Before buying any company, I must check my default check list.Apart from that even if all the check lists are satisfied,the most important thing I should not ignore is "valuation".Remember that a company may be a good one since last 15 years or it might remain excellent for next 20 years.But its stock price will not be good in between this time period, from a buyer's point of view.Stock prices oscillate in between cheap and expensive and I need to buy a good business in cheap or fair valuation.Sometime the stock price may not come to my calculated valuation and for years and I might have to sit with cash.It is okay if I sit with cash.But I need that margin of safety so that if the stock I purchased do not rise ,then also I can sit with mental peace.A good purchase price provides me that mental peace.
Scenario-1
Often you might be hearing this in business news channels that a particular stock is corrected 40% from its 52 week high and looks attractive.
If the business is not worth investing,then there is no point in calculating the valuation of the stock.It does not matter how much % the stock is corrected from its top.
I just don't understand the logic behind it.
TCS...no doubt ..it is a good company..... as on 19.07.2022...its stock price is Rs.3074/- and its all time high was Rs.4043/- .So,it means as on date the stock is corrected 32% from its all time high. Now TV channels are telling that TCS looks attractive.
give me a break....
look at its current market cap ...its 11.21 Lakh crore ....so at its all time high its market cap was 14.79 Lakh crore.
Even if you buy TCS at current price ...if you think to make your money double in TCS ,then its market cap needs to be 22.42 Lakh crore.Lets say its earnings will justify its stock price ,then its current EPS (i.e. Earnings per share) i.e. Rs. 104 need to be doubled i.e. Rs.208. TCS has nearly 22% margin.So in order to make EPS double ,its revenue needs to be doubled i.e. from 1.95 lakh crore to 3.9 lakh crore.Lets say it will happen over next 5 years it means its revenue needs to be grown at 14% .But its revenue is growing at 5.71% since last 5 years.So if the whole IT industry will grow at 15% for next 5 years ,then it will cross India's GDP perhaps.Again what other IT companies will do ? TCS is not the only company in this planet.Perhaps it need to go to the Mars for getting projects.
currently TCS is available at 30 PE multiple.Its growing at 5% and PE is at 30.It does not make sense.
Two things can happen....
1st... its stock price may stay there constant as it is for several years and gradually its earnings will increase slowly and justify its price.In this case you will not loose money in paper.But you will get -ve 6% yearly because in India inflation is around 6% minimum.
2nd....its stock price will collapse because market will not give 30 times premium to a 5% growth company.Lets say if it re-rates TCS to 15 PE multiple.So you will loose 50% of your money in paper.
In both way you will loose money.
Lets say we give premium to TCS ..since it can give whole EPS to shareholders ...still the 30 PE and target 22.42 Lakh crore market cap in next 5 years looks insane.
I may be wrong...but I don't want to take that much risk to make my money double.
Where we make the mistake is....we see the correction in stock price in isolation.
But we need to see the following things in together
- Current market cap of the company
- Current Price to earning multiple.
- How much headroom is there for the market cap to go up (considering the profit growth).
- What % of the EPS, the company can give to shareholders as dividend without affecting its business.
- Bank deposit interest rate during COVID pandemic is very low ..say 3.5%.So, if TATA Power is available at 4% dividend yield,then we should buy its stocks.PSUs are available at 5% dividend yield ,so we should buy them.These are all wrong metrics which seems right in extra ordinary situations.You need to ask yourself, that whether you want to own the businesses like TATA Power and PSUs.If not then it just does not matter in what dividend yield these stocks are available.If the business is an investment grade and headroom for multiple year growth is available and stock is available at 5% dividend yield and low PE ,then it makes a perfect buy.But you need to consider all the parameters together.Remember you invest in a business for growth in earnings not for dividend yield only.
- When interest rates are low,even the companies with 5% earnings growth ,available at 40 PE will attract you.This is a perfect illusion, as you are taking only the interest rates as the bench mark for calculating the valuation and ignoring the inflation completely.As per simple economics, interest rates should beat inflation and at present in INDIA ,it is not beating the inflation.So ,your mind will tell you that its ok to buy the stock at 40 PE since interest rate is very low.Remember that ,what is important is the "sustainability of growth in the prices of your stocks " .This is the whole point for which you are investing in stocks and this can only be justified by growth in the earnings of the company.But if you are justifying the growth in stock prices due to low interest rates,then it is nothing else just a bubble.
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