Five tips for picking stocks in a falling market

Warren Buffett, the legendary American investor, once remarked, “In the short term, the stock market is a voting machine, but in the long term, it is a weighing machine.” This highlights the contrast between short-term volatility and long-term fundamentals. On a daily basis, stock prices can fluctuate wildly, driven by temporary news and emotional investor reactions, much like voters’ sentiments during elections. 

Over time, however, the transient noise fades, and key financial indicators like revenue, profits, and balance sheets take center stage. As clarity around a company’s performance emerges, the market begins to assess its true worth, and its stock price aligns with its intrinsic value.

In the short term, a stock's market price can deviate significantly from its intrinsic value due to sentiment-driven fluctuations. For long-term investors, this disparity can offer an excellent opportunity to purchase quality stocks at discounted prices. 

However, identifying such opportunities requires a basic understanding of financial metrics and the ability to analyze the gap between a stock’s current price and its intrinsic value.

The recent correction in Indian equities, with steep double-digit declines in several frontline stocks, provides just such an opportunity for discerning long-term investors to build their portfolios.

Buffett has also emphasized that while equity investing is straightforward in principle, it is not without its challenges. Picking the right stocks in either a bull or bear market involves tracking changes in a company’s financial performance and valuation metrics. It’s not an impossible task—after all, there are far more successful equity investors than there are elite rocket scientists!

To help with this process, here are five widely used financial ratios available for all listed companies. These can serve as effective tools to identify potential gaps between a stock’s current market price and its long-term intrinsic value.

1. Return on net worth or equity (RoNW)

The return on shareholders' equity, also called the return on net worth, is one of the best ways to filter out high-performing companies from poorly managed ones. By checking out stocks like Primerica, you can ensure that you are looking for stocks that make sense for you personally. Choosing a stock that is doing well is easier when you speak to a financial adviser who understands how the stock market works!

As a thumb rule, RoNW or RoE should be consistently higher than benchmark interest rates in the economy such as the yield on 10-year government of India bonds. 

Companies with high double-digit RoNW tend to grow faster than their companies with low RoEs. Higher RoE translates into strong internal cash flows that allow these companies to invest in their growth and expansion without resorting to debt financing. 

This also insulates these companies from the vagaries of business cycles and changes in interest rates in the economy. Companies with consistently high RoE also tend to be cash-rich and pay generous dividends to shareholders or do large share buybacks. High RoE companies tend to outperform their weaker peers during an economic recession and market declines. So invest in a company with a high RoE if its share price declines without a matching decline in its profitability.

2. Return on capital employed or RoCE 

Companies not only use shareholders’ capital or equity in their businesses but also borrow capital from banks or the bond market to invest. That’s why it’s important to know the returns that it is generating on shareholder’s equity but on the entire capital that it has employed in its business. 

We can know this by calculating a company’s return on its capital employed or RoCE. It is calculated by dividing a company’s annual net profits by the average capital employed in the business in the last two years. 

Many analysts also use profit before interest and taxes (PBIT) instead of post-tax net profit (PAT) to calculate RoCE. Using PBIT gives higher RoCE compared to the one using PAT. 

As a general rule, RoCE should be higher than the cost of capital or long-term borrowing. 

And everything being equal you should invest in a company with a higher RoCE. For debt-free companies, RoE and RoCE are the same.

Also Read: Five stock market tips for beginners

3. Leverage Ratio or debt to equity ratio (DER)

The debt-to-equity ratio shows the extent of financial leverage or the borrowing that the company is using to grow its business. It is calculated by dividing a company’s average debt during the year by its average net worth or shareholder’s equity during the year. 

For a non-financial firm, a DER above 1.0 is considered to be risky while a balance sheet with 0.4 to 0.6 is considered to be prudent and financially sustainable. A company with high DER will spend a large part of its operating profit on interest payment leaving little for reinvestment in the business or distribution to shareholders as dividends. 

In fact, most of the higher performing stocks in India such as Hindustan Unilever, TCS, Infosys, Nestle, Asian Paints, Titan, Cipla, Divi’s Lab, Colgate Palmolive, Maruti Suzuki and ITC are largely debt free.

Also Read: Five financial planning tips for the self-employed

4. Price to earnings (P/E) multiple or ratio 

The price-to-earnings multiple is the first and basic tool to value a stock. It is calculated by dividing a company’s current market capitalisation by its annual net profit or its cumulative net profit in the latest trailing 12 months (TTM) or last four quarters. Alternatively, the P/E multiple can be calculated by dividing a company’s current share price by its latest annual earnings per share (EPS) or its trailing 12-month EPS. 

For example, Reliance Industries is currently trading at a P/E multiple of 26 times while ONGC is trading at a P/E multiple of 6.8 times. As a general rule, companies with faster growth in revenues and profits and those with higher RoNW and RoCE and lower debt-to-equity ratio get higher P/E and vice versa. 

So you can invest in a company if its P/E has fallen but it continues to grow at a decent pace, and is reporting consistently higher RoNW and RoCE and has low debt.

5. Price to book value (P/B) ratio

This is another common ratio to value companies on the stock market. It is calculated by dividing a company’s current market capitalisation by its latest annual net worth or shareholders equity which is also called book value in accounting terms. Networth in turn is the difference between a company’s total assets and its total liabilities. 

As a general rule, a financially healthy company’s P/B ratio should always be greater than one. A company’s valuation becomes cheap when its P/B falls below one. 

Here again, fast-growing companies and those with higher RoNW and RoCE and lower debt-to-equity ratios have higher P/B ratios than others. Also, companies in capital-intensive and cyclical businesses such as oil & gas, telecom, metals & mining, banking & finance, cement and infrastructure get lower P/B than companies in less capital-intensive industries such as manufacturing, FMCG and technology and software services. 

Buy a stock if there has been a sharp fall in its P/B ratio without a matching fall in its profitability and other financial ratios.

Happy Investing! 

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

Also Read: Top ten FDs with the highest interest rates

Look up our YouTube Channel