When the economy is improving and FIIs and DIIs are betting big on Indian markets investors tend to invest in all kinds of stocks, risking their capital.

Golden rule Irrespective of the capital market’s vagaries, an equivalent of a ‘Golden Rule’ employed by successful investors is: “Invest in high-quality companies at good prices and continue holding them as long as their performance merits doing so.” Pertinent issues that need to be monitored while studying a stock are management of company, fair valuation and corporate governance.

Additional parameters for evaluating management quality are profitability before taxes, other charges outside management’s control and return on equity (RoE). An investor should prefer companies with constant or growing profit margins and a stable return on equity. Comparing growth, profits and RoE amongst peers will help identify whether the company is geared to survive in the long-term or is simply a beneficiary of the current rising tide for its industry.

The various data points to evaluate a company’s potential are: its historical growth rate, reports indicating growth goals, consensus analyst estimates and estimates of future expansion.

One should also estimate earnings growth with respect to projected sales. The company’s historical sales and earnings should be compared with the company’s growth goals, as stated in its annual reports / analyst meets/ earnings conference calls. Always be conservative with respect to projections.

Once the EPS is forecast for five years, the next step is to assess the valuation. Firstly, one should analyse the stock’s price to earnings (P/E) ratios of several years and then forecast the likely P/Es at the higher and lower end over the next five years. The P/E, calculated by dividing the stock’s current price by the company’s EPS, indicates how much the market is willing to pay for ₹1 of a firm’s earnings. P/Es often go through volatile periods of expansion and contraction depending upon industry cycles, the economic scenario and investor preferences. Additionally, a stock may trade at extremely high P/Es for a while but eventually drop drastically when a high-growth company stumbles. P/Es also tend to contract during inflationary periods.

Three-way returns One can estimate the potential high price of a stock based on estimates of its high P/E. The high point EPS — forecasted five years from now — is multiplied with the high P/E to arrive at the potential high price.

While calculating stock return, one should also consider the dividends paid by the company. Thus, investment in stocks can provide an investor with returns in three ways: a) through dividends b) appreciation of stock’s price due to earnings growth c) appreciation of stock’s price due to P/E re-rating wherein the market believes that the P/E should be higher.

The writer is Arun Thukral, MD & CEO, Axis Securities