How to pick the right shares

Sulagna Chakravarty | August 04, 2005

Y esterday, we spoke of the reasons behind the phenomenal performance of the stock market in Is it a good time to buy shares?

Today, we discuss how to make the right stock picks.

Opinions differ on whether or not you should be buying shares at this time. Some say the market is too high to buy shares now, others say it will go even higher.

If you want to buy shares now, here are some tips to ensure you choose the ones that will make money over a period of time.

Buying shares for the first time?

Which stocks should you pick now?

Stock valuation refers to the value you place on a particular stock. This means y ou determine the value of a company’s stock based on the company’s earnings and the price the stock commands in the market.

If you find the price of the stock is much higher than its worth, the stock is over-valued. If you find the price of the stock is lower than its actual worth, the stock is undervalued. These are the stocks you should pick up.

Should you buy shares now?

Spotting the undervalued players

Alright, now this may get a little technical but it’s not too difficult. So read on.

There are two primary ratios you must understand at the start.

EPS = net profit/ number of shares

Earnings Per Share is the net profit a company makes divided by the total number of its shares. The purpose of this ratio is to tell you how well the company is doing.

PE = market price/ EPS

The Price Earnings ratio of a stock is the market price divided by its EPS. This tells you how other investors view the stock.

A company will have a high PE if investors hope their earnings from the stock will increase; this is is why they buy the share. This increase in demand will result in the share’s market price rising.

To understand these ratios in detail, read Spot a good stock. Win big!

The Price-Earnings ratio of the Sensex is around 16. This means if we add up the price of all the 30 Sensex companies and divide it by their Earnings Per Share, the result would be 16.

Is that high?

Some say yes, others say no.

Brokers say that, historically, bull runs have peaked at a much higher Sensex PE.

They also say that the strong growth in the earnings of companies justifies the high valuations.

How long will this bull run last?

Over to PEG

A sound way to invest in undervalued companies is by utilising a tool called the PEG ratio.

A Price Earnings Growth ratio compares the PE ratio to the growth rate. The PEG ratio, also known as the Lynch ratio, divides the PE ratio by the growth in EPS.

PEG = PE ratio/ projected earnings growth rate

Let’s take a few examples.

Reliance Industry Ltd

Market price = Rs 700

Estimated EPS for FY 2006 = Rs 64.5

Forward PE (PE based on the share’s projected earnings in FY 2006) = Rs 10.8 ( Rs 700/ Rs 64.5)

Now, RIL’s EPS is expected to grow from Rs 54.7 (for FY 2005) to Rs 64.5 (for FY 2006). This means a growth of 17.9%.

PEG ratio = 0.6 (10.8/ 17.9)

The rule of thumb is that, so long as the PE is below earnings growth, or the PEG ratio is less than 1, the stock is not over-valued.

Infosys Technologies

Market price = Rs 2,268

Estimated EPS for FY 2006 = Rs 90.72

Forward PE (PE based on the share’s projected earnings in FY 2006) = Rs 25 (Rs 2268/ Rs 90.72)

Infosys’ rate of growth in EPS is around 32%.

PEG ratio = 0.78 (25/ 32)

That means, even at a forward PE of 25, Infosys’ PEG ratio is below 1 and the stock could still appreciate.

One of the reasons foreign investors are so bullish on India is because they know the scope for growth here is immense.

Of course, there are all sorts of risks when the Sensex is at such stratospheric levels.

One of them is that the market has gone up too far too fast — the Sensex has gone up by about 17% in the last two months.

When the market rises too fast, it usually results in a strong correction (a reversal in prices, which means the market comes down and the prices of shares fall).

How to read quarterly results

How to read a balance sheet

Let me end on a warning note. Whether or not a bull run is on, buying shares is risky. You could make a million or lose all your money. In How I made and lost a crore. a reader documents his experience.

The only precaution you can take is to play as safe as possible. This means you need to do your homework. Don’t just buy a share because your neighbour is doing so.