investment decisions.