To find hidden gems, track PE ratio & ROCE!

Abstract from article By Kshitij Anand, Moneycontrol News

There are a lot of methods which can help you pick the right kind of stocks for trading, but for investment, focus on few parameters which could help you to pick winning bets.

P/E a better indicator

Companies which have a low P/E multiple compared to industry P/E have given exceptional returns of up to 280 percent in the last one year to name a few Escorts, REC, Hindalco, Jk Tyres, IOC, Navneet Education etc.

PE is one of the important and mostly used price multiples for valuation. The standard rule is -- the lesser the PE better the stock and vice versa. However, that might not apply to growth companies. If PE of a stock is lesser than the industry PE or its peers then it gives a sense of confidence to buy the stock. However, for company in a growth phase, a higher PE can be justified and it would still not be considered overvalued, suggest experts.

However, it is not wise to use PE as only parameter for evaluating a stock. “When it comes to investing, PE ratios aren't everything and should not be looked isolated. One must also study growth potential, future profitability and superior corporate governance practice,” Jaikishan Parmar, Sr. Equity Research Analyst, Angel Broking Pvt Ltd told Moneycontrol.

“Companies Like India Cement, Navneet Education, Federal Bank, Dewan Housing etc. have very good fundamentals and are available at lower PE which makes the stock looks attractive,” he said.

Goel further added that stocks like Escorts, Sun TV also have very good fundamentals but are trading at exceptionally high PE where investors should book profit because markets have already discounted growth factor and might not rally at the same pace as it did in the past.

RoCE is also important

Return on Capital Employed or RoCE is another ratio which investors can use when making their investment decisions. Usually, a figure over 12 percent is good for any company.

“RoCE is a good indicator to check operating performance and balance sheet health. Therefore, any company with RoCE better than 12% is good. Navneet Education is one such quality name with better RoCE and comfortable P/E,” Tushar Pendharkar, Head of Research, Right Horizons Investment Advisory Services told Moneycontrol.

“In addition, there are few exceptions in this list where the RoCE is low; however, they have strong business outlook, such as – Hindalco Industries Ltd, and Indian Oil Corp Ltd,” he said.

Two Valuation Methods

“There are two types of valuation methods, relative and absolute. Relative valuation looks at the valuation methods such as P/E, EV/EBITDA, P/B, EV/Sales, etc. These relative methods compare the valuation multiples against that of the sector and comparable peers,” he said.

Parmar further added that the absolute valuation method, however, is independent in nature and methods like DCF take a long-term view on the future cash flows to value the company.

The general theory is companies which have strong fundamentals such as healthy balance sheet and good return ratios, should get premium PE valuation compared to the companies with poor future growth rate, or weak balance sheet, suggest experts.