Technical analysis of share deals with the estimation of the worth of a share. Say a share is traded at $10, technical analysis will analyze whether that particular share is undervalued or over priced at $10. When an investor buys a share, he does make profits immediately. Stock Traders wait for few days to weeks before they sell their holdings to make profit, and long term investors may hold the share for five to ten years before they sell it to book profits. The point I am trying to make is that both traders and investors buys shares with expectations of future benefits that they may make by holding these shares for few days to few years.
Let me ask a very simple question, suppose a share is worth $10 today. As per some analysis, at the end of the fifth year the share price will rise to $12. Will it be ok to buy this share today? Technical analysis of shares is something like this, where an investor asks himself three questions every time he buys a share:
(1) How long I want to hold this share? Say for 5 years
(2) What will be the market price of this share at the end of 5 years? Say $12 (present value $10)
(3) Is it ok to pay $10 today for the future benefit of $10 If the answer is Yes, he will buy the share.
It is clear form the above three (3) technical questions that if we can estimate an answer of question two our half battle is won. But it is a fact that the answer to the second question has never been easy. Many financial scholars and experts have spend numerous hours to find an answer for this question. Of course many will say that it is almost impossible to predict the future price of a stock. But I am not a pessimist and I will not give you such a dull answer. Instead I will take a leaf form the guru of all investors and try to find a way out of this complex puzzle.
I will give you few simple steps which will help you in making at least a close estimation of future price of a stock. Let us take example of a stock ‘X’ which is presently priced at Rs 949.75.
Step1 (Analyze whether the present market price is over priced or under priced)
There are two ways of doing this, first by using EPS & PE ratios and other by using Book value of share.
Earning per share (EPS) and Industry’s Price earning (IPE) Ratios
Suppose the EPS of this share X is Rs 53.26 and IPE is Rs 18.32.
Market Price of Share = EPS x P/E = Rs 53.26 x 18.32 = Rs 975.8
As present market price (Rs 749.75) is less than the estimated market price of Rs 975.8 it means that this share in under valued.
Book Value of Share
First of all find out the nearest competitor (in terms of market capitalization, and businesses of the same sector) of this company and its market price and book value per share. Suppose the nearest competitor has market price of Rs 410.1 and book value = Rs 208.21. Now calculate the market price by book value ratio (P/B) = Rs 410.1 / 208.21 = 1.97
Now find out the P/B ratio of the company X.
Market price = Rs 949.75
Book Value = Rs 392.41
P/B = 949.75 / 392.41 = 2.42.
As P/B value of the competitor (1.97) is less than that of X, hence it raises a doubt on the market price of share. Investor will get suspicious that whether the stock is overpriced? To clear this doubt multiply the P/B ratio of the competitor’s share with the book value of company X.
P/B = 1.97
Book Value = Rs 392.41
Market Price = 1.97 x 392.41 = Rs 773
As calculated market price of share X is less than the current market price hence we can say that the share is over prices.
So you can see that two different analysis has given two different results. I know it is confusing but lets proceed to the step 2. We leave this analysis here for future reference.
Step2 (How the market price of share X has performed in last 5 years)
These days it is very easy to get a graphical representation of market price of stock. Try to refer an stock based internet portal and find out what was the market price of stock exactly five years form now. Suppose the stock X was priced at Rs 355 then. Also find out that what was the maximum variations seen the market price of stock in the last five years. It was observed that in the year 2008 the stock price touched a max of 1560 and in the same year it touched a lowest of Rs 507.
Now let us see what the above historical data’s means to us;
(1) Assuming that the stock market will follow the same trend (price increase of Rs 594 form Rs 355 five year back) of price increase, then at then at the end of fifth year, the market price of stock may rise form Rs 949.75 to Rs 949.75+594 = Rs 1540 (growth rate of 10.2% per annum).
(2) Assuming that the stock market will again show a bull phase. During the last bull phase the stock price soared to Rs 1560 (means increase of Rs 1200 form Rs 355). In such a condition the present market price of stock at Rs 949.75 may rise to Rs 949.75+1200 = Rs 2150 (growth rate of 17.75% per annum)
(3) Assuming that the stock market will again come across a bear phase. During the last bear phase the stock price fell to Rs 507 (means increase of only Rs 152 form Rs 355). In such a condition the present market price of stock at Rs 949.75 may rise to Rs 949.75+152 = Rs 1101 (growth rate of only 3% per annum)
After the above technical analysis of share in step1 and step2, we came to the following conclusions regarding its market price:
(1) The present market price of stock may be slightly over priced when it is compared with the nearest competitor of the same sector. But by industrial standards (IPE) the current price looks reasonable.
(2) Assuming the rate of inflation in India at 8% average, and return on bank deposits to be between 7% to 7.5% for net five years, we would analyze the returns for the below three possible events in the future:
- If market performs logically: Expected return on stock X will be around 10.2%. This beats inflation and the safer investment option of bank deposits. Hence it is good investment.
- If market sees a bull phase: Expected return on stock X will be around 17.75%. This certainly beats inflation and the safer investment option of bank deposits. A possible bull phase will make it an excellent investment. But investors must remember that within the next five years, if the stock price touches Rs 2150 leves, it will be wise to sell the stock and book profits.
- If market sees a bear phase: Expected return on stock X will be around 3%. This does not beat inflation or the safer investment option of bank deposits. Investors must remember that during the bear phase, as soon as the stock price fall below Rs 1400 levels, start selling the stock to at least make up for the inflation at 8%.
I hope the above analysis is helpful for my readers. And next time when they are buying a stock, they will rather use the above technical analysis method instead of depending in the advice of new channels and newspapers.
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