Monday, August 29, 2011

How to evaluate share price


This is one of the most important question that share market investors needs to answer before investing in shares. There has been so many concepts of “How to evaluate share price” floating in the market that at times investors can become confused. Evaluating share price can be done by variety of quick ready-to-use-tools available in the market,but what we are going to discuss here is the very basic of business stock market investing and related business operation.

This article will not only give my readers a idea about stock market investing but also a look into business operations that drive stock market prices. It is true that stock market prices are not only driven by business fundamentals but also by sentiments of traders.

Hence there is big fluctuation in the stock market prices. I will suggest my readers that they should panic during these price fluctuations, instead they must ‘buy’ when prices fall below the fundamental pricing of shares. Hence it becomes even more important to know “How to evaluate share price”, because this will tell you whether it a good time to buy or sell a share.

The concept of buying and selling of shares

It is very important for share holders to understand that why shares are floated by companies in the market and why investors like the great Warren Buffett buy them. Imagine yourself as a business owner of a small manufacturing unit. After few years of operation you have observed that its time to expand and modernize the capacity of the plant.

But in absence of sufficient funds you cannot do this project. It is very important for business to expand and modernize in order to increase their profits & profitability. There are two options available with the owner, either he can take a loan from banks or else he can raise his own funds by selling his shares of business.

By breaking the total net worth of company into shares and selling it to investors, actually the owner of a business is selling a portion of his ownership to share holders in order to raise capital for expansion and modernization projects. Expansion and modernization of business will increase its profit and profitability.

If it is so why not every one can buy shares and make money

There are only basic hurdles is making money from share market investing, one is how to evaluate a good business? & secondly how to evaluate share price? People who are not very conversant with reading financial statements of business will find it very difficult to answer the two questions. Hence the ignorance of investors about reading and evaluating financial statements have made money making form share market a difficult prospect.

Moreover a financial statement of business has too many interrelated information’s and values. Most investors do not know which values are more important to know so as to how to evaluate share price and a good business. One thing is for sure, if any investor really wants to make money in share market then he must learn the tricks of evaluating financial statements of a company.

According to me it is also very important to invest in share market with long term investing horizon. Share market trading for short term is as dangerous as giving loan to any unknown person, you can never be sure that whether you money will ever come back with interest.

As we have learn earlier that companies sell their shares to raise fund for their business expansion and modernization. Generally this expansion and business plans take three to four years to capitalize. SO if an investor who buys and sell shares within one year (say), he will not get the advantage by holding for such a small time.

This method of stock pricing is called speculation which is more like gambling then like investing. So in order to make money in share market people should first learn the skill of reading financial statements and then deciding to invest for long term horizon.

How to evaluate share price?

Market price of share is strong indicator for investors to know whether a particular share is driven by business fundamentals or it is riding on speculation. But market price of share alone cannot give a clear picture. If the share is riding on on business fundamentals then the market price of share will always be prices to perfection (neither high nor low).

But unfortunately most of the time our share market is driven by speculation and because of this the share prices are so erratic. But investors use this erratic pricing of shares to their advantage. When the market price of share fall below a pre-defined level, long term investor quickly grab such shares. So now the question comes how to set this pre-defined level (in other words how to evaluate share price?). All shall and big investors know what is Price Earning Ratio (P/E) of a share.

Inverse of P/E ratio is called Earning Yield. The higher the earning yield, the better it is for the investors to buy that share. In order to know how to calculate how to calculate earning yield, please visit this link. All share market investor shall make a list of top 100 shares (arranged in the order of decreasing market capitalization). Once this list is ready add a column to its side and start giving a earning yield (%) for each individual share.

The share with highest earning yield shall be ranked as one (1) and with lowest earning yield shall be ranked as hundred (100). The advantage of preparing this type of list is two folds; one as we have listed only top 100 market cap shares, it means we are only considering big companies with highest turnovers and profits. Out of these top companies we are identifying those companies which has highest earning yield.

It is important to know whether we are investing in a good business

From the above list of top 100 companies we have identified all big companies which has high earning yield. A high value of earning yield tells us that at present market price levels whether a share is over valued or undervalued. But still this list is not complete for investors, because this list does not talk with surety that whether the company will continue to make same level of earnings in future.

In order to know this, investors must learn to calculate the return on capital of business (ROC). A higher ROC means company is in a very strong position to at least produce the same levels of earnings in future. Include another colum in your excel sheet and start putting ROC figures for each individual shares.

The share with highest ROC shall be ranked as one (1) and with lowest ROC shall be ranked as hundred (100). After this list is prepared prepare another column and list down a cumulative ranking of each share (earning yield rank + ROC ranking). The share which has lowest individual ranking will make it the best buy in the market out of the total 100 shares.

Suppose a company A has an earning yield rank of 10 and ROC ranking of 20. The cumulative ranking of company A will be 10+20 equal to 30. Similarly ranking all individual shares and selecting that share for share purchase is a great tool for evaluating share price of a company. But what makes this form of tabulating share so useful for investors? This form of tabulating answers the basic questions of share investing:

(1) Are you investing is well established companies? (high market capitalization)

(2) Are you buying shares at bargain price? (high earning yields)

(3) Are you buying shares of companies with strong future growth prospects (high ROC).

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