Stock Shastra #11 – Before investing, find the right value of each stock – Its MRP
By now, you must have shortlisted a wonderful company i.e. a company with an excellent financial track record and checked if it has one or more of the competitive advantages (brand, patent, switching cost, exclusive control or the ability to price competitively). Also, after running a check on the management’s worthiness, you must be now asking yourself the question – below what price is the stock worth buying? Remember finding the right value of a stock is very important as a good stock is not always a good investment. You can lose money even after investing in a good stock if you pay too much for it. So, let’s learn how to find out the right value for the stock i.e. its MRP or Maximum Retail Price.
So, what is the right value (the MRP) for a stock?
There are many popular methods to calculate the right value of a stock popularly known as Intrinsic Value or Fair Value. Every model be it a Dividend discount valuation model or Discounted cash flow valuation model has its own basis for calculation. But the underlying common theme for all these models is the same: The value of a stock relates to the returns that investors expect to receive from holding the stock.
So, to arrive at the right value of a stock, we look at the future returns that an investor will get by investing in a stock and discount them to the current period using an appropriate rate of return that we expect from investing in the stock.
So, what are the returns that we can expect from investing in a stock as a minority shareholder?
Suppose you have invested in a stock, keeping a long-term holding period in mind. As a shareholder, the current price of the stock is the investment that you make in the stock. You earn income or returns from this investment in 2 ways i.e.
(a) Future Dividends: The Future Dividends which you will receive every year.
(b) Future Sell Price: The Price that you will receive when you sell the stock in the future.
So, the right value of the stock i.e. MRP can be calculated as
Now that we know how to calculate MRP, let’s look at how to arrive at the 3 individual parameters viz. Future Selling Price, Present value of future Dividends & Expected rate of return.
1) Future Selling Price: We learned that this is the price that you will receive when you sell the stock in the future. Here, you will benefit if the stock price appreciates., Now, it has been seen that over a long term, a stock’s price is primarily dependant on the long-term future earning capacity of the company. So, as a company’s earnings grow, so should its stock price.
So, how do we calculate the future earnings growth of the company?
The future earnings growth of the company depends on 2 things:
a) The prevailing market conditions i.e. whether the company is present in a growing or stagnant industry, the demand of the company’s product/service
b) The company’s own capability to grow and take opportunity of the market; this can be gauged by looking at its sales, earnings and book value growth rates in the past (y-o-y and CAGR), its average return on equity (ROE), average return on invested capital (ROIC).
2) Present Value of Future Dividends: These are the dividends that you will receive in the future and can be calculated by using the historical dividend per share that is paid by the company and growing it the rate at which you expect the dividends to grow. We calculate the future dividends for each of the years and then discount them to the present year. The summation of these individual present values is taken.
3) Expected rate of return: This is the rate of return that we expect to earn by investing in a stock. At MoneyWorks4me.com, we have taken this as the Cost of Equity of the respective companies. Cost of Equity is the minimum required rate of return that investors expect when they invest in a stock and take up the associated risk.
A holding period of 5 years (n) is taken into consideration to calculate every stock’s right value. This is what we call MRP- the Maximum Retail Price.
To summarize, MRP is the maximum price we should pay for a stock, so as to get a minimum expected rate of return (COE for that stock), every year for the next 5 years.
So, we now know how to calculate MRP, but how is this helpful?
All of us know that the stock market behaves irrationally in the short-term. Most of the time, it doesn’t value the stock at its MRP; sometimes higher/lower. Also, our MRP is based on estimates which can turn out to be different than our expectations. So, how do you protect your investment from this irrational behaviour or your estimates going wrong? The answer is look for a discount or margin or safety.
Logically every smart shopper buys stuff at a discount and the same should apply to stocks. Benjamin Graham – the Guru of Value Investing propagated the idea to buy stocks that were trading at a discount to their full value as this minimizes your risk to a great extent.. Hence, the principle we follow is: always buy much lower than its MRP and sell at when prices cross the MRP.
Now, you must be wondering why is MRP the Sell Price, when we earlier said this is the maximum price that an investor should be willing to pay? … Especially, if the stock market may value it much higher than its MRP.
Once the stock market stops behaving irrationally (i.e. in the long-term), it is most likely to value the stock at/close to its fair value based on rational expectations i.e. its MRP. As we said earlier, in the long run the stock price is driven by its earnings capability. So, consider MRP as the maximum price that the market is offering for the stock, i.e a benchmark for the ‘Sell Price’. Though there may be times, the market may value it higher, its right value will always be somewhere around the MRP. Remember this is a benchmark for Sell Price, a number somewhere around which the right value is likely to hover.
Having understood the method, you are now probably wondering where you can get the right of for the stock. Moneyworks4me.com is a website, where you can get this right value for around 1300 stocks in the form of the stock’s MRP. So, to know the MRP for your investments, visit www.MoneyWorks4me.com.
So, after telling you that you should buy the stock at a lower price than its MRP, you are now wondering what is the right price to buy. Hold on. You will have to wait until next week for that. See you next week with Stock Shastra #12.