Finding the intrinsic value of stocks

Volatility in stock markets can make even the most hardened investor jittery and question the merit of staying invested. For the benefit of the not-so-seasoned investor, let us go back to the basics of investing in stock markets.

Anecdotal evidence all over the world and across years has shown that equity investing is a long-term play and, over an extended timeframe, equities have outperformed all other asset classes in creating value for investors.

Internationally, the concept of value investing has found its biggest supporter in Warren Buffet, who is considered to be the most successful investor of all time.

But what exactly is value investing?
Value investing looks for stocks that are priced lower than their companies' intrinsic worth, which is determined by an analysis of fundamentals of companies. Mirroring the mentality and shopping style of a bargain hunter, value investors look for products that are of high quality but cheap in price.

In other words, the value investor searches for stocks that he or she believes are undervalued by the market. Like the bargain hunter, the value investor tries to find items that are valuable but not quite recognised as such by the majority of other buyers.

One of the ways to find out whether a stock is undervalued is to check the price to earnings ,or P/E, ratio.

So, what is P/E ratio?
The P/E ratio is the commonly used term for the ratio of the market price of a share to its earnings per share (EPS). This means that it could indicate how much an investor may be willing to pay for a share for every rupee of its earnings.

The P/E ratio can be calculated in two ways "" the forward P/E ratio is calculated as the ratio of the last traded market price of the share to its projected EPS for the current or future financial year. For a trailing P/E ratio, the actual reported EPS for the immediately previous completed financial year is taken.

The EPS is computed as the company's profit after tax divided by the number of its outstanding equity shares.

People who are unable to access these figures on a daily basis but would still like to invest in good value stocks, can invest in P/E ratio-based mutual fund schemes.

One such product is the recently launched Tata Equity P/E Fund, an open ended fund which aims to invest at least 70 per cent of its net assets in shares whose trailing P/E ratios are less than that of BSE Sensex at the time of investment.

Ved Prakash Chaturvedi, CEO, Tata Mutual Fund, explains the investment philosophy. "We strive to not just buy scrips of high quality, well-managed and globally competitive companies, but to buy them at appropriate valuations using techniques such as the P/E ratio to identify the hidden potential to outperform the market over the medium term. This fund is uniquely positioned to identify suitable investment opportunities in a volatile market," he says.

He added that the reason why the forward P/E ratio is not considered for this fund is because it is based on estimates of future earnings and is therefore uncertain.

So in effect, the use of P/E ratio by the fund is two-fold "" firstly, to make the first cut off for stocks for investment consideration and secondly, to exit from stocks when the ratio becomes higher than that of the market.

Another P/E ratio based fund is Franklin Templeton Mutual Fund's FT India PE Ratio Fund. It is a strategic asset allocation fund which uses the P/E of the NSE Nifty to determine whether the equity market is overheated or not and thus shifts its allocation to the debt or money markets.

The fund's equity component mirrors the NSE Nifty and it does not undertake active stock picking based on the comparison of the index and stock P/E ratios.

Analysts watching the mutual fund industry have mixed opinions about the success and acceptability of these schemes but agree that the valuations story will always hold true in the long term.