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7.1

Investment Guide 1.04

Hi There!! Once again, just like a soap opera on the idiot box – let me do a small recap. We are on a journey to discover a formula that can help to beat the markets. The learning’s till date are as follows:

  1. Equity is attractive if it yields returns better than risk free rate of return
  2. Stock market is subject to wild swings and Mr. Markets offers to do both – buy and sell stock at a particular price
  3. It is a good idea to buy stocks at a discount to its worth or at a very high margin of safety
  4. I have to share with you how to determine if stock is available at a bargain price

There are just two important parameters in the magic formula. This magic formula when applied in the markets can help to beat the markets. We have discussed on the first one which says that equity is attractive if it yields returns better than the risk free rate of return.

The first parameter is also known as Return on Equity (RoE) – in simple terms it calculates the profits a company earns in comparison to the capital that is invested. For eg :- Company A earns a profit of Rs 10,000 and the capital it employs is Rs 1,00,000 – this would mean that the RoE (%) of Company A is 10%, we take one more company and name it company B – herein the profits earned are say Rs 15,000 and for sake of simplicity we assume similar amount of capital – your mind I believe has already calculated that RoE is at 15%, again the next logical thinking going on is that Company B is better than Company A. Let’s talk of one more Company namely Company C and profits it earns is mere Rs 5000 on same capital. This translates into RoE of 5% and which is actually lower than return from PPF of 8% – we would avoid Company C in totality.

Let’s keep this understanding and conclusion in one corner of our mind – the learning “Companies generating higher RoE are better than Companies generating lower RoE”

Let’s now talk about second parameter in our magic formula. Mr. Benjamin Graham – one of the greatest thinker and writer of stock market has coined a person called Mr. Market. Mr. Market is subject to wild mood swings. Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business. On those days, you might want to take advantage of Mr. Market’s crazy offer to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing.

 

In our above example Mr. Market might give a quote of Company A at Rs 1,50,000 on say day 1, on  day 2 at Rs 3,00,000 and on some other day 3 at Rs 4,50,000. We know that company A is actually earning Rs 15,000. Now we have to calculate the difficult part namely the earning yield – on day 1 – the earnings yield of Company A is 10% (15,000 / 1,50,000) on Day 2 the yield is 5% (15,000 /3,00,000) and on Day 3 it is 3.33% (15,000 / 4,50,000)

 

The earning yield changes frequently and with moods and swings of Mr. Market – the logical takeaway is in case the value is low (Rs 1,50,000) – earnings yield is high (10%) and when value is high (Rs4,50,000) earnings yield is low (3.33%)

 

That is it – the two formula are the heart and brain of magic formula – believe me – you have mastered the magic formula of beating the markets – namely earnings yield and Return on Equity. Key takeaway if you stick to buying good companies (ones that have high Return on Equity) and do buying of those companies  only at bargain prices (at prices which give you high  earnings yield) you can end up buying good companies which Mr. Market has decided to wash its hands off.

 

You can implement this formula all by yourself and at low risk. As I say it’s a long journey so I will talk about the blend of two parts of our magic formula in ensuing episodes.

 

Takeaways so far:

  1. Higher RoE is better than lower RoE
  2. Higher Earnings yield is better than lower earnings yield
  3. Combing above 2 formulas is secret to making lot of money – how to combine the two will be shared later.

Chao till then !!!

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