About the Author, Badri Narayanan
The author is the founder of EquityLevers Finance Lab. He is a Chartered Accountant and also a CMA. He stood all India 13th in CMA final exam in 1991. Over the past 3 decades, he has worked in multiple financial domains including, investment banking, financial restructuring, private equity and fund management. He was a former partner at Ernst & Young where he headed financial restructuring in Mumbai. More recently, he developed a proprietary algorithm to invest in Indian equity markets, which has helped him generate strong equity returns over the past 10 years.
Section 1 – The practice of fundamental analysis
Fundamental Analysis is a holistic approach to study a business and assess stock performance. This requires basic level skills in accounting, financial analysis and valuation. The fact that there are millions of successful investors tells us that expert level knowledge is not necessary in these disciplines to succeed as an investor. Having said this, investors do need to develop a strong common sense to judge business trends and build skills to identify market patterns which then help in taking strong conviction investment calls. These financial and economic patterns can be learnt by anyone interested in markets by regular observation and practice. It is well known that human beings learn faster through pattern recognition as opposed to text book narratives. This book and the specially designed Finance Lab enable data pattern recognition.
Some notable examples of successful market patterns in fundamental analysis
Before we start, lets examine a couple of examples of Earnings Data Pattern.
Example 1 –Sport King India Ltd
Share price has increased from Rs 800 to Rs 4000 currently. A 5x (times) increase in 6 months. This increase is contributed by substantial increase in net profits - from Rs 10 cr per quarter to Rs 80 cr per quarter. An 8x increase in profits.
Data source: www.equitylevers.com/financelab, a unique finance terminal for valuation multiples
If you track companies, as part of earnings data pattern, this company would have come up. From January 2021 onwards, the earnings data pattern would show this as a potential buy. Of course, some understanding of the business drivers will be necessary (discussed later). Despite sharp increase in profits and price, notice that PE has remained at around 7 times and accordingly continues to hit upper circuit even as recently as August 12, 2021. (see chart below, last column)
The lack of growth is clearly visible and valuations high when
viewed as a trend line. This company would not show up on the
earnings data pattern.
When you place a fixed deposit with HDFC Bank, you are doing so
to get assured return (interest) on future periods. In equity
markets, the payouts come at a future period in the form of profits
(EPS/ cash flows) made by the company. However in the equity
markets, this future payout is not pre-defined. The estimation of
forward profits and EPS is one of the key objectives of investing.
The time value of money, the idea that money today is worth more than an identical amount of money in the future, is one of the first concepts taught in a finance class. Discounted cash flow model formalizes this concept. However, a recent survey of professional equity analysts found that “market multiples” were by far the most popular approach to valuation” among nearly 2,000 respondents (Source: Morgan Stanley).
The second key step in the investing process is learning how analysts make investment decisions using multiples based approach. This is important for all investors because most analyst reports are based on this process and investors should develop their own judgment on the recommendations they receive from analysts, as their money is at stake.
Both these aspects are part of most analyst reports: This text image is from Morgan Stanley, an international investment bank’s analyst report on Sun Pharma.
Notice that there is a forward PE assessment (22X) applied on a
future 12 month period (March 2023, EPS) and a statement about
Amid record rally in the equity markets, India has added on an
average 13 lakh new demat accounts every month since April last
year. Retail investors have become dominant investors and now
own stocks worth ~ 16 lac cr. We think at this stage of India’s retail
and individual investor equity participation, a specialised learning
and valuation focused terminal is essential to support investors.
“Formal background in finance is not required”
About this book
How seasoned investment analysts make decisions is the subject of this book. But made simple based just on observational thumb rules. We will study this in the following 4-step process.
1. Analysis of past financial data for the company
2. Making estimates of future growth and margins for the company
3. Finding and assessing the economic reasons (equitylevers) that are playing out for company or sector,
4. Making an assessment of valuation multiple the company may command next year.
Investing as an educational discipline is vast. We cover just the first but a very important step to understanding an analyst’s investment process. The idea is to declutter the process into simple observational steps that anyone with or without finance background can learn and build on.
Just like a doctor takes several years to learn and practice the study
of medicine, learning investing is also a journey. A very rewarding
journey if done well. A good investor should continue reading the
numerous wonderful books written by great investors and authors.
It is important to highlight a key difference between learning investing and learning core subjects like accounting, finance or engineering. Core subjects are specific and have correct and wrong answers. Let's say the solution to a core subject problem is “A”. If we come back to the problem after 1 year, the answer will still be “A”. This is because full information is known for a core subject problem. However, investing involves looking into future which is uncertain and full information is not known. Future events also keep changing based on current and future events that will happen. Hence, we can at best get a set of probable answers to an investment situation. Also, this answer could be different for each one of us, as we all will view it from our differing points of view about the future.
benefit from this book and our Finance Lab
Learning to think of “probable future outcomes” and also have the flexibility to keep changing opinions based on new events and information is a key skill for the field of investing. This skill is best developed through observation and practice. We have incorporated a number of new features to enable learning and practice of investing as described in the picture below. (More on this in Section 2)
Our application based
approach will help the following users.
“Skills come from consistent and deliberate practice”
Before we progress to take investment decisions, we present an overview of our Finance Lab. We will be using growth and valuation data from this Lab for our observations and examples.
Section 1 - Learning insights and developing intuition
This section of the Finance Lab provides market insight videos and real interactive games as detailed below.
1. Expert videos on practical investing insights to DIY: We will be adding regularly on the website.
2. Interactive games (quizzes) with real financial
2 - How historic valuation multiples help
Research Your Stocks Terminal - This section of the Finance Lab provides detailed historic financial data on growth and valuation multiples for each company and industry just as they are presented in analyst reports for 2000 companies.
1. The financial tables provide unified financial data for companies, combining consolidated and standalone data as appropriate by giving priority to consolidated data. The data, growth and margin ratios are precomputed.
2. PE, PB, EV/ EBITDA and PS valuations ratios are precomputed for all the previous quarters and TTM periods. This helps understand how markets valued a company in a past period in the context of the then prevailing growth and margin environment. This is quite useful in judging valuation for a company.
For example, the chart below shows that Asian Paints PE multiple has been consistently high across periods
Data source: www.equitylevers.com/financelab, a unique finance
terminal for valuation multiples
the contribution of PE ratio and EPS growth to share price. This is quite useful is assessing if the
valuation multiple has risen too fast relative to the EPS growth. The following chart shows that Asian Paints
EPS growth over 1 year period contributed Rs 1118 to the price increase of Rs
889 while PE multiple fell to cause a drop in share price by Rs 229.
4. Industry valuation aggregates are available for each past
period. This helps spot industries that show strong growth,
margins and also companies where valuation are beginning to rise,
indicating investor interest in the sector. Industry aggregates for
paint sector is given below - a very high growth and high margin sector.
3 - Algorithm and market patterns that work
This section of the Finance Lab provides market patterns based on ideas that work. One such pattern is based on earnings data pattern and is described below:
One of the most successful market patterns is based on companies that post strong results. Let's understand why this happens. Let's say you just passed the IAS or IIT exam. You would be in a sweet spot of great opportunity as you reputation and income can be expected to increase sharply over next few years. Similarly, if a business is in good economic situation its financial data with show this good tiding in its financial growth and this trend can continue for many months. Our proprietary algorithm that finds companies in the sweet spot of strong earnings performance. This list has been very useful for shortlisting potential investment targets.
The following table shows sample performance characteristics (back test basis) of our algorithm:
How to find companies that are expected to deliver robust profits
in the coming 12 months ? This requires the following skills:
As already mentioned earlier, we will study this in 4 steps
Step 1 - Reading financial statements
The most important financial data and ratios are just 8- 10. These are briefly highlighted below. In our expert videos and games section, we will use these data points and explain its usage across a variety of companies. For now, just a quick summary.
Understanding size - Price, Market capitalization, Sales, Profits and ROE. This gives us the context of size of company. Companies with market caps above Rs 10,000 Cr are large. Rs 2000- Rs 10,000 Cr are mid sized and smaller companies are below Rs 2000 Cr. Typically, small companies should grow faster to gain investor interest.
Understanding growth, margins and hygiene - Most important financial data and ratio is just 8 -10. We can break this into 3 broad categories.
Assessing investor interest
Recent (1 year, 1 month, 1 week) price movement for a company and industry players gives a good indication of investor interest for a stock. This is an important confirmation step for earnings-based investing model.
Step 2 - Making forward projections
“Equity markets discount future earnings”
Before we begin, please do note that we are simplifying a complex subject for ease of understanding.
There are 2 conventional methods to estimate the future financials. One is bottom up, where every aspect of projection is built step by step. For example, if we are putting up a restaurant in the high street. We will need to survey the alternative restaurants available, foot falls, pricing in the area, nature of customers and their preferences and many more aspects.
However, for listed companies all this may not be necessary. This is because, it has an established business model and the past financial data gives necessary clarity on its operating economics. In investing the key focus is to understand the expected change from the past financial trend. That Maruti Suzuki is large and profitable by itself will not make its price move up or down. Material acceleration in performance can be associated with expectation in share price increase and vice versa.
There are two components to making forward estimates:
In this step, we will demonstrate intuitive approaches to making
forward estimates based on past financial data, its growth and
margins. The focus of the second component, business outlook
assessment is the subject of the next step. There are essentially 3
simple ways we can project a forward number from past data as
shown in the picture below. These methods are fully explained in
the Developing Intuition Games and Expert Videos where we
take up companies for discussion.
How do these estimates compare with estimates provided by analysts
If the past trend computed as above corroborates with the business outlook for the sector or the company, then this estimate is normally a good approximation for getting a handle on direction and size of likely performance of the company. Remember, future is uncertain. Also, this approximation is good because even analysts extrapolate using most recent period financial performance and or management estimates. Some more reasons why this helps is as follows:
Step 3: Finding Equity Levers
Investors continually make qualitative assessments of future business outlook for a company. Company’s past performance and news flow determine investors' view of a company's future. We have already considered past financial data in making forward projections. Let us now focus on news flow. Company profits go up or down based on material changes in the external or internal environment that the company is operating in. Generally, changes arising due to company’s customer outlook, govt policies, products of competitors have greater impact than those arising out of changes in employee cost or advertising budgets. This means we don’t need to assess the impact on all items in the P&L or balance sheet.
Material information - Material changes are those that can have substantial impact on profits in the upcoming few quarters. Tata Consultancy Services (TCS) adding a new medium sized client may not have a material impact as it is a huge company with multiple offices. However, TCS adding 10% new work force is material and can be interpreted to mean better business prospect, even while this will have a cost impact.
Spotting the change - News items need to be assessed on the back of existing growth and margin trends. For example, when a company is in a positive growth phase and negative news gets announced, it could be a material turning point. Let us take an example, in 2018, Delta Corp, a gaming company, was in a period of positive growth. Just then Goa Government announced a large hike in license fee on their Casinos. This resulted in a sharp fall in share price.
Here are some quick thumb rules and steps to identify attractive opportunities.
Let’s start with step 1 and identify companies that are showing strong growth. Obviously, there will be a reason and we just need to discover this reason. This approach of first looking at earnings growth will get us to focus on possible winners. Now to find the reason, we can use publicly available resources. For example, YouTube videos, investor discussions in Valupickr.com, analyst reports from your broker, company filings, management interviews are possible sources for the same. Most are free and at times provide high quality information.
What to look for in these news/ analyst reports?
As an investor, the focus should be on structural trends. If you cannot spot any structural reason, may be the strong growth is one off. Further, it is important to know that not every situation we evaluate will be worth investing. Our job to find the headline reason and if we can’t find one, skipping the opportunity may be a good idea. Let’s take a few examples:
Once the big trend is spotted, the job should move to assessing the
risks. What could derail the big trend. For example, in the Tata
Coffee example above, how sustainable is the price increase will be
critical. It is now important to keep track news flow around coffee
prices as often as possible from authentic sources.
How deep should you analyze a company?
The idea is to understand the big economic picture of the company and the key drivers of expected change, which can be profitable or avoid losses. Some of the questions to answer are the following:
Some investors go in depth (some YouTube videos and analyst reports are quite in depth) or others just look for important drivers. We are in the latter camp as we don't think, we can discover too much new useful material information by spending more time in comparison to the well equipped large investors in the market. Investors should develop an understanding of the business and invest where strong growth at attractive valuation can be reasonably determined. Also,going deep, is generally useful when taking concentrated bets like PE investors. There is no right or wrong way, but the process should help build conviction on the expected future outlook.
“Do not miss the forest (the story) for the trees”
Once the story is understood, regular monitoring of news, events and quarterly updates will be easier. This will be available in most business newspapers and will not require too much time to gather.
How to find multi baggers
Everyone wants to invest in multi baggers, and this is a common question with beginners and DIY investors. While this is a detailed topic, a quick point is that the best time to spot multi baggers is during a bear market. April 2020 was a great period for investors to find multi baggers. Stocks were cheaper as they had taken a beating. Companies that had strong performance with good business outlook in bear markets are more likely to become multi baggers. Here is a list of multi baggers from the past 18 months. Each of these have delivered strong performance and have also enjoyed a positive business outlook. Their valuation multiples have expanded dramatically. We will be covering many of these in our monthly financial analysis videos as to how you could have spotted these companies at an early stage.
Listen to our video podcast on finding multi baggers
Step 4 -
Observing valuation - How to assign multiples
This is not a discussion on valuation concepts or methods. The idea is to provide simple thumb rules for valuation that can be used by anyone. This method works most of the time but not all the time. To become an expert, you will need to observe numerous situations and build your own observation experience.
This section is entirely based on data available at our finance terminal.
1. The basics of valuation
Valuation multiple is a derived figure. We know market price and the current EPS. With these data points, P/E ratio can be derived. We know that the market price reflects trading action by numerous investors, accordingly the P/E reflects the views of many investors . Once we have enough historic data points of trailing P/E ratios, it is possible to get a sense of likely future P/E multiple for a stock (see below).
Current trailing valuation multiples by themselves don't reveal much. P/E of 12 may not be cheap and P/E of 60 may not be expensive. Also, valuations change with market conditions, liquidity etc. Bull market valuation multiples tend to be very large and generous and bear market valuation multiples very low.
We discussed that the most common methodology is valuation based on forward valuation multiple, typically 1 or 2 years forward. . The are several factors involved while taking decision on likely forward valuation multiple as given in the table below. Some of these have been discussed in earlier sections but will be dealt with in detail in videos and investment games.
2. Mathematical quirks of Trailing PE
Price Earnings Multiples (PE) is computed as Market price divided by EPS. Before we begin, let’s look at some mathematical quirks of trailing PE. This is important to understand why forward PE expectation is more important than trailing PE.
For example, let’s say Bharat Forge with P/E ratio of 25 times is
expected to start reporting strong growth of 40% over next 1- 3
years, its P/E may rise in anticipation of expected EPS growth.
Suddenly the trailing P/E ratio could be at 40 times optically
making the stock look expensive. This sudden rise in PE is worth
deeper analysis to unearth and learn the opportunity in Bharat
Let’s say, a company normally reports Rs. 100 as EPS and quotes at
P/E of 15X or quotes at market price of Rs. 1,500. Let’s also
suppose that the company has a bad year (and the market expects
forward year to be strong) and its EPS drops to Rs 10. At this time
P/E will rise. Obviously, the market price will fall, but not to the
level of Rs 150 (Rs 10 EPS * old PE multiple of 15) as the market
expects good times coming back. Let’s further assume market
price settles at Rs 750, at this price the PE multiple will be 75 times
its trailing EPS. This P/E of 75X may not be cheap and may correct
further if the expected good times don’t materialize.
3. The valuation multiple thumb rules
Forward P/E ratio has 2 aspects -P/E based on fair assessment, typically based on how markets have valued the company in the past and sentiment factors. For example, raging bull or bear market tend to skew the P/E ratio to the extreme. For example, Nestle India’s historic P/E ratio has ranged between 40X and 80X. These two extreme ends are seen during bear and bull markets (for the company or markets) respectively. P/E based on observation can be estimated at 40- 60 times based on expected growth intensity. The higher range can be witnessed during bull markets due to market exuberance.
Price Earnings Growth (PEG) basis gives a start point for assigning valuation multiple. PEG is computed by dividing PE ratio by growth. Assume that a company has PE of 30 and is growing at 30% (past and future expectation). Its PEG will be 1. PEG Ratios that are 1 or less are considered to be attractive. The chart brings more clarity on this thumb rule.
One problem beginners face is how to pick a EPS growth rate from
a data set.This is because rarely do companies have linear growth. There is
significant volatility across periods. There are multiple growth
data points. For example, qoq, yoy, 1 year, 3 year, 5 year compound
growth rate. Studying these carefully should give you a broad
sense on historic growth rate. The next is to estimate expected
growth. This has been discussed in detail in the previous section.
As you apply these for different situations and time periods, you
will be able to build confidence in this all important subject for
investing. We also have investment games developed around
estimating growth and valuation multiple. Please play these games
to build skills.
Finding historic valuation range - As we have discussed, historic valuation tables are very useful and provide good indication of how market assigns valuation multiples to different companies. Here is the table below our Finance Lab for Maruti Suzuki for the last 10 years. It shows growth, ROE and P/E ratios for past 10 years.
Data source: www.equitylevers.com/financelab, a unique finance
terminal for valuation multiples
From the above data, it is easy to observe the below points:
In our expert videos section will cover many companies and their valuation observations that you can watch and learn.
Assigning forward multiple - Now we come to the last step to
our valuation multiple assessments. Normally, good investors
estimate possible growth in earnings and are conservative on
valuation multiples. Put in other words, investors invest basis
forward earnings expansion and not based on expected PE multiple
However, for our current purpose let us estimate forward PE multiples based on a possible situation. Maruti has TTM EPS (March 2021) of Rs. 145. Lets make some aggressive assumptions: -
P/E in future period should be around 30-32X, based on strong
growth expectation. Based on these assumptions, Maruti will
report TTM EPS of Rs. 284 in March 2023. At 30 times P/E
multiple, the target market price could be Rs. 8,526.
Here are 2 examples of analyst expectations for Maruti:
Stock investing is about future and hence different investors will
have different basis to estimate the future and these also keep
changing as new information become available.
We currently don’t like the business outlook for Indian automotive sector and don’t think the risk reward is in our favour to invest in Maruti Suzuki.
The data pattern we like:
We like the data chart for Globus Spirits: Quarterly data sheet from (August 20, 2021) www.equitylevers.com/financelab
Please join us to learn, practice and profit from investing.
“You don’t need to predict how everything will play out. Just master the
next step and continue moving in the right direction”James Clear.
There is risk to investing. Future is uncertain and it is impossible for any one to fully understand what will happen. Jeff Bezos, the famed founder of Amazon.com has said he makes an investment decision if he can build reasonable clarity (60%) about likely future outcomes. This holds true for markets most of the time and we have to invest basis 60- 70% clarity about the future.
Additional practical thumb rules:
As you will note, most of the above is observational skills and not complex financial or accounting or business knowledge. These skills can be built within 1 month by learning from examples and systematically tracking and analysis. This will set you up on a fun- filled journey into continuous learning and successful investing.