Market price of quality stocks are generally traded at most ambitious prices. One must have seen that some stocks are traded at P/E ratios of 5 and others at outrageous P/E ratios of 30. The question must be asked that why investors are ready to buy stocks at such exorbitant P/E ratios? Or to make the question more basic I will say all investors should ask, what is the right-price of this stock?

When we go to the market to buy groceries, vegetables, clothes we all see the price tags. We know the right-price levels of sugar, potato, T-shirt and the likes. Before we buy them we compare the market price with our right-price and only then we buy. People who bargain are those people who think that their right-price levels are lower than the current market price.

Of course the value of right-price differ form person to person but the difference is not huge and for sure it confirms a general understanding. If acceptable price levels of sugar are $1 per Kg and if a trader is selling it at $2 then he can be sure of loosing his business.

But in stock investment people do not know the right-price levels of stocks. This right-price is technically called as intrinsic value of stock. If one can learn to calculate the intrinsic value of a stock they can compare it with current market price and decide to buy/sell or avoid.

Warren Buffett says that stock s must be bought by maintaining a margin of safety of at least 2/3^{rd} of its intrinsic value. Suppose if a stock has intrinsic value of $300 and it is selling market price of $200 (2/3^{rd} of intrinsic value) only then the stock can be considered as an ideal buy.

So the steps involved to buy you ideal stock are:

**Step1** – Calculate intrinsic value of stock

**Step2** – Maintain the margin of safety

**Step3** – Compare current market price with 2/3 of intrinsic value

# Step1 – Calculate intrinsic value of stocks

Let us take example of an investor who would like to buy stock of a company names XYZ and in interested to hold it for next five years (form 2010 to 2015) at least. His expected return form stock is 15% per annum including dividends earned.

Step A – Calculate average growth of earning per share for last 5 years

**Rs.**

| 2005/06 | 2006/07 | 2007/08 | 2008/09 | 2009/10 |

EPS | 32.5 | 41.3 | 50.9 | 49.7 | 49.7 |

CAGR (EPS) | | | | | 8.9% |

We will assume that the same 8.9% CAGR will be maintained by the company for the next 5 years of investment horizon. Hence EPS will grow form present levels of Rs 49.7 @ 8.9% CAGR to appreciate to Rs 76.12

Step B – Assume Price Earning Ratio (P/E) in the fifth year of investment horizon

| 2005 | 2006 | 2007 | 2008 | 2009 |

EPS | 32.5 | 41.3 | 50.9 | 49.7 | 49.7 |

Market Price | 398 | 685 | 1132 | 761.6 | 1088 |

P/E | 12.2 | 16.6 | 22.2 | 15.3 | 21.9 |

Average P/E | | | | | 17.65 |

We will assume that the same level of P/E ratio of 17.65 will be maintained by the company in 5^{th} year of investment horizon.

Step C – Predict market price of stocks in the fifth year of investment horizon

### Market price = EPS X P/E

Market price = 76.12 (EPS in the year 2015) x 17.65 (P/E ratio in the fifth year) = Rs 1343

Step D – Calculate present value of market price of stock

Market price of stock in the fifth year = Rs 1343

Rate of inflation assumed = 7% p.a.

Present value of Rs 1343 = Rs 960

# Step 2 – Maintain margin of safety

Price maintaining margin of safety = Present Value X 2/3 = 960 x 2/3 = Rs. 640

# Step 3 – Compare current market price with 2/3 of intrinsic value

| 2009/10 |

Current Market Price | Rs 1000 |

2/3 x Intrinsic Value | Rs 640 |

# Conclusion

As market price is higher than calculated intrinsic value (with margin of safety) hence we can consider this stock as overvalued. Overvalued stocks are never purchased by the great value investor Warren Buffett.

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