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How to value a stock: An expert's view
Manali Rohinesh, Moneycontrol.com | May 29, 2006
He was among the first Indian analysts to work for foreign institutional investors. With a flair for numbers, a passion for fitness and a lifelong love affair with equities, that, in a single sentence describes Ridham Desai, the executive director, head of equity & research at JM Morgan Stanley.
Ridham's fascination with balancesheets began young. He collected them instead of comic books! He admits, "Yes, it is true and I don't know how it happened. May be, I was born with some genes which suggested that annual reports is what I should be collecting, so going back to the mid-80s, I started collecting annual reports and if I recall, by the end of that decade I had almost 5,000 annual reports in my bedroom. I did read about superheros but yes numbers did fascinate me a lot in those days"
Well, the little financial wizard in the making grew up and went on to do an MBA from Welingkar Institute of Management. He credits his education with helping him get a formal background in accounts and financial management. He recalls, "I also did my MBA in 1991-92, during the big bull market. So stock markets were very fashionable in those days and it helped a lot, in putting all those small pieces together, which I had picked up in the early years."
But he reveals a secret, that for all the help the MBA course gave him, he rarely attended college! He spent more time in the market, where the action really was. Truly, nothing compares with practical experience. He recalls, "In those days, markets were open between 12-2 pm only. There was physical outcry, the phones didn't work, brokers didn't pick up phones and we had a PTI screen, which flashed stock prices at a 15-minute lag. So there are some vivid memories of trading on the floor in those days."
After completing his MBA, he was determined to remain in the world of stocks and work with either Nimesh Kampani or Nimish Shah. He says, "They were the kind of people that I looked up to and then it so happened that JM came on campus and that was the only interview that I remember giving and I got the job. So it was a very happy moment for me. So I moved from stock market trading, which was the end of my stock market trading career, to a more professional approach to stock market investing."
There, he began doing equity research, which meant digging out ideas and selling them to clients. He explains, "Those were the early days, there were no FIIs in those days. Stock market research was a very nascent thing. I think if I recall, very few people actually had paid attention to it. The market was more about trading and speculation, less about investing."
"It was still evolving and I was lucky to be in an environment where research was important, where researching a stock idea, doing balance analysis and understanding valuations were important. So those early years really grounded me to this fundamental approach to stock market investing."
The fact that the idea of investing rather than speculating was very nascent and so data was not easily available to study the fundamentals of a stock. So he used to read the newspaper to track appointments and who was being hired. He elaborates, "We used to collect data points on who is hiring, who is advertising their products and things like that. We used different types of media to collect data to come to a conclusion as to which industry is doing well and therefore which stocks to look at."
He says, "It's only recently that things have turned for India, but over the past 10 years, I think it's been on a decline. So things were slightly different in those days, we did have individual investors who did pay attention to research and therefore there was a market for the stuff that we were doing."
He then moved onto Alchemy and spent about three years there doing a lot of ground research. He remembers "those were the wonderful years in terms of understanding smaller companies and doing a lot of intuitive stock picking, rather than macro top-down fundamental work." But now, that he's finetuned a more mature investment approach, he says even top-down stock picking has helped him a lot "but at the end of the day, stock picking is always bottom-up."
He's got a method to the stock market madness. There are sectors like steel and commodities, which are naturally top-down because they are linked to global growth, interest rate, demand and supply. There is not a lot of bottom-up stock picking there, which could add value. Then, there are other sectors like pharmaceuticals where it is bottom-up because each company's strategy will determine what value is created - the research pipeline, the NDDS work that they are doing on generic drugs etc.
On his journey, through researching and picking stocks, he's been inspired by a quote by BC Forbes. He explains, "It's this incident that BC Forbes has mentioned - a financial analyst is ridiculed for making a comment, that there was nothing commendable about a certain company except its earnings.
And BC Forbes goes along to say that earnings can be good in one year and bad in another year. Successful investing is all about picking up conspicuous brains and unimpeachable characters. So if you have a company that's run by people who have good brains and good character, the end result is usually good. It doesn't matter your earnings are good or bad in a year. I think that was the foundation of the work, that we built over the years."
He would need this motivation, especially when he moved to UBS as a metal analyst. There he did get down to doing more intensive modeling of companies earnings and forecasted earnings going into the next 5-10 years. He had to look at scores of pages of excel spreadsheets and thousands of lines of modeling.
"If you buy equity, it's a junior claim on the company's cash-flows and therefore the value of that equity is the dividend that accrues to you, over a period of a time. You discount them at your expected rate of return, you arrive at the value, compare it with the price and you make a judgment."
Though market players are divided over how to value stocks, it ultimately boils down two metrics, it's either free cash or dividends and he prefers dividends over cash-flow because "in free cash-flow, we pass the judgment on what the managers of company should be doing and I think that's left best to the managers of a company."
"So the reward that equity shareholders get is the dividend that comes to him. So the best way to value equity is to discount dividends rather than free cash-flow. Even though, it intuitively appears that free cash-flow is owned by the shareholders but it's actually retained by the managers of a company for a rainy day. That is really embedded in the dividend forecast that we make into the future."
He continues, "There is a bit of sophistication there because you are forecasting dividends and you are not looking at just the current dividend yield. So the growth stocks that are not currently paying dividends, will not be missed, if you are looking at what they will pay in the future."
For example, "if you go back to the tech bubble, you may have missed on a few opportunities right at the peak of the bubble because some of them were valued crazily. But I think there were opportunities better missed, and the way this framework works is that, you may miss some moneyspinners and some stocks that generate a lot of returns but you tend to stocks that lose money."
That's his tip to investors and his advice to youngsters starting out in his line of work, is to have passion for their work. Also some math and accounting skills, a little bit of macro-economics and the ability to and interest in reading balancesheets. Also keeping your eyes on world events would help a lot because India is no longer a pure socialist and insular economy.
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