How to Avoid Loss and Earn Consistently in the Stock Market: An Easy-To-Understand and Practical Guide for Every Investor

by Prasenjit Paul

return and also serve the purpose of diversification.

I prefer stocks with improving ROE or companies having ROE of more than 20%. (It doesn’t mean that companies having ROE of less than 20% will generate negative return)

However, Return on Equity (ROE) offers an approximate view. Increasing ROE over the last 5-10 years with improved operating margin and cash flow is a signal of sustaining economic moat.

Debt to equity ratio

Return on Equity (ROE)

Return on Equity (ROE) is the single most important parameter to analyse a stock. Considering all other parameters remain same, higher the ROE better is the investment option.  Investing in companies with wide economic moat during their early stage can generate a multibagger return.  Companies can create economic moat by offering better products/service or utilising their brand

Increasing ROE over the last 5-10 years with improved operating margin and cash flow is a prominent signal of economic moat.  It is highly recommended to avoid high debt companies. Avoid stocks having debt to equity ratio more than 1 (increasing) and ROE less than 12% (decreasing over the last few years).

Shareholding Pattern Dividend History and Tax Rate Return on Equity (ROE)

or institutional investors purchase stocks via “block deal” or “bulk deal” from the open market. It is also mandatory to disclose such deals. So at the end of the trading day, you can easily access similar data from the exchange website. Return on Equity (ROE) and the tax rate both are readily available from the financials of the company. For ROE, it requires basic calculation. However calculated ROE is readily available on few financial website (make sure to verify it). Dividend history is also readily available on BSE or NSE website. You can access the last ten years dividend history through a single click.

Promoters rarely increase their stake during bull market – It is very rare to notice that promoters are increasing their stake during bull-market.

Entity Effect on Stock Price Increasing Decreasing Promoters Positive Negative/Positive Institutional Investors (FII and MF) Positive Negative Retail Investors Negative Positive

Why pledging of shares is extremely risky?

The problem begins when the market enters in a bear phase. Drop in share price leads to decrease in collateral. It

If any company has a pledging percentage up to 2%-8%, then it can be ignored.

Higher dividend payout is another symbol of shareholder friendly management. However, don’t consider dividend payout number in isolation. A capital intensive business that requires higher investment may opt out to pay dividends for maintaining the growth. Higher dividend payout ratio with increasing dividend rate confirms shareholder’s friendliness of management.

However, those tax incentives can’t last forever. Over the last 5-6 years if you find the company was reporting tax rate of below 30% (on average) of net profit then you need to dig further.

Always consider last 5 year’s average ROE. Last 5 year’s average ROE of more than 20% indicates that the company is unlikely to be manipulating their accounts. Companies having last 5 years average ROE of more than 20% not only offers immense upside potential but also protects the downside risk. All other things remain same, stocks with increasing ROE would perform better than their counterparts.

Management-Business combination Stock Return Great Management – Great Business Potential multibagger Great Management – Bad Business Cyclical return Bad Management – Great Business Moderate return Bad Management – Bad Business Wealth Destroyer

Identifying great business is just the first step of successful investing. Finding out the attractive price completes the process. In this chapter, we will discover the ways for identifying attractive valuation of any company.

never follow P.E ratio in isolation. Combine P.E ratio with other factors to take a rational decision.

Compare with its historical average - This is the best possible usage of P.E ratio. You can compare a stock’s P.E with its last three years or five years historical P.E. If you find that a fundamentally strong stock is trading much below at its historical average, then it might be a worthy investment. Only make sure that the business model or the operating environment of the company hasn’t changed much.

PEG ratio less than 0.5 indicates that the stock is undervalued and can be a great investment bet. PEG ratio greater than 0.5 but less than 1 indicates that the stock is either undervalued or reasonably valued, based on other parameters it can be a good investment bet. PEG ratio greater than 1 but less than 2 indicates that the stock is reasonably valued. To take any investment decision, make sure to check other parameters. PEG ratio greater than 2 indicates that the stock is overvalued.

PEG ratio combined with historical valuation will provide better insight on

P.E at 8-12 (20%-40% discount than average) – Considering the current P.E, which is less than the last three years average growth rate, the range of 8-12 is considered as “undervalued” and may offer an attractive entry opportunity. P.E at 12-18 (near average) – In this range, the stock is “reasonably valued”. It can be a good entry opportunity if future prospects of the company

remain intact. P.E at 20-30+ – In this range, the stock is “overvalued”. If at the same time, P.E ratio is greater than twice of the last three year’s average profit growth rate then avoid the stock. P.E at 5-8 or below 5 – In this case, it requires serious attention. We can’t mark it as “undervalued” without having an in-depth study. Such low valuation may be because of recent serious damage in the fundamental of the company.

With the average earnings growth rate of 38%, PEG ratio will remain below 0.5. PEG = P.E/ Average earnings growth rate PEG = 19/38 =0.5 So, our first consideration of undervaluation will perfectly hold anywhere below the P.E of 19. Don’t take investment decision based on only one criterion. Now, considering the historical P.E band of 6-22, average historical P.E comes at 14. It will translate the followings – 20%-40% discount than average – P.E band 8-11 (Best investment opportunity) Near average – P.E band 12-17 (Mediocre investment opportunity) Upper range – P.E band 17-22 ( Don’t make fresh investment. You can sell your existing holdings) More than 50% discount than average – P.E band 6-8 (Requires serious attention) So, as per the formula, the stock will offer the best investment opportunity in the P.E band of 8 to 11. From 2010-2014, Yes Bank was found trading in this valuation zone twice –during December 2011 and during August 2013. During December- 2011 and early January-2012 P.E was hovering around 10 and the stock price was around ₹240. As per the valuation method, this is a great investment opportunity. No wonder, by December 2012 the stock price generated around 95% return (quoted around ₹470). At the price of ₹470, P.E ratio was around 18 i.e. upper band of the average. Thus, indicating Exit/Profit booking signal. Yes Bank Valuation analysis with entry and exit point Average P.E 14, Attractive Buy Zone – P.E 8-11 Dec,2011 Dec,2012 Stock Return Sensex return

P.E ratio 10 18 95% 25% Stock Price 240 470 Similarly,

during August-2013, P.E was hovering around 10 and the stock price was around ₹280. For a short duration, the stock price reached below ₹250 and P.E touched 6. The aim is not to find out the exact bottom. Successful investing does not require finding out the exact top and bottom. It is next to impossible to buy at the exact bottom and sell at the exact top. As per the valuation method, ₹280 was a great investment opportunity. No wonder, within one year the stock price generated 100%+ return. By August 2014 the stock price was hovering around ₹600. Yes Bank Valuation analysis...

Price 2...

current valuation (P.E and P.B ratio) is less than the last five years average and the current P.E is less than half of the last three years average profit growth (PEG ratio < 0.5), then we can conclude that the company is undervalued and can become a great investment bet.  If current valuation (P.E and P.B ratio) hovers around the average of the last five years valuation and current P.E is less than or equal to last three years average profit growth (PEG <= 1), then we can conclude that the company is reasonably valued.  If the current valuation is either in the lowest or highest range of last five years range, then it requires serious attention.  If current P.E is double of the last three years average profit growth

rate (PEG >2) and the current valuation is in the highest band of last five years average, then the stock is overvalued. It is always better to avoid such stocks.  You can get a better result if you replace profit growth rate with EPS (Earning per share) growth as it is the Earning per share that matters the most. Moreover, profit growth doesn’t always ensure EPS growth. After equity dilution, profit growth rate and EPS growth rate varies.  To judge any cyclical business, you can alter the consideration period. Instead of 3 years or 5 years average value, you can consider any period based upon the circumstances.