Share Price

By Investment Blogger, on March 13th, 2010

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What is a right value of a stock /share

How Shares Price can be evaluated?
There is no mathematical calculation for a share price. But yes there is a very important calculation called EPS (Earning per share) which can be directly be related to a shares price. From the profit and loss accounts of a company you can know what is the PAT (Profit after tax) of a company. Suppose PAT of a company is $1,000,000. You can also know this companies number of shares issued in the market, lets say it is 100,000 shares. Hence Earning per share (EPS) is $1,000,000 / 100,000 = $10 per share. It means, an investor will earn $10 for each share he has bought in a year. The mathematics of a share price ends here.

A share price is dependednt on the psychology of an investor. A share price is the cost an investors is willing to pay to earn $10/share (EPS) each year. If the reputation of a company is very good, then investors may be willing to pay a higher share price (say) 20 to 25 times the EPS value of its share. This is called P/E (Price earning) ratio. Like for the above company if EPS is $10 and P/E=25, then its share price will be = P/E x EPS = $250 (fundamental value).

What is a Fundamental Value of a share?
As explained above, the fundamental value of a share is = P/E x EPS.
EPS can be known from the companies financial statements but the big question is regarding P/E ratio.

What P/E value is correct (Fundamental ratio)?
If by chance, god blesses some one with this quality of knowing the correct PE value (fundamental value) of P/E ratio, then he will become rich as god. Yes the power of P/E is that big. It will make you aware about the timing of a share buy and sell. If the current share price is above fundamental value, many shareholder would like to sell their shares and if the share price falls below the fundamental value, the shareholders will like to buy.

How a lay man, who is not a yrader can evaluate a share price?
Before a common man enters a share market his biggest obstacle is his mental block of loosing money in the stock exchange. He has continuously been fed with the information that share market is only for those financially elite who understands money. Common man should only stick to indirect investments in shares like Mutual Funds, ULIPS etc. If you will ask a fund manager (on all talk shows on TV’s) they will always suggest a first time investor, common man not to invest directly in the share market. They all are making fool of us. Selection of a good share is like buying vegetables from the market. We all know the value of Onion is Rs 20/kg. If you go in the market looking for onion, the shopkeeper tells you the value of onion as Rs 19/kg, instantly you will consider it a good buy. Probably you will buy few Kgs extra in this situation. If the value of onion shoots to Rs 30/Kg we will try to cut down the consumption.

The same (simple) theory applies to shares price as well. It is important to know what the correct share price (like for onion it was Rs 20/Kg) at a particular moment of time. This is called fundamental share price. Knowing a fundamental share price is no rocket science.

There are three (3) steps of analyzing a share price and selection of individual stocks for long term.

Step 1	Identify Industries of future	Do you know which industries are going to grow bigger and stronger in India in the years to come? India is investing hugely to develop its infrastructure to meet its ever growing demands of roads, flyovers, bridges, power, housing, shopping malls which in turn means growth of steel, cement, real-estate, power generating industries to speak of few. The industries you expect to do better than others are ideal places for you to invest.
Step 2	Identify Companies of Future	Once you know from step1 above that which industries are for future, start picking-up specific companies in which you would like to invest your money. These companies must be in line with your analysis done in step1. Like if you thick Steel industry has future in India then you can pick companies like Tata Steel, SAIL, Jindal etc. As a rule of thumb try to pick your personal best 20 companies
Step 3	Study the companies Financial Statements	(1) Earnings Per Share (EPS) You can calculate the earning per share if you know the following: (i). Profit after tax of a company (PAT), (ii). Number of shares on issue (N), EPS = PAT / N Ideally, for a good share, earnings per share shall increase from year to year. The higher the value the better is the performance.
Step 3	Study the companies Financial Statements	(2) Price Earning Ratio (P/E) You can calculate Price earning ratio if you know the following: (i). Earning Per Share (EPS), (ii). Price of a share (P), P/E = P / EPS = (P x N / PAT) There is not one right P/E ratio for all companies. Instead each company has a normal P/E range. When the companies stock price breaks that range (share price soars high) its time to ask why. If the P/E ratio is too high its an indicator that its stock price is over rated. Or else the company is growing too fast. If P/E ratio is low, it can mean either that bad times are setting in or that the company’s share price is a bargain. A rule of thumb to know whether the P/E ratio has crossed its limit is see the annual growth rate of the companies earnings. In simple words, a stock that normally has a P/E ratio of 15 might be a good buy even when sold at 25 times its earnings if its profits were also growing by 25% per year. In other words is the companies earnings are growing at 25% pa. then stock price can be equal to 25 times its EPS A higher P/E ratio means that investors are ready to pay a higher share price for each share (P). The higher the price earnings ratio (P/E), the greater premium you are paying to buy the stock. This means you have more confidence on this share that it will deliver the returns to your investment. The P/E is sometimes referred to as the “multiple”, because it shows how much an investoris willing to pay per rupees of earnings. Share price is totally dependent on EPS & P/E ratio. However, the P/E ratio is not 100% reliable indicator for evaluating stock price. One must take care the following before considering the P/E ratio for evaluation a share price: (a) It is useful to compare the P/E ratios of one company to other companies in the same industry/sector. (b) It is useful to compare the P/E ratios of a company to the company’s own historical P/E. (c) It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects. When it comes to share price, knowledge of fundamental P/E ratio is the key>

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