In addition, the company's financial performance in the nine-month period ended December 2004 was also considered. If the record in terms of profit growth was impressive, such stocks were mostly retained, even if their return on net worth was quite low. The analysis considered only stocks that had appreciated at least 100 per cent between March 2003 and March 2005.

Price-to-book-value ratio

The price-to-book-value ratio is arrived at by dividing the market price by the book value of the stock. If the market price of the stock is higher than its book value, it indicates that the market expects the company to grow its earnings at a higher rate than the market average.

If the price-to-book-value ratio is high and the return on net worth low, it could be an anomaly that needs investigating further. Investors need to find out if the expected earnings growth would materialise because of improvement in profit margin or sales growth. If investors believe that such growth cannot happen, they should probably consider selling the stock.

Five stocks that are trading at a high price to book value ratio but with low return on net worth are Trent, Orchid Chemicals, United Breweries, Dhampur Sugars and Adani Exports. Profit-booking in these stocks can be considered.

The prices of all these stocks have gained substantially over the past two years. Earnings growth, or an improvement in their ability to generate profits, is yet to materialise.

These stocks also generate poor return on money invested in their business, which is not in consonance with the rich valuation they enjoy. Three of the five companies reported fall in profits in the nine months ended December 2004.

Price to earnings

The price-to-earnings multiple can also be used to gauge the earnings growth factored into the stock price. It has been seen in the past that the market views the PE multiple as a proxy for expected profit growth. If profit growth or guidance trails this multiple, it is considered negative for the stock.

The company would have then delivered an earnings shock. Profit growth or guidance higher than the PE multiple is a positive development. The company may have surprised investors on the earnings front.

For instance, a PE of 10 is taken to suggest that the expected annual earnings growth over the next three to five years would be at least 10 per cent. So, if the PE is high and the return on net worth is low, that could be considered an anomaly.

Based on this measure, investors can consider the following stocks for booking profits: JK Industries, Finolex Cables, MRF, United Phosphorous, Infomedia India, Mid-day Multimedia, Nahar Spinning, Forbes Gokak, HCL Technologies and Zee Telefilms. Except HCL Technologies and Zee Telefilms, other stocks in the list reported either poor growth or decline in profits in the nine-month period ended December 2004.

In HCL Technologies, profit growth has been impressive in recent times. There are, however, better exposures in the software sector. For instance, HCL Technologies and Infosys Technologies are both trading at a multiple of 33 times their latest earnings. However, the former has a return on net worth of 10 per cent while the latter sports a RONW of 40 per cent.

Incidentally, in terms of this measure, the valuation of a number of large-cap stocks does not appear stretched. There are 54 stocks with a market cap in excess of Rs 5,000 crore. The average return on net worth of these 54 stocks is about 25 per cent while the average price to earnings multiple is 15.

In contrast, the average PE multiple of 330 stocks with a market cap of Rs 250-5,000 crore is about 14 while the average return on net worth is about 17. This suggests that these stocks are relatively richly valued compared to large-cap stocks. In addition, only a small proportion of mid-cap stocks is likely to move up to the level of large-cap stocks. There thus exists a strong justification to cull such mid-cap stocks from your portfolio.

Price to cash

Profits earned by a company can be segmented into two portions — cash and accruals. The cash portion represents profits received by the company. The accruals portion represents profits yet to be realised in cash.

If the accruals portion works out to a substantial proportion of the profits, it could impede the ability of the firm to invest. If the return on net worth is also low then rich valuations will not appear justified.

Based on this parameter, not many convincing and prominent sell candidates make it to the list. Among those that make the cut, the case for booking profits in Agro Tech Foods and Aurobindo Pharma is strong, while that for Mega Corp, Granules India and Honeywell Automation is weak. The financial performance of these stocks is unimpressive and investors may have to consider reducing their exposures.

Incidentally, even in terms of operating cash flows, the valuation of large-cap stocks appears impressive. The proportion of operating cash flow to profits of a number of large-cap stocks is more than 100 per cent. That is, the operating cash flow is larger than the reported net profits. This places them in a relatively better position to meet the demands for investment in fixed assets which, in turn, would sustain profit growth.

More options

The case for booking profits in these 20 stocks appears strong. They have, on average, gained 270 per cent between March 2003 and March 2005. On an average, the price to earnings multiple of these stocks is 41. The average return on net worth of this set of stocks is 8.2 per cent.

In addition, most of these stocks have reported decline in profits in the nine-month period ended December 2004.

Moving out of these stocks and simultaneously enhancing the exposure to large-cap stocks may stand investors in good stead in their quest to lock into gains of the past two years and invest in stocks that could deliver capital appreciation.

Using the above parameters, one could, upon greater scrutiny, unearth a number of stocks that are not part of this list which one would also do well to sell.

There are, especially, a large number of loss-making stocks that have shot up sharply in value in the past two years. Investors may need to consider booking profits in these stocks too.

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