Monday, August 29, 2011

Fundamental Analysis of Market Price of Stocks

In order to understand the concept of stock valuation, we will present to you the four foundation pillars on which the stock’s valuation stands. None of the valuation discussed below are superior to each other. Each of them has their own importance. Any share which does not reflect all the four parameters as healthy means it is not a good buy.

(1) Market Price of Share Vs. Its Book Value (P/B Ratio)
Book value is that value of a company, which the owner is likely to gather if they decide to liquidate (sell off in dire straits) the company. If you are desperate to sell any item, it is most likely that you will compromise on selling price for time. Your focus is more on selling fast than price your amassing. What help does book value provides to investors? Suppose book value per share of a company is say \$10 and its present market price is \$8. You decided to buy shares of this company at \$8. In few years time, the company went broke and declared bankruptcy.

The government/ banks decided to sell off the companies (liquidation) assets. In this selling process the fund that is likely to be generated is \$10 per share. As you have bought the share of this company at \$8 per share, so even though the company has been liquidated but you are still making a profit of \$2 per share. But most often companies do not report the book value very accurately in their balance sheet (always reported on higher side). So it is always better for investors to buy shares at 2/3rd of its book value. Market Price = 2/3 x (Book Value)

(2) Market Price of Share Vs. Its Earnings/profits (P/E Ratio)

Like P/B ratio compares the market price with its book value, P/E value compares the market price with net profit (PAT) of the company. Suppose a company which has earnings per share of say \$10 and its market price is also \$10 it means P/E ratio will be equal to one. In case of liquidation of company the shareholders will have their money back only by sharing the net profit.

They will have further profits from asset (equivalent to book value) selling. But the point here to note is that, in case the company is making healthy profits why the condition of liquidation will come? For sure healthy profits reflects good business fundamentals of the company. So investors are willing to pay premium to own such shares. Market Price = 2/3 x (Book Value) + Premium.

As a rule of thumb an investor shall not pay more than 15 times of earnings of the company. Now it is point of debate that for which company you shall pay 8 times, for which 7 times, for which 12 times …. For a time being we will just settle down with this understanding which says, Market Price = 2/3 x (Book Value) + Premium </= 15 x Net Profit

(3) Market Price of Share Vs. Its potential to increase its earnings (PEG Ratio)

We have seen that an investors may be willing to pay 15 times its net profits to buy a stock. But what decided that whether 15 times will be good enough or we should only pay 12 times for that stocks. The factor that decides is called a “growth in earnings”. Suppose a company which has \$1 million in net profits in 2006, \$1.15 million in 2007, \$ 1.32 million in 2008, \$1.52 million in 2009 & \$1.75 million in 2010. The growing trend in net profits of company says that the company is able to increase its profits at the rate of 15% per year.

Means the growth in EPS is 15% per year. Suppose the P/E ratio of this company is 15, hence PEG ratio = (P/E) divided by (growth in EPS) = 15/15=1. If any share has PEG ratio of equal to one means we can go ahead and buy that share. But the control point is, the P/E ratio shall not be more than 15 (even if PEG ratio is 1).

If a share has P/E ratio of 14 and growth in EPS comes out to be 10, it means PEG ratio is 1.4 > 1, hence this share is not recommended for purchase even though it has P/E < 15. Market Price = 2/3 x (Book Value) + Premium </= 15 x Net Profit only if PEG ratio is </= 1

(4) Market Price of Share Vs. the dividend paid to the shareholders (Dividend Yield)

According to value investors share value can be calculated from the income it is going to generate for its shareholders. Value investors buys shares with the objective of holding it for their life, so the only income possible is through dividends. It may be possible that a particular share is able to satisfy all the above three (3) financial parameters discussed above, but it does not paying the required dividends, value investors will never buy such share. Level of dividend paid to the shareholders are a deciding factor for any value investor.

Dividend Yield and consistency of dividend paid to the share holders are very important for value investors. Long term investors will always look at the ‘dividend yield’ & ‘dividend consistency’ before buying a share. Now it will tough to decide that what level of dividend yield will be sufficient. Ideally if the dividend yield is greater that the ‘risk free rate’ will be best for investors. But this condition is tough to meet particularly in developing economies. So let us fix a nominal level of 3.5% dividend yield as our starting point.

But investors please remember to check the dividend consistency before buying any stocks. It is possible that a company has paid high dividend this year in last few years has paid only pea nuts. Looking at the dividend history of the company you can safely forecast the future dividend incomes.

Market Price = 2/3 x (Book Value) + Premium </= 15 x Net Profit only if PEG ratio is </= 1 and only if its Dividend Yield > 3.5%. (Also read: Dividend and Compounding of money)

Conclusion
Screen the market price of share with the following parameters and only then buy the share:

(a) Market Price </= 2/3 Book Value &
(b) Market Price </= 15 x Net Profit &
(c) Market Price </= PEG ratio of 1 &
Market Price </= Dividend Yield > 3.5%.
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