Stock investors fantasize of making a quick buck in a rising stock market. In their mind’s window they see their stock picks multiplying in value many times over. The reality however is usually very different.
In a market which falls, there are smart investors who short-sell and make money. Most of the small retail investors are bewildered a confused lot who do not know which stock to buy, when to buy and when to sell.
The bewildered investor is the one who is confused by the dust raised by stampeding bulls in a rising stock market, standing on the sidelines in miserable indecision.
He decides to join in the last lap of the Bull Run where he suddenly finds that the bulls have vanished into thin air, and all he is left with is junk and penny stocks after the dust settles down. As the stock market tanks his hot penny stock picks start loosing value faster than he can count. This is where our friend makes a distress sale, and then swears to stay far away from the stock market forever.
Does this story sounds familiar, or sadly still, is it your story too? What should one do in such a predicament? Is there a way for investors to identify good companies and time their decision correctly?
Fortunately, yes, for those who have patience and diligence.
The equity value of a company is the present value of future cash flows. The true value of a company lies in the eye of the beholder, clichéd but true.
“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it,” said the legendary Warren Buffett.
He bought businesses that were high on growth, high on return on capital employed and look where he is today.
When he bought Coca-Cola, many thought he had made a mistake. But he bought it because it had the capacity to do better than the stock market, due to its high returns potential.
Buffett advises investors to seek value. Let us look at it another way. One criteria by which equity value is determined is the P/E ratio. How can you, as an investor, use it to spot hidden gems?
Lets say you put Rs 100 in a bank fixed deposit at an annual return of 9%. You get Rs 9 on your Rs 100. So the invested-to-return ratio is 100/9, or 11.1.
It’s the same way with stocks. You put in Rs 100, and the company has an earnings per share (EPS) of, say, Rs 7. So its P/E is 100/7 or 14.29. In the bank FD, your risk is minimal and the payout is 9%.
But in the case of equity, the payoff is the dividend plus the potential for share price appreciation. Equity is risky; hence the potential payoff must be significantly higher to make investing sense.
So for companies that grow their profits significantly, the stock price is higher, and dividend earnings lower. The latter is made up for in terms of greater appreciation in the stock price.
PEG Ratio
Another good guide is to identify fair valuation in equity. This is referred to as the PEG ratio. It’s the P/E divided by the growth potential of the company. If that number is 1 or less, the company is said to be fairly valued, and if it is more, it is said to be |
