How do they decide the stock price? or how do they say if a stock is cheap or costly? like sometimes a stock at Rs. 75 is considered to be costly while a stock at Rs. 19990 is considered to be cheap! Unlike the usual price tag we see in shops, the price of a share in share market reflects value – i.e. how much you value a company to invest your money. Share market is pure economics, so it talks about value.
Coming back to the questions raised above, The price of stock reflects few things about the health of a company and share market evaluates its future potential. Its like the heartbeats or Blood pressure levels that let us know about our health. To be precise, to know the health of a company at present moment you need to look into its Balance sheet and order book. That’s like ECG report for doctors, we don’t see more than graph but a cardiologist know what is what in the graph. So But don’t worry we don’t need to know how to read balance sheet and annual report to trade a stock. (although you can learn it if you want to) There are certain ratios that reflects health of a company and we can compare these ratios of various good stocks in similar sector to make a better choice.
Please don’t be bogged down by the details. I know this can sound complicated for a new investor. Its all right if you don’t have or find these values. I am giving this information so that you make informed decision. You can simply buy/Sell a stock based on recommendation given by your broker or Moneycontrol or recommendation from CNBC TV18. Even the experts will use above ratios and if you have little idea about them, then you will understand their financial language. That’s all.
You dont need to sit and calculate these ratios as they are already provided by website like google finance and Moneycontrol. Lets take example of Britannia and see its ratio and overall stock information. The website will show some information as in images below,
For our purpose, focus only on the red underline information.
As we have learned before, there are 2 stock exchanges BSE and NSE and there can be a little difference in share price.
Here, the market sentiment is for BUY which means, market is positive about Britannia, so should you buy it just like that?
look what the Ratios are saying.
P/E ratio or price to earning ratio – 62.43
Price/Book ratio or P/B ratio – 21.02
and book value itself.
Lets understand what it means.
These ratio are called as valuation ratio. They tell us if stock is undervalued or overvalued. They also let us know about VALUATION, PROFITABILITY, DEBT, EFFICIENCY etc.
we are going to consider following ratios, i am making this ultra simple for you without any formula, if you dislike Mathematics like me.
- Price to Earning ratio – This tells us how much we are willing to pay for Rs. 1 earning of that company. High P/E means a growth company.
- PEG ratio – it means how much you are willing to pay per share for future growth/ earning of that company.
- book value – its not a ratio but important for next P/B ratio. Book value means what is current value of that company if it is to be sold today. Each company need capital to carry out its work so they borrow money and then they need to pay back this debt. plus they have to pay wage/salary (liability) so its all going to get reduce from what they are earning at present. So their net profit plus their plant, machines etc. constitute their assets. So Assets – liability = book value of that company.Price to book ratio – this means how much you are willing to pay for the share in this company when you know current value of that company.
- Return on asset (RoA) : how good a company is using its asset to make money.
- Return on Equity (RoE) : how good a company is rewarding its share holders for their investment in the stock.
- Price to sales : How much we are willing to pay for Rs. 1 sale.
- Profit margin : Higher margin are better.
- Debt to Equity ratio : Even a listed company can have debt aspect, loans to repay. So this ratio tells us how much debt a company has with respect to total share holding.
Obviously there is more hidden layers of each ratio. Its better to know that meaning, however, even after knowing above terms you can start investing, jump to next article. But it is highly recommended that you atleast try to know a little deeper meaning, I have tried to explain that below.
1. Price to earning ratio (P/E ratio) :
Formula : Price per share/ earning per share.
What it means : Price to earning ratio tells us what price you are willing to pay for Rs. 1 earning of that company.
If you search share price on google or moneycontrol then you will get this ratio ready made. In general to know this ratio you need to know current share price and earning of the company which is given in the balance sheet. So if you divide this earning by total shares available then you get earning per share and if you divide The share price with this earning per share you get P/E ratio.
How to use it – A P/E ratio tells us directly how market is looking at a company. P/E ratio of a value stock will be low and P/E ratio will be high for a Growth stock, thats a gross understanding. How to know which value of P/E is low or High? for that you need to consider the sector as a whole. for example in auto sector, lets consider 2 stocks – Tata motors and Mahindra and Mahindra.
In case of Tata Motor, the P/E ratio is mere 14.72
while the P/E ratio of Mahindra and Mahindra is whopping 202.35.
This clearly makes Tata Motor a Value stock, while Mahindra and Mahindra is a growth stock as its P/E is in 3 digits – means people are willing to pay more for its per share. But dont just jump to buy Mahindra!
Although these 2 stocks cannot be compared directly but This is an example to show you difference in P/E ratios. But then people make such mistake. In February Governmnet will present its budget, and usually in budget government announces something for rural economy. Mahindra group have their strong roots in rural economy – thus the stock is up in anticipation.
Thus, in terms of stock Tata motors is a pure auto stock, but Mahindra and Mahindra is an holding company, which means apart from their auto division this stock also reflects overall health of Mahindra group. (The Tata sons holding company is not listed) Further if you check Moneycontrol website for Tata Motors you will see that the sectoral P/E for auto is 39.60 while the P/E of tata motors is less than half at 14.72. So yes this makes Tata Motors is a value buy. (if you are still wondering why this stock is so down… we will see more about this analysis in trading tips) The real player of Auto in Indian market is Maruti Suzuki whose P/E ratio is at 37.76, it’s one of the big 10 companies in India in terms of market capital (market capital = No of shares* share price)
coming back to Price to earning ratio.
The P/E ratio takes into account past values, i.e. the denominator Earning is of past quarter and thus P/E tells us what company has done in past. It doesn’t tell us about future and share market is about future growth potential. Sometimes you will not see P/E data for a stock eg. There is no information on P/E of Idea. This means 2 things – Either the data is not available or the company post a loss, (negative profit) and loss means P/E ratio will be negative. In case of Idea, it has posted loss in 2017 (due to Reliance jio disruption). You can check it here that P/E for idea cellular is negative (-12.45) and Market dont consider negative P/E ratio.
Does Negative P/E makes idea a bad investment choice? Even post idea-Vodafone merger it will take some time for them to be profitable. As a company, idea+Vodafone have about 43% market share, and mobile data being the gold of 21st century, so it is going to stay for sure. With that said at what price you should enter in Idea that is the real question. We will see this strategy in next article on trading tips. There are many such companies with negative P/E yet they are multibaggers of 2017 based on future potential – eg. TV18 network, Future consumer etc.
2. PEG ratio – Price to Earning ratio / projected Growth). tells us about future prospects of the share.
Formula – (P/E ratio)/Projected earning per share.
Remember in P/E ratio indicated how much a buyer is willing to pay for Rs 1 earning of a share. The denominator of PEG ratio indicates increase in that Rs. 1 in future. So If a company is going to give more earning i.e. higher denominator, then it will reduce the overall PEG ratio. Thus Lower the PEG better the stock.
3. Book value : Book value of a company means – (Assets – Liability) of a company, this data comes from balance sheet of that company.
Price to Book ratio :
formula : Price per share at present/book value per share.
Book value per share = Book value/ Total number of tradeable shares.
Thus P/B ratio = Price per share/(Book value/No. of outstanding shares*)
outstanding shares means shares that are tradeable. Some companies buys back their own share and keep it away from trading.
Low P/B means market estimates share price less than its actual assets. Ideally the P/B should be 1 that is market estimate and current value of the company is same. But that rarely happens as market is always projecting future. So you will find P/B more than 1, however if you find a P/B lower than 1 then you need to look why market is evaluating assets of that company lower than market price. Eg. Unitech is a company in real eastate and it was a big player untill 2007-08 but then the management was arrested in money laundering in the 2G spectrum scam. As of 10 January 2018 unitech’s P/B value is 0.28 and share price Rs. 9.90 making it a penny stock. Compared to this Indiabulls real estate has P/B ratio at 2.54 which is a standard/ normal ratio for real estate stocks in India.
4. RoE : Return on Equity, or profitability – This indicates how good a company is rewarding its shareholders for their investment and faith.
RoE = Net Income/Shareholder’s Equity. Higher RoE is better, more than 15.
eg. If in 2017 RoE for Maruti Suzuki is 20.3, it means for every Rs. 1 of equity share owed the company is generating Rs. 0.20 in profit that year. 20% returns on actual share of the company in 2017. Check it here. But the market rewards this, much much higher – Maruti Suzuki stock is up 62% in past one year! it is one of the blockbusters of 2017.
ROE tells the investors about the management’s efficiency in making profits.
There is also a term EPS i.e. earning per share.
EPS = Net income/ reported shareholders equity. higher EPS doesn’t actually tell us about profitability of a company but you will still hear this word sometimes. If you see this EPS then look for RoE for such stock to make your decision.
*The ace investors like Warren Buffet uses RoE to invest in a company.
5. RoA : Net income/ average total assets : it means how good a company is using its assets to make money. Again, higher RoA is better.
6. Price to sales ratio : Just like Price to earning ratio, But Price to sales ratio is more reliable. Since a company can use creative accounting methods to show higher earning. But the sales number cannot be modified.
P/S ratio = Price per share/ annual sales per share.
7. Profit Margin : Just remember, higher margins are better so the experts will talk of margins and you will hear in annual reports, see if margins are changing.
8. Debt to equity ratio : total Debt/Shareholding
that is how company is using Debt and equity to finance its business.
If interest rate on debt is 8% and RoE is less than 8% then its a bad composition.
9. Miscellaneous :
There are some simple terms in doing a business. For example –
- Cash flow, which means how the money is entering into the business and going out of the business. A business with more inflow and less outflow is considered to be better.
- Net income i.e. total earning of the company.
- EBITDA margin – earnings before interest, taxes, depreciation and amortization (EBITDA) it tells us about profit, but don’t ponder upon it too much, this kind of analysis is complicated.
The 8- 9 ratios we saw in this article constitute the FUNDAMENTAL analysis of a stock, well not entirely but most of it. There is a bit part of Macro analysis i.e. situation of the economy of the country as a whole and what RBI and central government is doing about it, particularly the inflation. But as of book market of 2018 you need not worry about it yet. I will cover the important aspects of economy in the concluding article on equity, so lets not add more concepts for now.
Sure it will take some time to understand how the whole gamut of fundamental analysis works and how you can use it. But once you get this vocabulary you can trade and make money in the share market.
Remember the first Example of Britannia, its share value was 4725 with P/E ratio of 63 and P/B ratio of whopping 21. That is one expensive stock! but still market is positive on this stock with 100% buying sentiment. The reason for this is – its a consumption stock, the 1.2 Billion people of India are going to consume, like always. Britannia is one of the 3 listed biscuits manufacturer stocks in India (other being, ITC Parle) But unlike ITC and Parle, Britannia only deals with Buscuits with more than 30% market share.
Thus even with its rich valuation this stock will see upward movement, if not immediately then over a time. On the other side, Facts also says that the stock has run 60% in last year. And with P/E of 63 and RoE of 35% it will be a challenge for Britannia to maintain in. Thus, although Britannia is a fantastic stock to invest, at present its an overheat stock and may not run much for few quarters, it can infact correct/ fall a bit which can be your entry point if you wish to invest in this stock. Thus, As an long term investor, you can invest and wait for this stock to find legs again, but, when there is bull market, as a trader you can always put your money in other high momentum stock depending on market sentiment. This is how you need to trade off and make decisions. True, you will make some mistakes but you will learn much more than that, not just for share market but about life itself.
This is it! now you are ready to get going with trading. So In next article we will learn about actual trading and what cautions you need to take there.
NEXT : Prerequisite for Trading
If you want to study the ratios of stocks in your portfolio you can check them on https://economictimes.indiatimes.com. they give detailed information on on the stocks.
Thank you for showing the interest!
Here is a summary of your Journey to trading,
- Basics of Shares,
- Equity Related terminologies,
- Some technical stuff that you must know I.e. this article
- Some cautions and introduction to trading platform
- Some does and don’t of trading.