(2) Stock Picking Skills: How to select between 2 stocks? – Part II

This is part II of the article Stock Picking Skills: How to select between 2 stocks? – Part I. Please read the article from the first part before continuing with this one.

Ultimately, the technical analysis will work only if the investor is LUCKY. Looking at charts, patterns, up and down trends, candlelight patterns, head and shoulder patterns, etc. etc., nothing really helps. It’s only LUCK that dominates the technical analysis

The success rate for these kinds of technical analysis strategies work only for fulltime traders. They are the once who are able to capitalize upon the news based trading and that’s what constitutes the success rate of around 50% for these strategies – for e.g. IFCI. What we people are left with is the failure. Considering the majority of success goes to fulltime traders, our failure rate increases substantially. All we can end up doing is convincing ourselves with the famous punch line: “I am a long term investor; equities give better return in the long term”.

Fundamental Analysis :

Another commonly followed method is to look at the numbers and financial reports of a company, and then make a decision about the stock buying (or selling). This is what is done by majority of Mutual fund companies and their research teams. These researchers look at the balance sheet, profit and loss accounts, quarterly results, etc. and try to gauge the performance of the company in the coming period. The buzz words that are used here are EPS (earnings per share), ROCE (Return on Capital Employed), Dividend Payout ratio, EBITDA, etc. etc. Accordingly, they advice their fund managers to buy or sell a stock. Now, I’m not gonna get into the definitions and formulas of these terms like EPS, etc. you may look for these on the internet. But I’ll give only one straightforward explanation: Markets are Efficient – One cannot make any significant returns from using publicly available information. Hence, no body can generate any spectacular returns by looking at the publicly available nos. and financial data and doing buying and selling of stocks. This is what I tried to explain in my previous article about Efficient Market Hypothesis and how it works. Another problem with this analysis is that it is based on historical data. There is no guarantee that whatever has happened in the past, will continue in the future as well.

Another method applied by the researchers is to use the so called discounted cash flow (DCF) method. It is a highly quantitative method and it will not be possible for me to give you a detailed example here. But in essence, it is based upon estimating how much profit the company will generate, where its investment money will come from and at how much cost and so on. It is highly error prone task, as it requires making predictions about the nos. of the company financials, that too in the future. Let me give a simple example for DCF:

Suppose you start a company and there is ONLY ONE project in that company. The project will run for 1 year and will require an investment of 100 million $ at the start of the year. At the end of the year, it will generate a total sales of 200 million $. So, given this information, how do we calculate the stock price of this company?

This is how DCF works:
First, identify the source and cost of investment. The 100 million required at the beginning may be borrowed from the bank at an interest rate of 5% per annum. So at the end of 1 year, the company needs to return to the bank a total of 105 million $.

Second assumption: everything should go fine and as per the scheduled project

Third, assuming everything goes fine and as per the schedule, at the end of the year the company generates 200 million $. From this, 105 will go back to the bank. So the company is left with 200-105 = 95 million $. Hence this is the value of the company, not today, but at the end of the year. Hence, this is called the future value of the company.
When I want to buy stock today, I should look what is the value of the stock today, not in the future.

Fourth, from the future value, calculate the present value. For e.g. taking 100 Rs. from the bank today at 5% interest rate will mean paying back the bank 105 in one year. So this 100 Rs. is the present value while 105 is the future value.
Future Value = Present Value *(1 + Interest Rate)
Making reverse calculations:
(Future Value) /(1+Interest Rate) = Present Value
So, the present value of 95 million dollars at the rate of 5% becomes
95/(1+5%) = approximately 90 million (value as of today)

Suppose there are a total of 10 million shares of this company. Hence, for the total value of this company at 90 million $, value of each share will become =90/10 = 9 Rs. each.

This simple example shows how to calculate the value of a share using DCF method, given that you have information about the company’s cash flows.


Continue to Part III of this article