How to pick stocks based on m-cap

The market capitalisation (m-cap) of a company is defined as “the number of outstanding shares multiplied by the market price of each share.”

For instance, a company having an issued capital consisting of 1,00,000 shares valued at Rs 100 each on the stock exchange on a given day will have a m-cap of Rs 1 crore on that day. Predictably, the m-cap of a company keeps changing, with the change in its market price.

Companies in India are classified into three broad categories on the basis of their m-cap:
Large-cap companies, or those with m-cap of more than Rs 5,000 crore;
Mid-cap companies, or those with m-cap between Rs 500 crore and Rs 5,000 crore; and
Small cap companies, or those with m-cap of less than Rs 500 crore.

M-cap indicates the relative size and stability of a company as compared with other companies in the same industry. An investor can give due weightage to the m-cap of a
company before judging its potential as an investment candidate.

FIIs and other large investors usually favour large-cap companies because of the liquidity they provide and the fact that they can invest large amounts in these companies without causing wide fluctuations in the price. Also large-cap companies have an inbuilt stability due to their size and are better equipped to weather adverse business cycles.

M-cap is generally used as a valuation tool in calculating the future earnings of a business discounted to present values.

An analyst estimates the likely earnings from a business, usually over a period of 10 years. The earnings for each year are discounted to present value using an appropriate discounting rate, normally the rate of government securities of similar tenure. The liquidation value of the business is estimated at the end of 10 years. The sum of the 10-year discounted earnings and the liquidation value gives the intrinsic value of the business. If the intrinsic value is greater than the m-cap of the business by a wide margin, the business can be considered investment worthy.

Take a company having sales of Rs 500 crore, an m-cap of Rs 1,000 crore and earning profits of Rs 75 crore per annum. The first-year profits discounted to the present at the current yield on G-secs of 8% would be worth Rs 69.5 crore. In arriving at the above figure, we use the following formula:

PV = FV/(1 + i)n
In this case,
PV is the present value = 0
FV is the future value = n (in this case Rs 75 crore)
n is the number of time periods
(in this case 1)
i is the discounting rate (in this case 0.08, i.e. 8%)

We estimate that the company can grow its profits at 10% per annum over the next 10 years. The second year profits would be Rs 82.5 crore. Therefore, the earnings of the second year discounted to today’s prices would be Rs 70.75 crore. Carrying this calculation over 10 years we get the sum of the 10-year discounted earnings figure at Rs 755 crore. We estimate that the liquidation value of the business at the end of 10 years to be Rs 500 crore.

Therefore, intrinsic value = 10-year discounted earnings + liquidation value = Rs 755 crore + Rs 500 crore = Rs 1,255 crore.

Since the market cap is Rs 1,000 crore as compared to the intrinsic value at Rs 1,255 crore, the business is a good buy at current levels and the Rs 255 crore represents our margin of safety. It is for an individual investor to decide what margin of safety he desires on a particular investment.

Another useful indicator in evaluating a company is its m-cap to sales ratio (see table for m-cap to sales ratios of some engineering and infrastructure companies). This ratio indicates what value the market gives a company as a multiple of its sales. Generally, 2 to 2.5 times of sales is considered to be fair valuation for a business, depending on what industry it is in and its growth rate.

If a company is being valued by the market at extremely low multiples to sales, an investor can use this as a starting point to investigate why. This can be an important clue to discover undervalued companies. If further investigations into the fundamentals do not reveal any significant problems, it can be inferred that the market has not recognised the value of that particular business and it can be considered as an investment candidate.

Like all other ratios, m-cap to sales cannot be used in isolation but should be viewed in conjunction with other fundamental parameters and business attributes.

Another useful hint the m-cap gives us is that it points us towards the untapped potential of a business model which is in the nascent stage in a country and therefore is not making any profits yet, but the same business model has performed well in other countries where it has had time to flourish and realise its potential.

Serious fundamental investors should therefore look at the m-cap not only from the viewpoint as an indicator of business soundness, but also as a starting point to spot businesses which are being ignored by the market in spite of being strong investment bets based on other parameters.

The writer is proprietor of Capital Management Services. He blogs at www.investologic.blogspot.com and can be reached at
mknaik99@rediffmail.com