Sunday, January 13, 2008

Fundamental analysis 102

My every Blog is so heavy that I feel the readers will just run away. So i thought if I post a financial post then I should also post something of pure fun. I like a lot of things and I always research on those so that won't be a problem.
Now we start were we left the fundamental analysis 101. PE ratio as you remember. What is great about this number that comes in so handy? Let’s answer this question. As you can see Price of share divided by earnings is just a way of telling yourself how much time in years it is going to take for the company to earn as much money as its share price is valued right now, with no growth whatsoever. Say IBM has PE of 10. Then it will take 10 years with no growth to create money/earn net profits equivalent to the price at which it is quoted right now. What is the price quoted is same as what you see in the stock market. Since both the numbers in the PE ratios are also multiplied by number of shares of that company so there is a fundamental way of saying the same thing i.e. (Price of a share* No. of shares)/Net profit of the comapny. Price of a share* No. of shares is what we call market Capitalization. PE is nothing but Market capitalization divided by net profit. Remember in long term the "investors" determine the value and price of a share and not the normal people like us. And every good investor looks at the PE of a company as the first thing. It is just like if I ask you to invest in my cookie shop then your first question will be/should be is how much time will it take to get your money back and after you get it, how much profit you will be entitled to. Precisely what PE ratio tells you about a stock. Now an intelligent person reading my Blog will point out what about a company with growth. Growth makes PE harder to imagine and the calculations become cumbersome. Of course you are not going to calculate a Geometric progression and some other things for every other stock. So here is one of the most important trick you can receive from someone. I received it from none other than the great Peter Lynch. I read it in his book of course. Whatever the PE of the company is, that’s what people pricing it thinks will be the growth of that company in next 11 to 15 years. So if PE is 10 then Market as one entity is assuming that the company will grow at 10% for the next 11 – 15 years. Why a range because I don’t know the inflation of your country. 12 years for no inflation to low inflation (1% types) and 15 for moderate inflation countries (6%). Don’t worry about the exact value because you can’t predict the exact future growth, only thing you can predict consistently is a range and bigger it is the greater is the consistency but lesser its practical value. A paradox, I love paradox. So the part highlighted in BOLD, just remember it by heart. It is not an advice but a statement. If you know mathematics then try it out and you will arrive at the same conclusion. I tried it out after reading Peter Lynch and came to the same conclusion. If you don’t know math then just take it on faith, that’s all I can say. At least better than an astrologer I think. It is very powerful way to gauge the overpriced and under priced stocks. Trust me.
I hear this so many times from people around me that I thought that this is not a trivial question as I used to think. Many times I hear “hey that stock is selling at around 100 Rs and the other stock is selling at 1000, so the stock priced 100 has to be cheaper”. I hear this from normal people who are buying stocks and selling it. And when these people lose money, they blame it on the stock market. I feel so sorry about them. Little knowledge about something is dangerous but no knowledge about something can be disastrous. So let’s clear few things out.
As I said PE ratio is Price of a share divided by the earnings per share/Net Profit per share. So Lets see an example. Company A has a net profit of 10 million and company B also has a net profit of 10 million. They both are in the same industry and are almost same to the customers. Call them pair companies. (Actually there are quite a few of them in real world and there is one good strategy discovered by people of Morgan Stanley few decades back that can still be profitable. Technically it is called pair trading. Like Ford and GM, Infosys and TCS etc.) Company A has 1 million shares in the market and the Company B has 100 thousand shares in the market. Always remember that number of shares is arbitrary number and has no significance in determining the value of the company. It can be anything that common sense permits. Company A’s share is selling at 100 Rs/share and Company B’s share is selling at 1000 Rs/share. Profit per share for company A is (10 million) / (1 million), that is 10 Rs per share. Similarly for company B it is 100 Rs per share. We technically call this as EPS (earnings per share and is same as Net profit per share). So what is the PE of the stock? Company A’s PE is 10 and company B also has a PE 10. If both have the same PE and same growth rate in same industry then how come one is under priced and other over priced. It can’t be and is not. Both are priced same, that is Company A’s share price of 100 is same as Company B’s share price of 1000. Under priced and over priced in stock market has different rules and has nothing to do with what your pocket feels about it. If that would have been the case then Berkshire Hathaway(Warren Buffet’s company) would be the most overpriced share and all the penny stocks selling for few cents will be the most under priced. The truth is exactly opposite and that’s why people lose money most of the time. I hope it is understood by now. Just remember the statement highlighted because it will be used quite often. Infact you can forget everything in this post and just remember that nice statement higlighted in Bold.

If you have any problems then just leave a comment and I will try to explain your query.

1 comment:

chennai said...

Builder
Customising and providing residential homes & commercial space as per clients requirements