Many-a-times, stock market investors take their investment calls based on certain prejudiced views which are often erroneous in nature.
However, such investors are reluctant to stop following the myths they traditionally believe in, unless they’re explained as to why their views are illogically supported. It is important that investors keep a realistic view of the market terminologies.
Myth 1: Stocks with High PE ratio are Expensive
The most common myth among the investors is that the Price to Earning Ratio (P/E) is the ultimate analytical tool to understand the valuations of a company’s stock price. Even as the P/E is one of the most important gauges to base an estimate on the stock’s valuations, it is not the sole statistical figure that throws light on whether to buy a stock or not.
Investors feel that if P/E is high, stock is over-valued and vice versa. However, that is not correct. Just give a thought – When are share prices allotted high P/E valuations?
The market allots a high P/E to a particular scrip’s valuation when the prospects or fundamentals of that counter is estimated to be an out-performer in terms of earning potential over a period of time, say, for example, 1 year forward earnings.
Even as the stock price could be quoting at a higher P/E valuation currently, the market signal could well be that as proceeds from the higher earnings start trickling in; the valuations of the stock will be rendered with a sobering effect going forward.
Myth 2: Stocks quoting Below Rs.50/- are Cheap
Yet another most common understanding among new investors is that stocks which quote below a certain price range, say, for example, stocks quoting below Rs.100 or Rs.50, are cheap in terms of valuations.
Over here, one must remember that a stock price in no way indicates the actual valuation of the company’s stock. The valuations of a stock price are gauged by factors such as P/E, Price to Book Value, Price Earnings to Growth Ratio (PEG), Earnings per Share (EPS), Return on Assets and Growth Rate among others.
Just imagine, if stocks could have been valued simply by price, people would have never bought stocks which quote above, say, Rs.1000 or 2000. They would always buy stocks within the range of Rs.50-100/-. Don’t you agree?
Suppose you want to invest Rs.10000 in equity markets. With so much money you can either buy 4 shares of Infosys Technologies quoting at around Rs.2600 or 525 shares of Hindustan Motors (HM) currently at Rs.19 per share.
But, if you calculate the percentage rise or fall (let’s assume 3% up) in the stock price of both – 4 shares of Infosys and 525 shares of HM – you will realize that the net gain in actual terms for both the stocks remains same from the fluctuation in the stock prices.
Myth 3: Multi-baggers can be Explored only amongst Mid-caps
The term ‘multi-bagger’ is the most over-rated in the world of stock markets. First of all let’s discuss as to what does a multi-bagger mean? The term multi-bagger is used for stock where the price appreciation has been significantly higher than other stocks.
Usually, we measure the returns from a stock price in terms of percentage price appreciation, for example, 30% gains or 40% gains. Whereas returns from a multi-bagger stocks are measured in terms of certain number of ‘times’ of the original investment or more than 100% returns, for example, a stock ‘X’ has appreciated 2 times or 5 times from the price an investor could have bought.
The most common myth about the term multi-bagger is that most of such stocks could be explored amongst small or mid-cap stocks with lower base size. However, that is not true. Investors can as well explore such multi-baggers amongst fundamentally sound large-cap counters but at a time when the valuations are at their cheapest.
Take, for example, during the recent global recession, several large-cap jewels had sullied at depressing lows. The stock price of Bajaj Auto had slumped to Rs.315/- as on December 5, 2008 and has surged to a Rs.2200/- as on June 8, 2010, a whooping 7 times price appreciation for its lows.
There are plenty myths among investors in the stock markets. But, I’ve mentioned only three of the most common ones in the mindset of gullible investor.
It would be interesting to come across many other myths from the readers’ side?
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 | Author: Viral Dholakia Viral Dholakia is a Businessman from Mumbai who also loves to dabble into financial markets and is constantly in search of value stocks. Stay in touch with him at bull4bears-at-yahoo.co.in or on twitter at @viralsss |
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So viral how can one put together the P/E, Price to Book Value, Price Earnings to Growth Ratio (PEG), Earnings per Share (EPS), Return on Assets and Growth Rate indices to make the buy or not to buy decision. are there any thumb rules for these indices ????
Hello Vikram,
The point I mean to convey is that P/E should not be the ONLY guide for making investment decision, though it could be one of the most important determinants.
Take, for example, while taking an investment call on BANKING stocks, apart from the P/E ratios, one can also have a look at Price to Book Value Ratio. It is nothing but the share price of the company divided by book value (Net worth / number of shares).
While valuing banks, this ratio is more useful for analysing purpose as it gives a clue about the growth prospects in relation to the bank’s net worth and it’s ability to leverage it’s business prospects based on it.
However, book value is more useful during bearish times when the ratio is near by or lower than 1, hinting towards under-valuation of the scrip to its networth.
Apart from Book value ratio one can also use P/E ratio to compare the valuations. But, P/E ratios are comparable only between the peers within that particular industry. It would unfair to compare the P/E ratio of SBI with that of L&T, as both are from diverse sector of operation. However, one can compare SBI P/E with PNB P/E to get a more clearer picture.
Thus, various ratios can be used in synch with each other to arrive at a broader fundamental decision. It would not be appropriate to take a decisive call only based on one aspect of fundamental analysis.
Hi Viral,
Another good post on a very good topic. I would also like you bust the Market Astrologers and Technicians with a similar post some day!
Hi Vikram, (though Viral may answer your question separately, if I may share my thoughts with you)
For me, most of the terms you have mentioned don’t hold much water. Terms like ‘Earnings’ are esoteric and as real as Mickey Mouse. What really matters are dividends paid to shareholders or the amount retained and re-invested into the business.
Similarly, what is an asset? Is real estate an asset of the firm? It depends! If it is a new building in a prime locality it may be more valuable than the paper value that has been recorded as book value for the last 20 years on the balance sheet. Or, if it is a dilapidated building (or equipment) in a village outskirt, it might be worth very little.
What matters to my investment decision are:
- What industry is the company in?
- What is the revenue size of the company in terms of the market opportunity.
- How many competitors exist and where does the company rank in that ladder?
- What is the Net Profit Margin-NPM (or ratio of Profit After Tax to revenue) of the company (that tells us if the company sold Rs.100 of product, how much is left for the shareholders after all liabilities are paid)
- What is the future (more than 3-5 year horizon) for the industry?
- What is the capital requirements of the company/ industry to produce 5-10 times its current output.
- What are the risks that the revenues that the company (or you) are expect may not materialize?
Just to give an example to explain my thinking let me take the example of Educomp (one of my holdings) which is in the education industry.
- The market opportunity is thousands of crores over the next couple of decades
- The company is a market leader in terms of revenue and PAT.
- There are only 3-4 competitors, and what its competitors are just starting out to do Educomp has already been there and done that. So they know the industry, faced the challenges and are already moving into growth areas which its competitors can only dream of going into when they have resources to do so.
- The capital needs are very less in many lines of business. In fact, if you look at the key raw material for the education business it is educational content (software) that are created by its employees (about 2-3000 of them). So though your book value (which is the cost to produce the education content) could be Rs.1, since the same content can be reused in n-number of ways (cd’s, books, internet content) for thousands of students, the book value is not a true measure of the “value” of the company and hence its valuation, for this industry/ company.
- The risk of the company not meeting its revenue estimations – there is a lot of dependency on the government giving it projects. If the projects go to its competitors or the margins are low, or the government priorities change and they slow down their spending on education, the company will take a hit from this line of business.
Of course each industry and company may need to be valued differently and with different parameters.
Hope I was able to give some sort of answer to your question.
Hello Madhav,
You have perfectly replied to Vikram’s query in detail at it’s best. What a wonderful reply on fundamental aspects. Just that I tried to specifically resolve his query as to how various ratios can be clubbed to arrive at a more sensible decision.
Madhav… now, coming to your point on a post towards busting astrologers and technicians. I fully agree with your perspective on astrolegers specifically in terms of stock market calls. But, I feel it comes to a debate about Technicals or chart calls. Where, indeed, I feel that Technicals do work in stock markets.
Specifically speaking, charts are nothing but actions taken by traders/investors in the past. And, there are broader ramifications in studying this past data as they have a strong tendency to affect the future course of action by market participants based on the happenings of the past.
I think, we can debate on this sometime whether Technicals actually work or not. Charts are nothing but action of market participants. It depicts as to how fear and greed worked in the past and how those levels can come into play in future. It is, in fact, a science and art both.
Science becoz the data is related to past actions hence something concrete data to analyse on. However, it’s also an art becoz, over here, one has to study past data and based on that use their own skills to analyse as to how will future actions pan out.
I am not sure whether, stock markets is an essential topic on this blog. However I would prefer to see some article about markets on daily basis.
Though I am weak at so many fundas discussed above, I trade online from time to time.
So my preference would be if readers get some Multibaggers recommendation for long term and some good shares for medium term trading at least on a weekly or monthly basis from experts.
“You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right-and that’s the only thing that makes you right.” -Warren Buffett, the world’s most successful investor.
If the quote is well understood by all, the myths of the stock market could soon disappear. Stock market to some is an influx of transactions based on emotions. I would probably term it as speculation. Speculation is safer than assumptions as it allows room for exploring the facts. However when people assume things about the stock market, it leads to creation of a myth.
If I had to add some more myths the 1st one that clearly came to my mind was that a stock market is nothing but gambling; one of the very common sustainable myths that has come down through generations. Gambling, needless to mention is an activity where one benefits if the other looses. There is no creation of any new value to the financials. However, stocks resemble ownership. They generate value for future. They give you the title to that value. They privilege you with the identity of a member of the company. Gambling is an all win or no win situation unlike online stock trading. Good investments made in the stock market can benefit an individual with higher returns.
The 2nd myth I would consider is evaluating a company’s balance sheet or its corporate earnings for purchasing stocks or shares. It is a myth that corporate earnings actually drive stock prices. Balance sheets of a company cannot aid you in deciding the profitability of investing in its shares or stocks. Market trends and economic fluctuation, both have to be well considered before you decide to invest in any company. A good balance sheet, showing huge profits will not necessarily ensure higher returns for its stocks/shares and similarly a fall in the earnings of any company does not imply falling stock prices.
Myth 3 would be again the common mighty one – To gain from the stock market, you need to prepare for high risks. This is again false as factors like –
• Buying stocks that are spread over a period of time and not bought in bulk
• Buying stocks with consistent and predictable earnings record
• Investing in stocks that have their earning or the return rate higher than the predicted inflation rate
• Avoiding bulk ownership in any one company
• Avoiding investment of more than 10% of your income in stocks and such other ways can prove this point as a myth.
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