You don’t need complex math to pick stocks. This simple BPCL valuation shows why

If someone is using complex mathematics to evaluate a stock, chances are he is simply trying to speculate in the guise of an investment.
If someone is using complex mathematics to evaluate a stock, chances are he is simply trying to speculate in the guise of an investment.

Summary

  • Here’s how you can use a simple back-of-the-envelope calculation to decide whether you should consider investing in a stock or reject it.

I believe all of us would agree that our parents and grandparents excelled at making pretty accurate back-of-the-envelope calculations.

Take my mom, for instance. She managed the household budget for years using just a few simple calculations. There weren’t hundreds of rows for each line item and everything on the expense side was rounded off to the nearest multiple of 10 or 100. All she needed was a few minutes every month and voila, the budget was done and dusted. It worked remarkably well, to be honest.

I often used to ask her to be more scientific and precise in her approach, but the appeal fell on deaf ears. She was of the view that scientific rigour and precision may be required in the design and engineering of complex structures. However, for something as mundane as a household budget, a back-of-the-envelope calculation works just fine.

Does it work in a field such as investing as well, or does that require scientific rigour and precision?

Well, if you look at all the great investors such as Ben Graham, Warren Buffett, and Peter Lynch, I don't think any of them applied complex mathematical formulae to evaluate their investments. If the stock appeared expensive based on simple ratios like PE or price to book, they simply walked away. They never tried to get more precise with their calculations. 

Here's what Ben Graham once said about using higher-order mathematics in stock picking.

“In forty-four years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra.

“Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment."

In other words, keep it simple. If someone is trying very hard and using complex mathematics, chances are he is simply trying to speculate in the guise of an investment. I think Graham hit the nail on the head.

Allow me to show how you can use a simple back-of-the-envelope calculation to decide whether you should consider investing in a stock or reject it. Please note that this is not a recommendation. It is only a tutorial to help you understand the concept better.

The stock that I have shortlisted for this exercise is none other than that of oil refining and marketing giant BPCL. It has been shortlisted based on its recent popularity and stellar bull run, and nothing else.

BPCL takes crude oil as the raw material and takes it through a series of processes to produce different fuels such as petrol, diesel and aviation fuel. It then sells these fuels through its own marketing network and through tie-ups with various entities.

Of course, since BPCL is an oil PSU and oil is a political hot potato, it is subject to government interference in the way it prices its products and allocates its profits. The business is also quite sensitive to geopolitics beyond India's borders, almost all of which is beyond its control. Hence, there is a high level of uncertainty with respect to the profits it generates.

This is also reflected in the company's historical performance. Profits crashed to 21.3 billion in FY23 from a huge 117 billion the previous year. In fact, for the trailing 12-month period, profits jumped to a staggering 289 billion.

Having said that, if you look at the company's bottomline over the past few years, 100 billion seems to be its earnings potential on a conservative, realistic basis.

As I just highlighted, profits dipped to a mere 21 billion in FY23 and also went as high as 289 billion. However, these seem to be outliers, with the normal earnings power being in the region of 100 billion based on its historical performance over a seven to eight year period.

With 2.13 billion in shares outstanding, it has an EPS of around 50. In other words, BPCL can be relied on to earn around 50 per share in a normal year.

Now, what kind of a PE multiple would you give to a stock like this?

Well, the AAA corporate bond yield is currently at around 7.5-7.6%. Inverse of yield is the PE ratio. This means that corporate bonds are available at a PE multiple of around 13-14x. Therefore, our margin of safety will be based on this number.

If we factor in a margin of safety of at least 33% on a PE of 14x then BPCL should be bought at a PE of around 10x or lower. But if we take a margin of safety of at least 50%, considering BPCL's PSU status and its volatile business model, the fair PE for BPCL drops to 7x or lower.

Let's be conservative and go with 7x. Considering the stock's earnings power of 50 a share and a PE of 7x, we get a price of 350 a share. In other words, according to our study, the stock is attractive at a price of 350 or lower and expensive after a gain of 50-100% from these levels.

In fact, you should add another 40-45 to the maximum buy price of 350 to account for its investments in listed entities such as Indraprastha Gas and Petronet LNG. As I said before, this is not a recommendation but just a tutorial to help you better understand this topic.

So, there you are. This is how a back-of-the-envelope-calculation works for valuing a stock.

Of course, while we took the current earnings power of BPCL to arrive at its fair value, one can also consider its future earnings power and work backwards from there. However, this will require a more detailed study of its prospects, its new initiatives and value they would add. If you are up for this, please go ahead and try it out. Otherwise, the approach we discussed also works fine for a lot of companies.

In fact, why don't you try the same approach on HPCL and let us know what you get?

Over time, as you see the results, your faith in this approach will definitely go up in my view.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. 

This article is syndicated from Equitymaster.com

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

MINT SPECIALS

Switch to the Mint app for fast and personalized news - Get App