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.

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Happy investing