Saturday, April 29, 2006

Stock Valuation

- by Kuppusamy Chellamuthu

The topic discussed below might be too trivial to some. But still as many in this group are getting the flavor of equities for the first time, it might make more sense.

Have you been amused by statements like
* Indian market over valued
* Prices have already discounted 2008 earnings
* 16.5x of FY06 earnings
* Shares trades at 8 times of earnings which is below its peers
* Indian stocks are fairly valued when compared to other emerging markets

What does this damn things valuation mean? Let us discuss it with an example below.

What is EPS:
First and fundamental thing to understand is EPS (Earnings per Shares). This means the money one share (which is a part of the ownership) earns in that year/quarter. If there is a total of 1000 equity shares and the company’s profit for the year is Rs 10,000, each individual share earned Rs.10. This is what is known as EPS by dividing the profit by total number of shares.

What is PE ratio:
PE ratio is price earning ratio which is the ratio of market price of the share to the earning of the shares. In the above example we calculated the earning of a share (EPS) as Rs.10. Let us assume that this share trades at Rs.120 in the market. PE ratio is calculated as Price/EPS = 120/10 = 12. This company trades at an PE of 12 or 12 times of its earnings.

What can one infer from this? Well.. you need to pay a price of Rs. 120 to earn a profit of Rs.10 at the end of the year. Is it costly or attractive? Purely depends on the risk appetite of the investor. This turns out to be 8.33 % earning in an year (10/120) * 100. Anyone is OK for such a gain/return in a year could buy at this level. As a matter of fact a low PE value is good and higher PE is certainly expensive. When there are two companies that operate in the same market with same efficiency (say Infy & Wipro) it is good to buy the company that have the lowest PE , given all other variables remain same.

Does that mean that a higher PE is not to be bought at all? Then why the heck some companies are trading at 40 times to 100 times of their earnings. Well.. the market expect these companies perform exceptionally well. A share price of Rs.200 for EPS of Rs 4 translates to a PE of 50. Is one simply looks at the yield it is just 2 %. However if the earnings double for the next 2 years, its EPS would Rs 16 after 2 years. So the current price of 200 is 12.5 times of n+2 yrs (say year 2008 yearnings). This looks OK. But one needs to be sure about the growth like how Infosys, Bharati tele etc have grown.

Being equipped with these terminologies helps one understand (al least an attempt to understand) and analyze recommendation and so called hot tips from your broker. Mind you.. brokers feel ease to work with clients who asks no questions; but pay little respect. After all for him it is money for every trade no matter you gain or loose.

Have a nice day!!

Friday, April 28, 2006

Setting Realistic Expectations

A friend of mine called this afternoon to convey the vacancy he came across in his company which he thought might suit me. We talked about few other things as well. He has been an investor through equity mutual funds for the past 1 year. Most of his funds have appreciated more than 100 % and his net investment as per NAV is around Rs 2 lakhs. He sounded pretty optimistic to make it to Rs 5 million (half crore) in the next 5 years.

With a very optimistic gain of 20% a year, Rs.100 invested now would becomes Rs. 248 at the end of 5 years. (refer first table)
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This is just around 2.5 times. With this formula, his current investment of 2 lakhs would turn somewhere near 5 lakhs. Not 50 lakhs!!!

Now we’ll see how much CAGR (compounded annual growth rate) is required to turn his Rs.2 lakhs into half crore. (refer second table)
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A consistent 90% gain every year without fail is mandated to achieve this ambitious destination.

No one of us have any doubt on the performance share market from 2003 onwards. It has been exemplary by any standards. But, can we expect this to repeat every year?

Let me draw a simple parallel from game of cricket to illustrate this fact. I have a friend who is a great soccer player himself and a great fan of the game. He hardly watched any cricket during his life till now. This year some of us were watching an one day cricket match. It was the initial 15 overs of the game and Shewag scored 4 consecutive 4 run shots with ease (some thing we have been watching with the market in the last 3 years). Power cut!!! People started anxious to know the progress of the match & the score India can get at the end of 50 overs. We also started making small bets to pass time on the likely to be score. Our man calculated remaining 40 overs (with the same rate Shewag scored in the last 4 deliveries) and believed India could get 960 more runs (40 overs * 6 balls * 4 runs) at the end of the innings. Total asinine!!

To arrive at a score one should know
* how many wickets remain
* which bowlers line up in the opposition team
* nature of the pitch
* pressure level in the game etc etc..

Same goes with share market. Bombay market index touched the four digit figure for the first time in 1990. It took 16 years to reach 12000 points. This is nothing more than 16.81 % growth on annualized basis. (if we leave last 3 years, the returns could be nothing but poor). This is how the investing game has been played & runs scored. There could be few loose deliveries & bowlers to exploit with. But beware, scoring runs at international level is not an easy affair and so is making easy money in capital market.

Before ending this write up, let us see how Warren Buffet the most successful investor over the years has compounded his money. (refer third table)
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Warren has compounded his money at 22.43% on an average with respect to 11.66 % return produced by S&P 500 with dividend included. If the best investor in the world could achieve only this much, I humbly believe that we should not have unrealistic goals or targets. I personally have set a target of 15% growth for some years to come which I should try hard to achieve. That is the level I believe I can achieve given my limitations and knowledge.

Most of the investors/traders are relatively new to the market. We set unrealistic expectations based on the recent performance. How different is this from the person who expects India to score 960 runs in 40 overs?

The content and intent of this message is based on my limitations. There could be extraordinary people (even in this group) who can generate more than 25% every year. For that you need to be another George Soros.



“Indians are becoming stronger. Some years two strong men were needed to carry groceries worth Rs.200. But now 5 years old boy can carry the same”

Does this sound as if we are getting stronger as the years progress? Or does this indicate the inevitable scenario of prices of goods rising? Or is it some kind of joke far from reality? We neither are getting strong nor is it a joke. The prices keep increasing every year whether we like it or not. It is technically known as ‘Inflation’ in the financial terms.

Inflation is always measured in %. An inflation of 5% this year means that the price of a good that was available at Rs.100 last year would cost us Rs.105. We (at least I) remember the days when petrol was available at Rs.10 per liter. Inflation does not determine the commodity prices; rather the commodity prices determine inflation

Inflation & Interest rate:
You are planning to buy a TV worth Rs.10,000 now. But a friend of yours is in dire need for the same amount and promises to return it back after one year. As you know that the inflation clocks at 5% an year, you expect the TV to cost Rs. 10,500 next year. So to get the TV at that time you require Rs.500 extra. To be at a no gain/loss state you require your friend to return back with an interest of Rs 500 equaling inflation. Any interest or gain you receive below the inflation rate is not acceptable. As inflation goes up, interest rates also go up. It is essential for one to get a return well in excess of inflation; otherwise he better spends that money right now.

You get a pay raise of 2% in a year when inflation is 6%. During the next year get pay reduction of 2% (-2% raise) when the inflation is 0 %. Which would make you feel good or bad? Naturally and emotionally you feel happy when you got 2% hike and felt bad when it got reduced. However a closer looks suggests that the pay change is negative during the high inflation year and nil during zero inflation year after adjusting for inflation. Experts call this ‘money illusion’. You were delighted to get a 12% interest when inflation was 25%; but feel bad to get 6% during a 6% inflation year. Actually the second is better.
What is more important is

inflation adjusted returns

It is the duty of the government to control inflation by regulating the interest rate. Why does the prices raise? Many people try to chase very few goods. Supply outpaces demand and hence the price increases. However if the government increases the interest rate, people would tend to deposit in bank/bonds instead of buying good. Thus inflation is reduced by indirectly controlling the supply of cash towards fewer goods.

Inflation, Interest rate & stock market:
In the recent past (3-4 years) many people try to venture into stock market. The primary reason has been the reducing interest rates. When the assured interest that could be fetched from bank deposit is no longer worth considering, people look at share market with the intention of getting better returns (even though it is risky). But when the inflation is too high and the interest rate as a result of that is also high, people feel safer to lock their money in fixed income securities as they offer a decent risk free return. This is not only true to individual investor like you and I, but for major mutual fund manager and FIIs as well. Inflow into the share market gets reduced due to high interest rates and hence the market does not move as much as one would love it to. This is just a supply-demand of money part. There is another more important factor. Many companies borrow money to run their business. Revenues after having paid for interest and tax become the profit for the share holders. As the interest rates are high, most of the revenue is eaten up by the interest component and hence very little is left for share holders in the form of profit. Worst hit are the companies that are heavily leveraged with barrowed fund. So.. Watch out for companies with high debt-equity ratio during high interest rates.

Inflation is not the only factor determining the interest rate in a country; it is just one of factors. We would talk various such points later in this group.

Please feel free to pass on you comment/suggestions/feedbacks.

Punch Dialogue:
It does not matter whether you are right or wrong; but how much you gain when you are right and how less you loose when you are wrong.

By: Kuppusamy Chellamuthu