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Evaluating a company's stock price
When we are talking of the price of a company's stock we are normally referring to the price at which the stock is traded at the exchanges. This is the market price. That stock prices fluctuate wildly is a common knowledge. To be sure, such fluctuations, which we call volatility, attract a certain type of people who attempt to profit from rapidly fluctuating prices. Whether they are able to make a profit is a different matter though. For most, however, taking a decision on what price to buy a stock at, is truly vexing . A company may have a great business and its future is likely to hold tremendous profit potential but if its price has already run up substantially, investing at that price is not likely to be a good investment. What then is the right price to buy a stock. For that let's get familiar with what are the different ways we ascribe a price to a company's stock.
The first is the face value or the par value. This is linked with how the company raises its capital which is the money for starting and running the company. Apart from the promoters of the company putting their own money companies also raise money from the public by selling certain number of stocks . The money thus raised is the equity capital . Companies also borrow capital. The proportion of such borrowed capital to the total and also its relation with the equity capital is a matter of choice of the financial planners of the company. The equity capital divided by the number of stocks offered gives the face value. In practice though this is a convenient round number and the number of stocks is calculated on the basis of the face value so fixed to arrive at the required equity capital.
So is it that the face value or par value is what the stock price ought to be. No, actually the face value has nothing to do with the market price. This is because as the company carries on with its business over time it accumulates profits which go into it's reserves and so the stock of the company has a greater value than the face value which the market aptly recognizes by paying a higher price. Another example would be of a company distributing dividend twice the face value. Dividend yield in such a case would be enormous if one pays the face value to acquire the stock. The market price therefore assumes a higher value to bring the dividend yield to comparable levels. The reverse could also happen . The company could be making losses year after year. Instead of accumulating reserves it could be eroding its net worth. Markets then would not pay even the face value of the stock and the stock would quote below par value.
If the face value is not at all a correct indicator of price because of subsequent changes in the company's worth, what if the reserves are added to the equity capital to arrive at a workable value. Such a value is the 'Book Value' which is obtained by dividing the sum of the equity capital and the reserves by the total number of stocks subscribed. But relying on the book value has its own limitations. As mentioned, book value takes into account the reserves accumulated over the years in the past and can be of little use in forecasting future profits. Book value being balance sheet based does not reflect any appreciation of assets which continues to maintain original valuations inspite of the market price of the assets having gone up. It has been seen that prices of good companies invariably quote higher than the book value. Another criterion namely the ratio of price to book value (P/V ratio) is a little more useful. An important characteristic of this ratio is that it remains more or less constant and remains close to the average value over a period of time. This is a valuable tool in the hands of the investor. Any increase in the ratio would indicate that the stock is overpriced and vice versa.
If there is any criteria that has the most dominating influence on the price of a company's stock is its earnings, so much so that markets start paying higher prices merely on anticipation of higher earnings. This is the Price to earnings ratio (P/E ratio) where the earnings are taken to be earning per share (EPS). Like the P/BV ratio it also tends to remain around it's average value over a period of time and any deviation from the mean would indicate whether the stock is overpriced or underpriced. But it scores over the P/BV ratio because it is able to capture the opinion of the market as regards the earning potential of the company. Such is the halo of the P/E ratio that it sometimes runs into several hundred signifying an inordinate price in relation to its present earnings which may not have started coming in. Companies in gestation period fall in this category. But here also there are limitations. Accepting a high P/E multiple enhances risk. Further when earnings start coming in for a company which was in gestation, the P/E multiple can actually fall to comparable levels. It therefore follows that buying a high P/E stock does not necessarily give high returns on investment . It can be a bad investment also.
It therefore is difficult to ascertain whether the market price of a stock is appropriate for investing by using any single approach mentioned above. But inspite of their limitations these criteria when taken together nevertheless offer a reliable way to answer the question "Is the price right". The right price has to reflect not only the present but also the future. For that both the P/BV ratio and the P/E ratio when taken together becomes more powerful than any single approach for evaluating the price at which investment can be made in a company. This is done by calculating the mean of the average P/BV and the average P/E. This is the 'Intrinsic Value'. Buying at a price close to or less than the intrinsic value will give the investor a maximum return. Average for both can be over any number of years depending on the time frame of the investor keeping in mind that the greater the period, longer will be the time frame of the investor which in turn should give better return.
One final point though. It is to be kept in mind that the intrinsic value should reflect future earning potential of the company. It means that by estimating the intrinsic value we are trying to forecast the possible price appreciation in future. This also encompasses the objectives and expectations of the investor. Towards that end using other forecasting techniques to project a company's future earnings alongwith investor's own judgement greatly enhances the accuracy in finding out if the stock is reasonably priced.
Till my next then
Happy investing
The first is the face value or the par value. This is linked with how the company raises its capital which is the money for starting and running the company. Apart from the promoters of the company putting their own money companies also raise money from the public by selling certain number of stocks . The money thus raised is the equity capital . Companies also borrow capital. The proportion of such borrowed capital to the total and also its relation with the equity capital is a matter of choice of the financial planners of the company. The equity capital divided by the number of stocks offered gives the face value. In practice though this is a convenient round number and the number of stocks is calculated on the basis of the face value so fixed to arrive at the required equity capital.
So is it that the face value or par value is what the stock price ought to be. No, actually the face value has nothing to do with the market price. This is because as the company carries on with its business over time it accumulates profits which go into it's reserves and so the stock of the company has a greater value than the face value which the market aptly recognizes by paying a higher price. Another example would be of a company distributing dividend twice the face value. Dividend yield in such a case would be enormous if one pays the face value to acquire the stock. The market price therefore assumes a higher value to bring the dividend yield to comparable levels. The reverse could also happen . The company could be making losses year after year. Instead of accumulating reserves it could be eroding its net worth. Markets then would not pay even the face value of the stock and the stock would quote below par value.
If the face value is not at all a correct indicator of price because of subsequent changes in the company's worth, what if the reserves are added to the equity capital to arrive at a workable value. Such a value is the 'Book Value' which is obtained by dividing the sum of the equity capital and the reserves by the total number of stocks subscribed. But relying on the book value has its own limitations. As mentioned, book value takes into account the reserves accumulated over the years in the past and can be of little use in forecasting future profits. Book value being balance sheet based does not reflect any appreciation of assets which continues to maintain original valuations inspite of the market price of the assets having gone up. It has been seen that prices of good companies invariably quote higher than the book value. Another criterion namely the ratio of price to book value (P/V ratio) is a little more useful. An important characteristic of this ratio is that it remains more or less constant and remains close to the average value over a period of time. This is a valuable tool in the hands of the investor. Any increase in the ratio would indicate that the stock is overpriced and vice versa.
If there is any criteria that has the most dominating influence on the price of a company's stock is its earnings, so much so that markets start paying higher prices merely on anticipation of higher earnings. This is the Price to earnings ratio (P/E ratio) where the earnings are taken to be earning per share (EPS). Like the P/BV ratio it also tends to remain around it's average value over a period of time and any deviation from the mean would indicate whether the stock is overpriced or underpriced. But it scores over the P/BV ratio because it is able to capture the opinion of the market as regards the earning potential of the company. Such is the halo of the P/E ratio that it sometimes runs into several hundred signifying an inordinate price in relation to its present earnings which may not have started coming in. Companies in gestation period fall in this category. But here also there are limitations. Accepting a high P/E multiple enhances risk. Further when earnings start coming in for a company which was in gestation, the P/E multiple can actually fall to comparable levels. It therefore follows that buying a high P/E stock does not necessarily give high returns on investment . It can be a bad investment also.
It therefore is difficult to ascertain whether the market price of a stock is appropriate for investing by using any single approach mentioned above. But inspite of their limitations these criteria when taken together nevertheless offer a reliable way to answer the question "Is the price right". The right price has to reflect not only the present but also the future. For that both the P/BV ratio and the P/E ratio when taken together becomes more powerful than any single approach for evaluating the price at which investment can be made in a company. This is done by calculating the mean of the average P/BV and the average P/E. This is the 'Intrinsic Value'. Buying at a price close to or less than the intrinsic value will give the investor a maximum return. Average for both can be over any number of years depending on the time frame of the investor keeping in mind that the greater the period, longer will be the time frame of the investor which in turn should give better return.
One final point though. It is to be kept in mind that the intrinsic value should reflect future earning potential of the company. It means that by estimating the intrinsic value we are trying to forecast the possible price appreciation in future. This also encompasses the objectives and expectations of the investor. Towards that end using other forecasting techniques to project a company's future earnings alongwith investor's own judgement greatly enhances the accuracy in finding out if the stock is reasonably priced.
Till my next then
Happy investing
Sunday, August 9, 2009
Minimizing investment risks
The objective of any investment is to bring in returns through profits generated on the money deployed . In the case of stocks this can be by way of dividends received or appreciation in the value of the stocks or both. If none of the above is realized the investment turns to loss and is no longer an investment. This is equally applicable even if the invested amount remains the same numerically because of the erosion of the purchasing power due to inflation. In the case of investment in stocks the chances of the investment giving profits may at times be jeopardized by numerous factors. There is no guarantee that dividends will keep coming in and market value of the investments will keep soaring in a linear fashion. What is true is that company's fortunes don’t always remain the same. It is dependent on a host of environmental and internal factors. Investing in stocks therefore involves exposure to a possible loss. That is, there is a risk element to it. In fact there is nothing as a risk free investment. Taking risk is an integral part of investing in stocks. Yet investing in stocks have been known to be giving superior returns despite the risk involved.
One other aspect of risk is that it is directly related to return. This means the higher the risk involved with the investment the higher is the return. Put in other words if one wants high returns one has to contend with high risk. How does it happen that way. Let's see. Suppose one decides to put in a certain amount on money in buying stocks of a certain company in an initial public offer. The investment is made on the basis of the assessment of the company's ability to set up the project and start earning profits at the end of a specified period. The uncertainty lies in the gestation period and how successfully the company gets its business running and hence the risk. The greater the amount of money that is committed at the start, and hence a greater risk, the higher is the return if the company delivers as per the investors expectations. If however things go wrong and the company struggles with its business the investor's capital may as well, in the worst situation, be written off. A higher investment is this case would result in higher loss. A low risk low return investment brings safety to capital.
The question then arises as to how do we go about dealing with the risks. The answer is to minimize the risks since it cannot be got rid of completely. In the paragraphs that follow an attempt is made to understand various important risk areas and how to deal with these.
At the individual level the first and probably the most important is to have a clear idea of how much risk one is capable of taking. Not knowing one's limits is an invitation to disaster. This requires clear headed decision, free from greed or any other emotion. Decision required to be taken are on the level of expected return and the extent of loss that can be tolerated. This again is influenced by age, income level, financial commitments, mental makeup and personality traits. It is the individual investor who has to decide for himself what his goals are and set it clearly.
The other aspects are quite general. For example a decision on whether the stock of a given company can be bought, if based on a complete study of the company is likely to be far less painful if at all. Questions that need to be asked are what environment is the company operating in with respect to the economy, political and social situations. In other words how are these factors likely to impact the business prospects of the company going forward. Is the company's management capable of delivering on its stated profit targets. Has the intrinsic value of the company's stock been determined. The intrinsic value in most cases is different from the market value . Intrinsic value is arrived at by calculating what the stock price ought to be taking into account its sales, profits, profit margin equity capital etc. Market value is the price at which the stock is trading at the stock exchange. The extent of any gap between the two gives valuable indication of any risk involved in buying the stock at the prevailing market price. This is possible because stock prices always tend to adjust so as to close the gap between the two. If the market price is higher than the intrinsic value then there exists a certain degree of risk in buying at the market price. Of course in many instances market gives a higher price to a stock on the basis of its perception of profitability and expects the intrinsic price to move up to close the gap. Again if market's perception of future profits is low any rosy estimation of intrinsic value will hardly be of any use. Nevertheless examining the intrinsic value can go a long way in reducing risk. It is the answer to the question "Is the price right". This is an example of fundamental analysis that is an analysis based on study of aspects fundamental to a company's business.
Fundamental analysis has its limitation. In that it cannot come to terms with market behavior. This is because not all people will arrive at similar intrinsic value estimates and differences here can be wide indeed. Another type of analysis known as technical analysis attempts to capture just this. Trends in price movements. Both fundamental and technical analysis when used in conjunction can help minimize risk by allowing us to properly choose a company and to fairly assess its right price for investment.
Diversification in investment is another strategy to minimize risk. Broadly speaking diversification would mean spreading one's capital in different asset classes. One could for instance allocate varying amounts of the total fund in different areas such as gold, real estate,
equities, commodities, bonds etc. These days people even invest in paintings, works of art that is. But here we are dealing essentially with investing in stocks. This form of investment nowadays is by far the most convenient in terms of ease of management and also has the ability to deliver superior return. So if one is investing only in stocks then the golden rule is the proverbial "never put all your eggs in one basket" as every one knows what happens when the basket drops. You loose all your eggs. A basket of 5 to 10 stocks would be more than adequate for most. And if one has the inclination and time to track more stocks one can add more. But then again just as diversification limits losses and thereby the risks also, it at the same time caps profits also. Betting on a few potential winners at times offer fabulous returns. But that would depend on the investor's risk appetite .
In order to keep investment risks low one has to ensure that the investments are liquid at all times. This is as important as any other approach to minimize risk, if not the most. This means one should be able to exit the stock if the need arises on account of any requirement. Getting stuck with a dud stock is the worst nightmare for an investor. Here also, it has been seen that the most liquid stocks give moderate returns whereas less liquid ones give high returns. As before it's the investors risk appetite which is of prime concern.
Finally it needs to be mentioned that there is no single approach to investment analysis. Proper tax planning without doubt can maximize returns which therefore offsets a great deal of risk. An investor needs to work out his own methods to suit his requirement. Here the role of personal judgment of the investor cannot be overemphasized. Investor's own judgment based on his experience and also gut feeling plays a very important role in successful investment.
One other aspect of risk is that it is directly related to return. This means the higher the risk involved with the investment the higher is the return. Put in other words if one wants high returns one has to contend with high risk. How does it happen that way. Let's see. Suppose one decides to put in a certain amount on money in buying stocks of a certain company in an initial public offer. The investment is made on the basis of the assessment of the company's ability to set up the project and start earning profits at the end of a specified period. The uncertainty lies in the gestation period and how successfully the company gets its business running and hence the risk. The greater the amount of money that is committed at the start, and hence a greater risk, the higher is the return if the company delivers as per the investors expectations. If however things go wrong and the company struggles with its business the investor's capital may as well, in the worst situation, be written off. A higher investment is this case would result in higher loss. A low risk low return investment brings safety to capital.
The question then arises as to how do we go about dealing with the risks. The answer is to minimize the risks since it cannot be got rid of completely. In the paragraphs that follow an attempt is made to understand various important risk areas and how to deal with these.
At the individual level the first and probably the most important is to have a clear idea of how much risk one is capable of taking. Not knowing one's limits is an invitation to disaster. This requires clear headed decision, free from greed or any other emotion. Decision required to be taken are on the level of expected return and the extent of loss that can be tolerated. This again is influenced by age, income level, financial commitments, mental makeup and personality traits. It is the individual investor who has to decide for himself what his goals are and set it clearly.
The other aspects are quite general. For example a decision on whether the stock of a given company can be bought, if based on a complete study of the company is likely to be far less painful if at all. Questions that need to be asked are what environment is the company operating in with respect to the economy, political and social situations. In other words how are these factors likely to impact the business prospects of the company going forward. Is the company's management capable of delivering on its stated profit targets. Has the intrinsic value of the company's stock been determined. The intrinsic value in most cases is different from the market value . Intrinsic value is arrived at by calculating what the stock price ought to be taking into account its sales, profits, profit margin equity capital etc. Market value is the price at which the stock is trading at the stock exchange. The extent of any gap between the two gives valuable indication of any risk involved in buying the stock at the prevailing market price. This is possible because stock prices always tend to adjust so as to close the gap between the two. If the market price is higher than the intrinsic value then there exists a certain degree of risk in buying at the market price. Of course in many instances market gives a higher price to a stock on the basis of its perception of profitability and expects the intrinsic price to move up to close the gap. Again if market's perception of future profits is low any rosy estimation of intrinsic value will hardly be of any use. Nevertheless examining the intrinsic value can go a long way in reducing risk. It is the answer to the question "Is the price right". This is an example of fundamental analysis that is an analysis based on study of aspects fundamental to a company's business.
Fundamental analysis has its limitation. In that it cannot come to terms with market behavior. This is because not all people will arrive at similar intrinsic value estimates and differences here can be wide indeed. Another type of analysis known as technical analysis attempts to capture just this. Trends in price movements. Both fundamental and technical analysis when used in conjunction can help minimize risk by allowing us to properly choose a company and to fairly assess its right price for investment.
Diversification in investment is another strategy to minimize risk. Broadly speaking diversification would mean spreading one's capital in different asset classes. One could for instance allocate varying amounts of the total fund in different areas such as gold, real estate,
equities, commodities, bonds etc. These days people even invest in paintings, works of art that is. But here we are dealing essentially with investing in stocks. This form of investment nowadays is by far the most convenient in terms of ease of management and also has the ability to deliver superior return. So if one is investing only in stocks then the golden rule is the proverbial "never put all your eggs in one basket" as every one knows what happens when the basket drops. You loose all your eggs. A basket of 5 to 10 stocks would be more than adequate for most. And if one has the inclination and time to track more stocks one can add more. But then again just as diversification limits losses and thereby the risks also, it at the same time caps profits also. Betting on a few potential winners at times offer fabulous returns. But that would depend on the investor's risk appetite .
In order to keep investment risks low one has to ensure that the investments are liquid at all times. This is as important as any other approach to minimize risk, if not the most. This means one should be able to exit the stock if the need arises on account of any requirement. Getting stuck with a dud stock is the worst nightmare for an investor. Here also, it has been seen that the most liquid stocks give moderate returns whereas less liquid ones give high returns. As before it's the investors risk appetite which is of prime concern.
Finally it needs to be mentioned that there is no single approach to investment analysis. Proper tax planning without doubt can maximize returns which therefore offsets a great deal of risk. An investor needs to work out his own methods to suit his requirement. Here the role of personal judgment of the investor cannot be overemphasized. Investor's own judgment based on his experience and also gut feeling plays a very important role in successful investment.
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