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Is it a good time to accumulate SAIL – Part 2

Here is the second and last part of our analysis of SAIL. You can read the first part here – Part 1.


We take up an analysis of P/E & EPS Expansion (& Contraction) of SAIL in this post.

The Blue blocks in graph are Trailing Twelve Month EPS figures for SAIL since April 2004. The Red Worm is a plot of P/E multiples of the stock.

SAIL PE EPS figures
SAIL – EPS (TTM) & P/E figures since April 2004

As of now, stock is trading at a PE multiple of 7.8. Though this in itself looks cheap, it is still not close to its historical lows of around 3. Another thing which we observed, and we may be wrong, is that PE expansions trail Earnings Expansion for this company (or cyclical commodities in general). And since last 2 years, it seems that earnings are neither going up nor going down. They have stabilized in a band of Rs 7 – Rs 9 per share. We believe that this may be the bottoming out of the earnings. The earnings may not go down much from here. And since, there is no immediate trigger for stock to move up, we believe that market expectations (and we take P/E as a proxy for that) are bound to stay stable or go down in near future, i.e., the stock may stay at these levels or go down a little. We don’t know if it will go down to PEs of 3 with current earnings or not. If it does, then that would mean that stock would move lower to levels of 35-40. But that would be the worst case scenario.

What seems more plausible here is that earnings have bottomed out and after a few quarters, they may make an upward move. With expansion in earnings, market sentiments would also catch up with an expansion in PEs. Hence there is a possibility of increase in share prices from current levels of less than 70.

Hence though we do like the stock as the risk reward ratio seems more skewed towards reward, there is also a possibility that stock may go down, even without a fall in earnings, just because of lack of positive news. And if Indian economy does start gaining momentum in quarters to come, that would once again help in raising market sentiments and hence a higher PE assignment to SAIL. On the downside, if things don’t turn out to be as bright was we might like them to be, we always have a decent dividend payout to look forward to. Over the years, SAIL has consistently doled out generous dividends. And we think that same would be continued in future.

So once again, we come back to our original question?

Is it a good time to buy / accumulate shares of SAIL?

Upfront, we would say that one can start accumulating this stock. By this we mean that one can start buying in small quantities. We are still not sure if the stock can go down more or not. But if stock is going down more because of PE contraction rather than earnings contraction, then one can continue accumulating the stock. Atleast this is what we plan to do. 🙂 But if the earnings, which we are assuming have stabilized for the time being, start going down, then one has to relook at the investment.

A lot of indicators (read more in Is it good time to accumulate shares of SAIL – Part 1) are pointing that downside may be limited. Hence, we plan buying this stock in small quantities for capital appreciation as well as dividend income.

This should not be taken as an investment recommendation. Do your own research before investing your hard earned money.

Disclaimer – Created long positions recently in SAIL. Author(s) plan to accumulate the stock in future, depending on various factors detailed in this and previous post.

Disclaimer – Author had a short stint in steel industry.

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Graham’s Number for Indian stocks

They say that profits are made at time of buying and not selling. Now suppose you have shortlisted companies, whose shares you want to buy, i.e. you have a Ready-2-Buy-List with you. (Check our favorite ones here). So would you buy these stocks at any given price or would wait to buy at prices, which are low, atleast by some standards? We assume you belong to the small minority (fortunately) which believes that it is wiser to adhere to some set valuation standards. Though not widely used in Indian markets and having its own sets of shortcomings, we decided to use Graham’s Number as the standard to evaluate our favorite stocks.
 
Graham’s Number (GN)
 
Graham’s Number measures a stock’s fundamental value by taking into account the company’s earnings per share and book value per share. The Graham number is the upper bound of the price range that a defensive investor should pay for the stock. According to the theory, any stock price below the Graham number is considered undervalued, and thus worth investing in. The formula is as follows:
 
 
But before we share details of Graham’s Number for chosen Indian companies, we would request you to read this article. The article highlights the dangers of using just one parameter like GN for stock buying decisions. For those who don’t want to read the entire article, it would be suffice to say that GN is based on just 2 of the total 7 criterions suggested by Graham. So, just using this number means that you are missing out on other 5 equally important criterions.
 
So without any further delay, here are the GN’s for some of our chosen stocks-
 
 
  • We have calculated two values for Graham’s Number. One is named G (Column 8)and takes into account EPS of last twelve months (TTM) alongwith current book value per share. Second is G* (column 10) and takes into account the 3 year average EPS values and current book value. Taking 3 year average smoothens out any extraordinary earnings of one year and helps in arriving at a more normalized EPS value. Though we would have preferred a 5 year average EPS, we could not find sufficient data for all the stocks.
  • Stocks like Sterlite Industries, BOB, Balmer Lawrie, Graphite India are trading almost 40% lower than their respective GNs. Please be reminded that a price below GN is considered to be a sign of undervaluation.
  • But we, being a lot more risk averse, decided to add a margin of safety of 25%. We found that even if we reduce the values of GN by 25% (in column 12), these stocks are still available 25-30% below their GNs. This is a clear sign that any investment made at current levels, may not be a bad idea at all.
  • You won’t be wrong if you believe that our previous statement (in particular, underlined part) is speculative in nature. All we can say is that with investments, no matter how careful we are, no matter how large the margin of safety we keep, we can never eliminate the risk of being wrong. 🙁
  • On the redder end of spectrum is Clariant Chemicals (India) Ltd. Though we ‘love’ this stock for its simplicity, robustness and dividends (obviously), our calculations show that it is trading 65-120% above its GN. Add to this the fact that it is currently available at a PE > 18, it can be safely deduced that shares of Clariant Chemicals are currently overvalued. (Historically, it has an average PE of 15).
  • We also observed that Banks, as a whole, seemed to be trading at levels much below their GNs (including margins of safety conditions!). To see if this was an exception or a trend, we calculated GNs for all major large cap banks.
  • The above table clearly shows that Public Sector Banks are trading at significant (40-50%) discounts to their GNs. Whereas their private sector counterparts are trading much above the GNs. We are not sure about the real reason for the same. (It may be due to PSU tag or higher growth associated with Private banks).
  • Our favorites BOB and SBI (part of DMP) are almost 48% and 23% below their GNs. But be cautioned that this should not be taken as a buy signal. There are a lot many issues like NPAs, etc which need to be looked into, before taking a call of buying into banking stocks.
  • But considering the growth possibilities (here we go again: read forecasting and speculation) that Indian banking sector has; and the role that large cap banks are about / supposed to play, wouldn’t it be an interesting idea to start accumulating units of a thematic (Banking Sector) mutual fund? We think it can be a good idea if one is ready to take the risk of taking a focused bet.
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Historical Sensex EPS Growth & PEG Ratio

How do market experts predict future index levels? It is done by estimating EPS (Earnings Per Share) of the index and then multiplying it with what they consider a logical multiple (P/E Ratio). In past 18 years, Sensex’s EPS has grown from Rs 81 to Rs 1270 (E) as show below –

As per analyst estimates, Sensex is expected to do an EPS of 1055 in FY2011 & 1270 in FY2012. This information should be taken with a pinch of salt as these are predictions. And predictions can be based on speculation. Capital Mind has an interesting post on senselessness of EPS projections.

A little calculation shows that in last 18 years, EPS has grown at 17.1%. Analysts predict that EPS for next 2 years is expected to grow at more than 20%. But considering present challenges of high inflation, high interest rates & global macro events, it seems to be a little too optimistic.

So how do we decide whether markets are fairly valuing future growth or not?

To answer this question, we use the PEG Ratio. It was popularized by Peter Lynch in his book One Up on Wall Street.

PEG Ratio is calculated as follows –

 

There is no hard and fast rule of which growth rate one should take. One can either take an estimate of future earnings growth or an average of the past earnings growth.

At present Sensex is trading at a multiple of 16.7 (Get latest P/E from here; For Nifty50, you can check this analysis too) and we take average EPS growth rate of 17.1% in our calculations. This gives us a PEG of 0.97 (=16.7/17.1).

So how do we interpret this number?

  • Normally, a PEG of greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. So a PEG of 0.97 indicates that at present, Sensex is fairly valued.
  • Lower the PEG, the lesser one has to pay for each unit of future earnings growth. So, to put it simply, one should be interested in low PEG values.
  • Consider a situation where you have a stock with low P/E. Is it that the market does not like the stock? Or is it that the market has overlooked a fundamentally strong stock of good value? To figure this out, we look at the PEG ratio. Now, if the PEG ratio is big, we know that this is probably because the “earnings growth” is low & this is kind of stock that the market thinks is of not much value. Now consider another situation where the PEG ratio is small. It may be because the projected earnings must be high. We know that this is a fundamentally strong stock that market has overlooked.

But PEG is not a fool proof way valuing future growth and there are a few issues –

  • In strictest of sense, it is more of a rule of thumb rather than a formula. Reason being that the two sides of the formula have different units: you’re comparing a fraction with a percent.
  • It works well with normal values of growth rates only. For certain values, the results can be absurd. For example, it implies that a company with zero growth should sell for a P/E of 0.

An interesting but technical take on PEG Ratios can be found here. Drawbacks of PEG ratio can be found here.

Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate. Also, being just a ratio it should be looked in conjunction with other ratios and numbers.