winner's curse- investing psychology

Investing Psychology: Winner’s Curse

Investing Psychology- Winner’s Curse :

Have you ever had a chance to participate or witness an auction?

If yes, then you would relate to this better! As interesting as the name of this phenomenon sounds, the outcomes are pretty relatable too.

Many statisticians, mathematicians, and successful investors have discovered and scribbled a pretty common sequence of scenarios that happens mostly during the auction. Let’s try to give you an overview of this:

A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.

As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”.

But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.

Such scenarios are quite noticeable everywhere – from IPL auctions to jewelry auctions to the real estate to the stock market, you might get to see this every time. The phenomenon could be explained clearly with the use of a couple of suitable examples in this article.

“Winner’s Curse” is quite noticeable in the domain of investing. Generally speaking, a newbie tends to fall in such pitfalls quite often! Keep reading this article to know more about the winner’s curse!

Also read: How to Earn Rs 13,08,672 From Just One Stock?

The Auction Scenario:

If you haven’t had a chance to witness an auction yourself then you have a chance to virtually experience it over here!

Basically, an auction is a set up organized by the “current owner” of an asset who is interested in selling the asset to one of the bidders who are participating in the auction. The owner can be a bank or any other financial institution as well.

A set of people who are interested in purchasing the “on sale” entity are called bidders who have the leverage of placing the bids on the entity. The bidding starts with a base price (the one put forward by the “current owner”) and the bidders have to one-up their biddings to own the asset/entity.

The mentioned set of actions is repeated until no bidder out rules the last bidding. As a result, the final bidder gets the asset – sound simple?

Where is the loophole?

Suppose if the real (true value) price for the asset was 1 hundred thousand dollars and if the final bidder claims it for two hundred thousand dollars, would he still be called as a winner?

Psychologically speaking, the overwhelming and competitive environment of bidding in an auction makes the bidder claim the entity at a higher price than what is profitable (admissible).

This overestimation of the final bid for an entity is actually the cause of “winner’s curse”.

winner's curse graph

New to stocks? Confused where to begin?  Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount. 

What triggers this curse?

They say, “Emotional stability is one key factor when it comes to investing”.

You would have seen various collaborations of multinational companies. In fact, the whopping amount for which the shares for a certain company get sold is quite huge, right? Well, the winner’s curse is actually playing the cards for it sometimes.

In fact, various multinational giants get caught in this trap. Is it emotional friction or winning at any cost? I’d say both.

The human brain works in a pretty competitive way and the reason can be delved into the core of cognitive science. After the “successful bidding” one gets to realize the loss incurred but the dust gets settled by then.

A rapid increase in an entity’s price followed by its contraction is a sequence followed by various financial experts. The strategy works when a number of people get lured by the so-called “lower prices” of the assets and end up paying for it.

Also read: Efficient Market Hypothesis -The Only Theory That You Need to Read Today.

Winner’s Curse in the Stock Market:

Winner’s curse is not new to the stock market. You can notice multiple scenarios in the stock market where the investments of the people are influenced by the winner’s curse. Few of the best examples are:

1. Buying stocks at a high price.

In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is never advantageous for the investors.

2. Investing in IPOs where the insiders are selling their stakes and public is bidding.

IPO is a scenario where a company offers its shares to the public for the first time. During an IPO, insiders like Promoters, Family, Early Investors- Angel capitalist, Venture capitalist etc are selling their stakes to the public.

However, do you really think that the insiders will sell their stakes to the public at a discount?

Anyways, in order to win, the public is ready to bid a high premium (most of the time) for that IPO. However, after the IPO gets allotted to the people, the winner’s curse starts playing its role.

Also read: Is it worth investing in IPOs?

stock market bidding

You might want to steer clear of this the next time you go for a hefty investment, right? Don’t worry you can try out some precautionary measures with which you should do fine at the “war zone”.

Things to Remember while Bidding:

1. Just as analysis and research are two important things to do before making an important investment. Similarly, knowing the true value of the asset you are bidding for is quite important before you even go for it. You should know that you stick to your actions even better once you have the basics cleared in mind.

There must be a fair standard price of the commodity you’d be bidding for. Get to know about it beforehand.

2. Draw a line: Putting aside an emotional mindset is the best thing that you can do while bidding for an asset as emotions and finance don’t mix well together. As soon as you start placing your first bid, you should know where to draw the line. This would help you hold your grounds in a much better way.

3. Know how important it is for you to win: Rational arguments are always better when you are in a confused state of mind. Ask yourself why does winning actually matter to you?

Also read: Loss Aversion- How it Can Ruin Your Investments?

November 28, 2018 Investing Psychology, Investment Basics No comments yet
Break all the rules and conquer FIRE - Financial Independence and Early Retirement cover

Break all the rules and conquer FIRE- Financial Independence and Early Retirement!

Financial independence and early retirement? Sounds cool, right?

Over the past few weeks, I have been going through the blogs of a lot of successful FIRE enthusiasts who have actually achieved financial independence and are pursuing early retirement.

From different FIRE subreddit group discussions to the story of a software engineer who retired at an age of 30 (yes, that’s 30) by spending only a small percentage of his salary and consistently investing the remainder (particularly in a stock market index fund)… I read them all.

And in this post, I am going to share a few of my learnings regarding what exactly is financial independence and early retirement (FIRE) and why you should sign up for this movement.

I hope you are also as excited as I’m. Let’s get started.

What is Financial Independence and Early Retirement (FIRE)?

Let me start with a question. If I ask you to think about a retiree, what picture comes in your mind? If you are like me, then most probably the picture is of your grandparents.

grandparents retired

In general, most people dream of financial independence or retirement only by the age of 50s or 60s. After all, thinking about early retirement might even sound insane to people who are living pay-check to pay-check and have a number of dependents (like spouse, children, parents etc) to support.

However, time and again, a lot of ordinary people with similar financial situations like that of us- have proved that financial freedom can be achieved even at a comparatively young age if people have a definite plan and are ready to put some serious efforts.

“Financial Independence and Early Retirement (FIRE) is a lifestyle movement that aims at reducing expenditures and increasing investments in order to quickly achieve financial freedom and retirement at an early age.”

In simple words, the two terms described in FIRE can be explained as:

  • Financial freedom — which is a financial situation where an individual does not have to work for the sole purpose of making money anymore.
  • Early retirement — is a situation of quitting your job/career and pursuing other activities that you’re passionate about.

Anyways, most FIRE enthusiast does not always look forward to quitting their job completely and not working at all. However, after attaining financial independence, one can be picky about their job and choose whether they want to continue working or not. Nonetheless, people who sign up for FIRE targets to become financially free in their 40s, 30s and sometimes even in their 20s.

This movement has got a lot of momentum in recent years. A lot many people are signing up for FIRE- who want financial freedom and early retirement to pursue what they always want to do when they still are young enough to enjoy it.

Does FIRE mean the same for everyone?

Although both financial independence and early retirement are crucial steps, however, both side of the equation of FIRE may not be always balanced for different individuals.

Many people prefer financial freedom over early retirement. Some may even plan to work at the same place when they are financially free just because they enjoy doing it. However, financial independence gives them a choice to choose whether to work or not.

Moreover, how much net worth is required to attain financial independence also varies from people to people. As a rule of thumb, if your net worth is greater than 25 times your annual expense, then you might be financially free.

However, many individuals choose a higher factor just to give a benefit of the doubt in case of unforeseen emergencies.

Who is FIRE for?

In the general population, there is a myth that FIRE can only be achieved by people who earn a lot of money. And I agree to a little. After all, making huge money obviously helps towards the path of attaining financial freedom.

However, this is not the only requirement. In order to obtain financial freedom, one also needs to optimize his spending habits.

FIRE can be more easily attainable for those people who can save money and are willing to follow a disciplined path. Even if you do not earn a huge income, still you can reduce your expenses, build other sources of income and invest intelligently to grow your net worth.

Overall, attaining FIRE depends more on the willingness to develop a financial freedom road-map and sticking to a plan. Moreover, it’s not much difficult if you are ready to make some small but significant optimizations in your life.

financial-freedom

The basic principle behind FIRE.

The basic principle behind attaining financial independence and early retirement is very simple-

  1. Spend less than what you make – This is the method used to make a big distance between your income and spending, which most people fail to do.
  2. Invest your savings: By investing intelligently, you can make your money work for you and let it grow with time using the power of compounding.

Anyways, deciding where to invest can be a personal preference. You can choose different investment options depending on your risk appetite like stocks, bonds, index funds, rental properties, real estate etc.

Actionable steps to reach FIRE:

Here are the five actionable steps that can help you to work towards conquering financial independence and early retirement:

1. Figure out WHY you want to attain FIRE.

This might be the most crucial question to ask before you start your journey of financial freedom- Why do you want to attain FIRE?

The reason can be as simple as to spend more time with your loved ones, to travel or to start a long-dreamed business with your pals etc. However, it’s really important that you figure out your why. Having a definite reason will help you keep motivated to pursue FIRE and to stick with your plan.

2. Track your expenses

The next step is to track your monthly (and annual) expenses by looking at your bank statements, credit card statements, and other bills. This will help you out to find how much you are spending and moreover, where exactly you’re spending each month.

Tracking your expenses will also guide you to figure out whether your expenses are meaningful or you are just spending recklessly. Quick Note: You might be a little shocked after calculating your expenses. Generally, it is way higher than what an individual roughly calculates in his mind.

3. Calculate what your lifestyle may cost you per year

After tracking your expenses, you need to figure out how much are your annual expenses and what net income you will require to live a lifestyle that you want to pursue. (Quick tip: Keep in mind about inflation while doing your calculations.)

4. Start working to optimize your expenses and to increase your savings

Once you have figured out your expenses and how much you need annually to start living your preferable lifestyle, then start working to increase your savings. You can cut back the small but significant expenses and optimize your spending so that you can save to the fullest. A few ways to reduce your expenses and save more:

  1. Purchasing used car instead of a brand new.
  2. Lowering your house costs/maintenances
  3. Avoiding frequent visits to restaurants.
  4. Buying monthly groceries instead of frequent visits to the supermarket.
  5. Adding secondary sources of incomes etc

Although these steps are known and quite straightforward, still they are effective to reduce your spending and to increase your savings.

Why You Should Start Saving Early - Enjoying

5. Invest your savings

The final step is to spend your savings intelligently in the different investing options which can give you the best possible returns.

Anyways, always keep in mind your risk appetite while selecting the investment option. For example, if you are not much comfortable in taking higher risks, then you can invest in bonds or index funds. On the other hand, if you are young and willing to choose slightly riskier options to get higher returns, direct investment in stocks can give you great returns.

While making decisions, plan your investments in such a way that your future assets should be enough to generate sufficient income for you so that you do not need to work any longer.

Quick Note: Although saving money is considered as the hardest step to attain FIRE, however in actual, the toughest one is to keep patience. After all, it might take years for your money to compound to the level to attain financial freedom. And all that time, you have to avoid the urge to reckless spend your money. And therefore, an individual requires a lot of patience to stick to his plan over long-term.

Also read:

Closing Thoughts:

Although many people have publically shared how they achieved their financial freedom and retired early through their blogs/articles, still FIRE is a relatively new concept in this society which believes that working continuously from their 20s to 50s is the only way to live a successful life.

Moreover, different people have different versions of FIRE. This movement basically means to live frugally and make your money work for you in order to attain financial freedom and to retire from your full-time work as soon as possible. However, not everyone has the same expectations from it. For example, whether one wants to go for a mini-retirements, part-time retirement or permanent retirement after attaining financial freedom- it totally depends on the individual’s preference.

Anyways, although it’s not easy to achieve financial freedom and retire early, however, it is practical and achievable even by people making average salary by building a financial plan and strictly adhering to it.

That’s all for this post. I hope you’ve enjoyed reading it. Finally, if you are also a financial independence and early retirement enthusiast, then spread the FIRE among your friends and family. Cheers!!

November 21, 2018 Personal Finance No comments yet
Why should you invest in the stock Market in your 20s

Why Should You Invest in the Stock Market in Your 20s?

Why should you invest in the Stock Market in your 20s?

For the people who are in their 20s- stock market investing might seem too early. Plenty of years left to invest, right?  Why get involved in the complex world of the stock market so soon? Most youngsters believe that either it is too soon or they do not have too much money to start investing in their 20s.

However, both of these assumptions are wrong.

The best time to start investing in the stock market is when you are in your 20s. Why? Let’s find out!!

Why should you invest in the Stock Market in your 20s?

1. Stock market investing gives the best returns:

Do you know that if your parents have invested Rs 10,000 in the stocks like WIPRO or Infosys in the early 1990s, it’s worth would have been turned out to be over crores by now? (Here’s a case study on WIPRO and Infosys). Note that we are not even talking about hidden gems. Few other common stocks like Eicher Motors (Royal Enfield Parent Company), Symphony, Page Industries (Jockey) etc has given even better returns than Infosys and WIPRO.

Historically speaking, the stock market has outperformed all the other investment options in the long run. If you buy an amazing stock in your 20s and have the patience to hold it for long-term (20-30 years), you can also get a fantastic return. Here, you’re giving your investment enough time to grow.

2. You won’t require extra money anytime soon.

When you are in your 20s, you won’t need to worry about a lot of things like kids, house loans, kids college fees, retirement plan etc. Moreover, at this phase of time- most of the people do not have any dependents like spouse or kids. When you invest in your 20s, you won’t require to sell that stock anytime soon. You can easily invest and forget that money.

3. It’s a great way to plan your future goals.

Planning to buy a beach house by your 30s or become a millionaire by 40s or just having enough saving to retire early — all these can be achieved if you start investing early. Set a definite future goal in your 20s and invest systematically to attain it.

4. You can take a lot of risks.

When you are in your 20s, you can take a lot of risks while investing in stocks.

Instead of investing in just large caps or blue-chip stocks, you can also invest in small caps like promising startups which recently got listed in the stock exchange and have a huge upside potential. Although, the risk associated with small caps are relatively high compared to the well settled and trustable large caps- however, the rewards are also higher.

low risk low reward

When you are in your 20s – even if you incur some loss, you have plenty of time to learn and recover from your mistakes. At this stage of time, while you can handle more risks you can also earn great rewards.

Bottom line:

It’s always advantageous to start investing early. One of the greatest investors of all time started investing at an age of eleven.

“I made my first investment at age eleven. I was wasting my life up until then.” -Warren Buffet

Eleven might be a little soon for an average investor in India. However, the 20s is most suitable to start investing in the stock market. At this stage, most of the people have money with no responsibilities.

In the end, here is the golden rule of investing to make build amazing money in the long term—“Invest early, invest consistently and invest for the long term…” #HappyInvesting.

November 20, 2018 Investment Basics 7 comments
dcf analysis cover

How to value stocks using DCF Analysis?

Share market is a place where one can sell you a one-liter packet of milk for Rs 1,000 and if you might be even happy to purchase that. It’s completely impossible to decide whether a stock is overvalued or undervalued just by looking at the market price of the company.

And that’s why valuation is a crucial factor while deciding whether to invest in a stock or not. You do not want to purchase a stock at ten times its valuation. After all, a good company may not be a good investment if you are overpaying for it. It’s always preferable to invest in stocks when they are trading below their true (intrinsic) value.

In the words of the legendary investor Warren Buffett, the intrinsic value of a company can be defined as —

“The intrinsic value of a company is the discounted value of the cash that can be taken out of a business during its remaining life.” — Warren Buffett

Nevertheless, evaluating the value of a company using this definition is easier said than done. After all, finding the intrinsic value of a stock requires forecasting the future cash flows of a company which needs a lot of calculated assumptions like growth rate, discount rate, terminal value etc.

Anyways, one of the most popular approaches to find the intrinsic value of a company is the discounted cash flow (DCF) analysis. In this post, we are going to discuss the step-by-step explanation of how to find the true value of a stock using the DCF method. Further, we’ll also perform the DCF analysis on a real-life company listed in the Indian stock market to find its true value.

Quick note: I’ll try to keep the explanation as simple as possible so that you can easily understand the fundamentals. Let’s get started.

Discounted cash flow valuation:

Before we start the actual calculations, let’s quickly discuss what exactly is discounted cash flow analysis.

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity.

DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. (Source: Discounted Cash Flow (DCF)– Investopedia)

In other words, discounted cash flow analysis forecasts the future cash flow of a company and later discounts them back to their present value to find the true intrinsic value of the stock (at the time of calculation).

Further, I would also like to mention that valuing stocks using the DCF method requires a little knowledge of a few common financial terms like free cash flow, discount rate, growth rate, outstanding shares etc. Here is a quick walk through the key inputs required in the discounted cash flow analysis.

Key inputs of Discounted Cashflow Valuation:

1. Free cash flow (FCF): Free cash flow can be defined as the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It’s important for an investor to look into the free cash flow of a company carefully because it is a relatively more accurate method to find the profitability of a company than the company’s earnings. Free cash flow of a company can be calculated by using the below formula:

FCF = Cash flow from operating activities — capital expenditures 

Also read: What is Free Cash Flow (FCF)? Explained in Just 1,000 Words.

2. Growth Rate: It is the expected rate at which the company may grow in the upcoming 5–10 years. It’s really important to use a realistic growth rate for efficient calculations. Else, the calculated intrinsic value might be misleading.

Different investors use different approaches to find the expected growth rate of a company. Few of the common ways are by looking at the historical growth rate for the earnings/profits, reading the analysts reports to find out what they are forecasting, peeking in the company’s annual report/latest news to find out what the management/CEO is saying regarding the company’s growth rate in upcoming years etc.

Quick Note: In the book- ‘The little book of valuation‘, the author Aswath Damodaran has used an interesting method to find the growth rate of a firm. He argues that for a firm to grow, it has to either manage its assets better (efficiency growth) or make new investments (new investment growth). He used the multiple of proportion invested and return on investment to arrive at the growth rate in earnings. If you haven’t read his book, it is a good place for the beginners to start learning valuation of stocks.

3. Discount rate: The discount rate is usually calculated by CAPM (Capital asset pricing model). However, you can also use the discount rate as the rate of return that they want to earn from the stock. For example, let’s say that you want an annual return rate of 12%, then you can use it as the discount rate.

As a thumb rule for the discount rate, use a higher value if the stock is riskier and a lower discount rate if the stock is safer (like blue chips). This rule is in accordance with the principle of the risk-reward which claims a higher reward for a higher risk.

4. Terminal Multiple Factor: This is the fourth input of the DCF calculation that is used to find the terminal value of the company. Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the DCF model as it typically makes up a large percentage of the total value of a business.

There are two approaches to the terminal value formula: (1) perpetual growth, and (2) exit multiple.

In this post, we are going to use the exit multiple approach. This approach is more common among industry professionals as they prefer to compare the value of a business to something they can observe in the market. The most commonly used terminal factor is EV / EBITDA. (Read more here).

Steps to value stocks using DCF Analysis:

Here are the steps required to value stocks using the discounted cash flow valuation method:

  1. First, take the average of the last three years free cash flow (FCF) of the company.
  2. Next, multiply this calculated FCF with the expected growth rate to estimate the free cash flows of future years.
  3. Then, calculate the net present value of this cash flow by dividing it by the discount factor.
  4. Repeat the same process for the next 10 years to find the net present value (NPV) of the future free cash flows. Add the NPV’s of the FCF for all the ten years.
  5. Next, find the terminal value the stock by multiplying the final year FCF with a terminal multiple factor.
  6. Add the values from step 4 and 5 and adjust the total cash and debt (mentioned in the balance sheet of the company) to arrive at the market value for the entire company.
  7. Finally, divide the calculated number in step 6 by the total number of outstanding shares to arrive at the intrinsic value per share of the company.

If the final intrinsic value of the company is lower than the current market price of the share, then it can be considered undervalued (and a good time to invest in that stock assuming the quality of the stock is also amazing).

On the other hand, if the final intrinsic value of the company is greater than the current market value, then the stock might be over-valued. In such a scenario, it’s better to keep that stock in the watchlist and wait for the price to come down within the purchase range.

That’s all. This is the exact approach used to find the discounted cash flow value of any company.

In any case, if you are not comfortable in performing DCF valuation using excel sheets, you can also use the Trade Brains’ online DCF calculator to find the intrinsic value of a stock.

Here’s a link to our simplified online DCF calculator (It’s free to use).

Real life example of valuing stocks from Indian stock market using DCF analysis.

Now, let’s calculate the Intrinsic value of Ashok Leyland (NSE: ASHOKLEY) using the Discounted Cashflow Valuation method. (Please note that all the data used here has been gathered from Annual reports.)

  1. First, we will start by finding the free cash flow of Ashok Leyland. Here, we’ll take the FCF for the last 3 years and consider their average as a reasonable FCF. Now, free cash flow is equal to cash from operating activates minus the capital expenditures. The average FCF for the last three years turns out to be Rs 1715 Cr.
  2. Next, we’ll project this FCF only for the upcoming ten years. Although, the company may continue for many more years after the tenth year, however predicting free cash flow for over 10 years is really difficult. Therefore, we assume that the company will sell off all its assets at the end of year ten at a ‘Sell off valuation’ (Terminal value). We’ll use a multiplier of 9 for the tenth year cash flow to simulate the value of these cash flows in the case company would sell all its assets (This is a necessary assumption that we need to make in order to find the value of the company).
  3. Apart from the cash flows, the next important input is cash and cash equivalents which the company reflects on its balance sheet. For Ashok Leyland, this value is equal to Rs 993 Cr.
  4. Besides cash, the next essential input is the debt (as debts have to be first paid off and shareholders are last in the line). Ashok Leyland has a total debt of Rs 515 Cr.
  5. Next, we need to find the annual growth rate for Ashok Leyland. From the historical reports, we’ll consider a conservative growth rate of 12.75% per annum for our calculations of forecasted cash-flow.
  6. Further, here we are considering a discount rate of 13.5% for discounting the future cash flows to their present value.
  7. In addition, we need the total numbers of outstanding shares of Ashok Leyland. It is equal to 294 Crores.
  8. Finally, let’s take a margin of safety of 10% on the overall calculated intrinsic value to give our calculations a benefit of doubt. (Higher the margin of safety, lower is the risk).

dcf calculator

After placing the above values in the online DCF Calculator, the intrinsic value per share of Ashok Leyland turns out to be Rs 93.19 (after a margin of safety of 10% on the final intrinsic price). This is the true value estimate per share for Ashok Leyland at the time of writing using the DCF model.

The current stock price of Ashok Leyland is at Rs 105.55. This means that this stock is currently slightly overvalued compared to the calculated intrinsic price.

Quick Note: This intrinsic value is based on my calculations and assumptions. Although I’ve tried to be reasonably conservative in using the inputs, still no valuation should be considered precise as there is no guarantee that the company will grow at the assumed growth rate for the upcoming years. The key while performing DCF is to always consider rational inputs to arrive at a roughly correct intrinsic value.

Also read: How to Find Intrinsic Value of Stocks Using Graham Formula?

Warning: Garbage in, Garbage out

Now that you have understood how to value stocks using the DCF analysis approach, let me give you a FAIR WARNING. DCF is a very powerful tool for valuing stocks. However, this methodology is only as good as the inputs.

For example, even a small change in inputs (like growth rate or discount rate) can bring large changes in the estimated value of the company. (Try changing these values by 1% or 2% and you can notice a significant change in the result). In short, if the inputs are not reasonable, the out will also not be correct -’Garbage in, garbage out’.

Therefore, fill all the inputs carefully as they all have the potential to erode the accuracy in the estimated intrinsic value.

Closing Thoughts:

DCF method is a very powerful method of valuing stocks. However, this method requires rational inputs.

Many investors who have already made up their mind to purchase a stock, can easily infiltrate the final result by assuming a higher growth rate/ terminal value or a lower discount rate. However, if you are choosing wrong or unrealistic inputs for growth rate, discount rate etc, the final intrinsic value per share may also be incorrect. Therefore, it is always recommended to use conservative inputs while performing DCF valuation.

That’s all for this post. I hope it is useful to you. If you have any questions, feel free to comment below. Happy Investing.

**Investing for Beginners**

If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!

November 20, 2018 Valuations No comments yet
How to Find Intrinsic Value of Stocks Using Graham Formula cover

How to Find Intrinsic Value of Stocks Using Graham Formula?

How to find intrinsic value of stocks using Graham formula?

Valuation is one of the most important aspects while investigating any stock for investing. A good business might not be a good investment if you overpay for it. However, most valuation methods like DCF analysis, EPS valuation, dividend discount model etc requires little assumptions and calculations.

Luckily, there are also a few valuation methods available that are pretty simple to use in order to find the true value of a company.

In this post, we are going to discuss one such valuation method which is really straightforward and simple to use. And this valuation method is known as Graham formula. Here are the topics that we are going to discuss today:

  1. A brief introduction to Benjamin Graham
  2. How to find the intrinsic value of stocks using Graham formula?
  3. Pros and cons of graham formula.
  4. Real life example of valuing stocks from Indian stock market using graham formula.
  5. Closing thoughts.

Overall, this post is going to be really helpful for all the beginners who are stuck with the valuation of stocks and want to learn the easiest approach to find the true intrinsic value of companies. Therefore, make sure to read this post till the end.

Let’s get started.

1. A brief introduction to Benjamin Graham

Benjamin Graham was a British-born American investor and economist. He was a sincere value investor and often credited for popularizing the concept of value investing among the investing population. Graham was also:

Graham was a strict follower of value investing and preferred purchasing amazing businesses when they were trading at a significant discount.

In his book- Security analysis, Benjamin Graham mentioned his formula to pick stocks which become overly popular among stock market investors for valuing stocks since then.

graham formula security analysis

2. How to find the intrinsic value of stocks using Graham formula?

The Original formula shared by Benjamin Graham to find the true value of a company was

V* = EPS x (8.5 + 2g)

Where,

  • V* = Intrinsic value of the stock
  • EPS = Trailing twelve-month earnings per share of the company
  • 8.5 = PE of a stock at 0% growth rate
  • g = Growth rate of the company for the next 7-10 years

Anyways, this formula was published in 1962 and was revised later to meet the expected rate of return as a lot concerning the market and economy has changed since Graham’s time to present. The revised Graham formula is:

graham

During 1962 in the United States, the risk-free rate of return was 4.4% (this can also be considered as the minimum required rate of return). However, to adjust the formula to the present, we divide 4.4 by the current AAA corporate bond yield (Y) to make the formula legit.

Presently, the AAA corporate bonds are yielding close to 4.22% in the United States. (Source: YCharts). In order to make an apple to apple comparison, we’ll consider the bond yield for 1962 and current yield- both for the United States. Therefore, you can consider the value of Y equal to 4.22% currently, which may be subjected to change in the future.

Quick note: You can also use the corporate bond yield of India in 1962 and current yield to normalize the equation for valuing Indian stocks. In such case, the value 4.4. will be replaced by the Indian corporate bond yield in 1962 and Y will be the current corporate bond yield in India. Make sure to use the correct values.

Note: The Adjusted Graham formula for conservative investors.

Many conservative investors have even modified the Graham formula further to reach a defensive intrinsic value of the stocks.

For example, Graham originally used 8.5 as the PE of the company with zero growth. However, many investors use this zero growth PE between 7 to 9, depending on the industry they are investigating and their own approach.

Further, Graham used a growth multiple of ‘2’ in his original equation. However, many investors argue that during Graham’s time, there were not many companies with a high growth rate, such as technology stocks which may grow at 15-25% per annum. Here, if you multiply this growth rate with a factor of ‘2’, the calculated intrinsic value can be quite aggressive. And hence, many investors use a factor of 1 or 1.5 for the growth rate multiple in their calculations.

Overall, the adjusted formula of conservative investors turns out to be:

V* = EPS x (7 + g) * (4.4/Y)

3. Pros and cons of Graham formula.

The biggest pros of Graham’s formula is its ease and straightforwardness. You do not require any difficult input or complex calculations to find the intrinsic value of a company using the Graham formula. In a few easy calculation steps, this method can help the investors to define the upper range of their purchase price in any stock.

However, as no valuation method is perfect, there are also a few cons of Graham formula. For example, one of the important inputs of Graham formula is EPS. Anyways, EPS can be manipulated a little by the companies using the different loopholes in the accounting principles, and it such scenarios the calculated intrinsic value might be misleading. 

Another problem with Graham formula is that like most valuation methods, this formula also completely ignores the qualitative characteristics of a company like Industry characteristics, management quality, competitive advantage (moat) etc while calculating the true value of stocks.

4. Real life example of valuing stocks from Indian stock market using graham formula.

Now that you understood the basics of how you can value stocks using graham formula, let us use this formula to perform a basic stock valuation of a real-life example from the Indian stock market.

Here, we are taking the case study of HERO MOTOCORP (NSE: HEROMOTOCO) to find its true intrinsic value using the Graham formula. For Hero Motocorp,

  • EPS (TTM) = Rs 186.29
  • Expected growth (for the next 5 years) = 9.89%

(Past 5-year EPS growth rate per annum (CAGR) of Hero motocorp is 14.14%. Taking 30% safety on this growth rate as it is a large cap, we can estimate a conservative expected future growth rate of 9.89% for next few years).

Now first, let us find the intrinsic value of Hero motocorp using the original Graham formula,

V* = EPS x (8.5 + 2g)
= 186.29 x (8.5 + 2*9.89) = Rs 5268. 28

Now, using the revised formula with conservative zero-growth PE of 7 and growth multiple of one, the intrinsic value of Hero motocorp turns out to be:

V* = EPS x (7 + g) x (4.4/4.22)
= 186.29 x ( 7 + 9.89) x (4.4/4.22) =3280.65

At the time of writing this post, hero motocorp stock is trading at a market price of Rs 2961.90 and PE (TTM) of 15.90.  Therefore, by using Graham formula, we can consider this stock to be currently undervalued.

Disclaimer: The case study used above is just for educational purpose and should not be considered as a stock advisory. Please research the company carefully before investing. After all, no one cares more about your money than you do.

You can also use Trade Brains’ online GRAHAM CALCULATOR to perform your calculations fast.

5. Closing thoughts.

An important point worth mentioned here is the concept of margin of safety that Benjamin Graham repeatedly taught in his books.

In simple words, according to the concept of margin of safety, if the calculated intrinsic price of a company turns out to be Rs 100, always give your calculations a little safety and purchase the stock at a 15-25% below that calculated value, i.e. when the stock trades below Rs 75-85.

Overall, Graham formula is a fast, simple and straightforward method to find the intrinsic value of stocks. If you haven’t tried it yet, you should definitely use this valuation approach while performing the fundamental analysis of any stock.

Investing for Beginners

If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!

Additional credits: Vasanth (for data inputs in Graham Formula)

November 18, 2018 Valuations 17 comments
3 Simple Tricks to Stock Research in India for Beginners cover

3 Simple Tricks to Stock Research in India for Beginners.

3 simple tricks to stock research in India for beginners: Hi Investors. It’s been a while since I have written a blog post. This is because I’ve been working on a new project.

Since launching this blog ‘Trade Brains’ in January 2017, I have received a tremendous amount of emails, messages, and calls concerning stock market investment. Most of my readers are facing a similar problem- how to pick a stock to invest from a pile of over 5,500 stocks listed in the Indian stock market.

Though I have helped most of my readers, who have asked this question; however answering the same question, again and again, is little tiresome and mundane. Further, as this is a big topic, it took lots of hours to explain the same to every individual.

That’s why I created this video course on how to select stocks to invest in Indian stock market. Earlier I decided to include this post- ‘3 simple tricks to stock research in India’ in my course module. However, I felt that this content deserves to be publicly available on my blog as it can be quite helpful to the beginners to start stock research in India.

In this post, I will show how you can research good stocks in India to invest in using three simple implementable tricks. So, let’s get started.

3 Simple Tricks to Stock Research in India

1. Money control- Index composition.

If you want to investigate the stocks in a given industry/sector, why not to start with the market index composition of that sector.

An index composition of an industry consists of all the top companies that are included in that index.

For example, if you want to invest in a company in the metal industry, you should first start by investigating the stocks in the market index- S&P BSE Metal or Nifty Metal. Here S&P BSE Metal consists of companies like Hind Zinc, Coal India, Hindalco, Jindal Steel, JSW Steel, NALCO, SAIL, etc.

The index composition will give you a list of companies that you can investigate further in the industry.

Now, there’s a simple way to find out about the index composition of the different industries (Capital Goods, FMCG, Healthcare, Banks, Auto, Energy etc).

Either you can search for ‘money control index composition’ on google and click on the first link.

money control stock research in india 1

This will open the money control index composition page.

money control stock research in india 2

Or, you can directly visit the index composition linked here.

On the same page, you can navigate through different industries to know their composition.

money control stock research in india 3

Further, you can find the same information on NSE India website.

Here are the steps to find the index composition on NSE India:

nse stock research in india 1

  • Change the view to find the composition of the specific index.

nse stock research in india 2

  • Select the industry which you want to investigate.

nse stock research in india 3

Also read: 7 Must Know Websites for Indian Stock Market Investors.

2. Mutual Funds Portfolio:

This is the easiest way for stock research in India. Just look at the portfolio of the top mutual funds and find out its holding stocks.

If the mutual fund is performing good, then the chances are that its top holding stocks will also be doing good.

Check the portfolio of few of the top ranked mutual funds in India and you can get an idea of the portfolio allocation for stock research.

Now, the next question is, where can I check the portfolio of top mutual funds?

The answer is- there are a number of financial websites where you can find the details about the mutual fund portfolio. For example- Value research online, Money Control, Economic times market etc.

However, in this post, I’m going to describe how you can find the portfolio of the mutual funds on money control website.

Here are the steps to find the portfolio of the mutual funds for stock research in India:

  • Go to money control website.
  • Click on ‘Mutual Funds’.

mf holdings stock research in india 1

  • ‘Best Funds to Buy’ page will be opened. Click on ‘complete details’ link.

mf holdings stock research in india 2

  • Select the fund whose portfolio you want to check.

mf holdings stock research in india 3

  • The fund home page will open.

mf holdings stock research in india 4

  • Navigate down and select ‘Holdings’.

mf holdings stock research in india 5

  • Portfolio Holdings will be shown.

mf holdings stock research in india 6

Similarly, you can check the holdings of different mutual funds that you are interested in.

Studying the holdings of the top mutual funds is the simplest way to stock research in India.

In short, if you do not know where to start, which stocks to investigate; then start with investigating the holdings stocks of these top ranked mutual funds.

New to stock market? Here is an amazing book on Indian stock market for beginners which I highly recommend to read: How to Avoid Loss and Earn Consistently in the Stock Market by Prasenjit Paul.

3. Screener:

Url: https://www.screener.in

Screener.in is a stock analysis and screening tool to see information of listed Indian companies in a customizable way.

This is one of the best websites for stock research in India. Screener gives you the facility to screen various stocks based on different criteria like growth, dividend, PE etc.

You can find the list of stocks based on different screens like- ‘The Bull Cartel’, ‘Growth Stocks’, ‘Loss to Profit Companies’, ‘Undervalued growth stocks’, ‘highest dividend yield share’, ‘bluest of the blue chips’ etc.

How to use screener website for stock research in India?

screener stock research in india 1

  • Click on screens on top menu bar.
  • Select the suitable screen according to your preference. For example, if you want to investigate companies with a good quarterly growth, select ‘The Bull Cartel’.

screener stock research in india 2

  • Navigate through the list and investigate the stocks.

screener stock research in india 3

Screener also gives you a facility of Query Builder, where you can customize the query according to your preference. We will discuss more how to write a query in Screener in another post.

Using the screens on the Screener website, you can undergo the stock research in India. Further, the different screens help the investors to investigate different stocks based on their choice.

Also read: How to do Fundamental Analysis on Stocks?

That’s all for this post. I hope these simple tricks for stock research in India is helpful to the readers. Please comment below if you have any doubts. Happy Investing!!

November 16, 2018 Investment Basics, Stocks 7 comments
Investing in Bad News- Is it worth being contrarian cover

Investing in Bad News: Is it Worth Being Contrarian?

Investing in Bad News: Is it Worth Being Contrarian?

“To succeed as a contrarian you must recognize what the crowd believes, have concrete justification for why the majority is wrong, and have the patience and conviction to stick with what is, by definition, an unpopular bet.” -Whitney Tilson

Hello Readers. Contrarian investing in one popular strategy which has definitely build wealth for all those who have followed this strategy strictly. However, being a contrarian is easier said than done. 

For today’s article, we will be exploring the strategy of investing in bad news, which also happens to be a common investing strategy used by most retail investors when dabbling in the stock markets.

The topics we shall be exploring today are as follows:

  1. What is bad news investing?
  2. Can bad news investing go wrong? If so, how?
  3. Cockroach Theory
  4. A thinking model for investing during bad news
  5. Conclusions

It’s going to be a very interesting article, especially in the dynamic market scenarios like that of late. Therefore, make sure that you read the article till the end so that you do not miss out any important concept. Let’s get started.

1. What is bad news investing?

Bad new investing is a simple strategy followed by investing across experience level where they buy stocks of companies that have been beaten down by negative sentiment in the media.

Most investors buy such companies when they believe that the news surrounding the company is only temporary in nature and the company can resume its past stock levels in time.

This is a strategy that was espoused by Benjamin Graham and has been followed by many of the great investors ever since including Warren Buffett, Peter Lynch, Carl Icahn, Mohnish Pabrai among others.

2. Can Bad News investing go wrong? If so, how?

Like all investing strategies, this one too is not without flaws. The strategy if not employed properly can result in losses or worse in permanent loss of capital. 

Although it takes courage to go against the herd and a lot of the times it pays handsomely to do so. But, when deciding to invest in a stock surrounded by negative sentiment, it is important to realize that sometimes the stock would have fallen in price because it deserved to be priced lower.

A lot of times investors (including myself) tend to anchor to the price a stock was trading prior to the emergence of the bad news that price that is available at a significant discount to that price may seem to a buying opportunity (Also read- Value Traps).

A lot of times we tend not to redo our homework and perform the valuation for the company factoring in the effect of the news that has emerged instead we buy the stock based on the valuation we may have performed months before to make a buying decision.

3. Cockroach theory, Murphy’s law, and probabilistic thinking

Learning from my experience, a conservative investor would do well to keep these two thumb rules in mind when analyzing investment opportunities arising out of bad news.

The Cockroach Theory is a market theory that states that when a bad news is revealed about a company there is usually many more around the corner. This comes from the common belief that when a cockroach is spotted in a household, it is likely that there are many more in the vicinity.

Murphy’s law is pretty simple and straightforward compared to the former, it posits that whatever can go wrong, will go wrong.

Since investing is an imperfect art and it is impossible to state anything with certainty, investors would do well to think probabilistically to ascertain possibilities of thing going more wrong with the company.

For example, If a company’s management has been accused of fraud, then in all likelihood it is possible that the fraud has been happening for years and not a one-time thing.

On the other hand a factory being shut down due to worker protests could be a major event but the probability of such events impacting a major manufacturing company for the long term is pretty low since managers usually try to solve such issues by entering into contractual agreements with trade unions on new terms of operations and not just a non-written understanding of sorts.

4. A thinking model for investing during bad news

Many a time Warren Buffett has made an compared his investing style to Ted William’s baseball style in ‘The Science of Hitting’. Ted, famously proclaimed that he would wait for a fat pitch before attempting to hit a shot and ignore everything else.

We believe this concept is best explained in his own words, kindly refer to the excerpt below

the science of hitting

Now building on his concept, let’s try to develop a map of bad news pitches we would receive as an investor.

From a logical perspective, the bad news could be of two types – it could be a temporary or a permanent problem while the impact this could have on the price could be large or small.

Taking different combinations of these would give us four possibilities as shown in the graphic below.

possibilities bad news-min

The sweet spot for us as investors would be to hit only those pitches that come at us from quadrant one since this is likely to be the situation where the market has overreacted to a minor news and has subsequently mispriced the underlying stock.

An investor could then proceed to add the stock into their portfolio all the while averaging down if the price of the stock were to drop below the initial entry price.

New to stocks? Here is an amazing online course for the beginners- How to pick winning stocks? Enroll now and start your journey in the exciting world of the stock market today!!

5. Conclusion

Although Bad news could provide an amazing opportunity for investors to add stocks to their portfolios, it can cause an equally potent damage to the portfolio in the event the buying decision turns out to be a bad one. It is therefore imperative for every investor to take time to think about the new realities the company is faced with before buying its stock.

We believe a prudent investor using a well defined rational process to invest in these situations should be rewarded handsomely over time. Happy Investing…!!

November 13, 2018 Investment Basics No comments yet
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