Stock Shastra #11 – Before investing, find the right value of each stock – Its MRP

By now, you must have shortlisted a wonderful company i.e. a company with an excellent financial track record and checked if it has one or more  of the competitive advantages (brand, patent, switching cost, exclusive control or the ability to price competitively). Also, after running a check on the management’s worthiness, you must be now asking yourself the question – below what price is the stock worth buying? For this, you need to find out the right value of the stock – its MRP or Maximum Retail Price.

So, what is the right value (the MRP) for a stock?

There are many popular methods to calculate the right value of a stock popularly known as Intrinsic Value or Sticker Price. Every model has its own basis for calculation – Dividend discount m odel(dividend),  Discounted cash flow (future cash flow) and many more.  What you really need to do is, is to look at the right value of a stock with the perspective of a minority shareholder.

Consider this: Suppose you have invested in a stock, keeping a long-term holding period in mind. As a shareholder, the current price of the stock is the investment that you make in the stock. What is your  return on this investment? You earn income in 2 ways i.e.

(a) Future Dividends: Dividends which you will receive in future

(b) Future Sell Price: The Price at which you sell the stock. Here, you will benefit if the stock price appreciates. As you have seen in Stock Shastra #2, as a company’s earnings grow, so should its stock price. So, the basis to find the right value of a stock is primarily dependant on the long-term future earning capacity of the company.

So, how do we calculate the future earnings growth of the company?

The future earnings growth of the company depends on 2 things:

1) The prevailing market conditions i.e. whether the company is present in a growing or stagnant industry, the demand of the company’s product/service

2)  The company’s own capability to grow and take opportunity of the market; this can be gauged by looking at its sales, earnings and book value growth rates in the past (y-o-y and CAGR), its average return on equity(ROE), average return on invested capital (ROIC).

So, now you know the 2 ways in which you earn income, once you invest in a stock(i.e. Future Dividends + Future Sell Price). Discount these 2 sources of income with an expected rate of return over a reasonable holding period. At Moneyworks4me.com we have taken an expected rate of return for the Indian market as 15% and holding period of 10 years to calculate every stock’s right value. This is what we call MRP- the Maximum Retail Price.

To summarize, MRP is the maximum price we should pay for a stock, so as to get a minimum expected rate of return of 15% for the next 10 years.

So, we now know how to calculate MRP, but how is this helpful?

All of us know that the stock market behaves irrationally in the short-term. Most of the time, it doesn’t value the stock at its MRP; sometimes higher/lower. So, how do you take advantage of this irrational behavior? Logically every smart shopper buys stuff at a discount and the same should apply to stocks. Benjamin Graham – the Father of Value Investing always tried to buy stocks that were trading at a discount to their full value. Hence, to take advantage of this irrational behavior of the market, always buy much lower than its MRP and sell at when prices cross the MRP.

Now, you must be wondering why is MRP the Sell Price, when we earlier said this is the maximum price that an investor should be willing to pay? … Especially, if  the stock market may value it much higher than its MRP.

Once the stock market comes out from its irrational expectations , it is most likely to value the stock at/close to its fair value based on rational expectations i.e. its MRP. As we said earlier, in the long run the stock price is driven by its earnings capability. So, consider MRP as the maximum price that the market is offering for the stock, i.e a benchmark for the ‘Sell Price’. Though there may be times, the market may value it higher, its right value will always be somewhere around the MRP. Remember this is a benchmark for Sell Price, a number somewhere around which the right value is likely to hover.

What is more interesting is that we have back tested this concept of MRP for the Sensex stocks over a period of as much as 10 years and found that it is valid. Outlook Profit, one of India’s most renowned stock-investing magazines, have also recognised the value of this concept and published our story of the MRP concept titled as the ‘The Right Price’. Check  this link (‘The Right Price) out for the proof on how MRP works for you as an investor. Here you will also get the complete methodology of calculating MRP.

Having understood the method, you are now probably wondering where you can get the right of for the stock. Moneyworks4me.com is a website, where you can get this right value for around 1300 stocks in the form of the stock’s MRP. So, to know the MRP for your investments, visit www.MoneyWorks4me.com. In fact, all this while, the term ‘Full-Price’, that you’ve been reading in Company Shastra is the stock’s MRP.

So, after telling you that you should buy the stock at a lower price than its MRP,  you are now wondering what is the right price to buy. Hold on. You will have to wait until next week for that. See you next week with Stock Shastra #12.

You should also read the following:

1. Stock Shastra #1: Stock Investing is not Rocket Science!
2. Stock Shastra #12: Buy at 50% discount to minimize risk and get fantastic returns
3. Timeless Principles of Stock Investing
4. Stock Shastra #14: To enjoy the fruits of stock investing, be like a fruit orchard owner
5. Stock Shastra #27: Stock investing, with all its risks, is only for the young; or is it?