Monday, 24 December 2012

Stocks - Buy Cheap or Buy Expensive?

The general tendency when buying in stocks is to judge it by its current market price (CMP). Some think that if the price is low today then the price may appreciate in the future and give big returns. Other think the other way around and invest in highly priced stocks thinking that the price may still appreciate further and give good returns. If there is a stock priced at Rs.150/- and another priced at Rs.3000/- , of companies in the same sector, which one to go for? Which is right? To buy cheap or to buy expensive?

We say, the question itself is wrong. When it comes to stocks, there is no cheap or expensive and it is the wrong way to judge any stock in the first place. Evaluating a share/stock before buying is an art and if you master the art then you become a value investor.

Valuation based on PE:

Learning to invest in stocks can be exiting once the different nuances are explained clearly. We had dealt with the definition of PE in our post on Performance Indicators. Now we present a detailed picture of PE and the importance of the parameter in spotting value stocks. Different companies in the same sector may have different equity capital structure. Lets say, a company divests part of their equity paid up capital (T) to public. So, out of their total equity paid up capital (T) they issue some shares (say X) at a face value of Y to public at an issuing price of Z.

X may constitute 10, 20 or  30% of T and is the subscribed paid up equity capital.
Keeping the above in mind, lets take two companies with the following data :

Total Equity Paid up (T) in Cr
Profit in Cr
EPS (Profit/no. of Shares)
Share Price (CMP)
Company A
Company B

Initially tendency is to rate company A as highly priced and company B as cheaper based on the CMP. But, from the valuation point of view, seeing at the PE ratio of the two companies instead of CMP, it is clear that though company A’s market price is high (Rs.3000/-) still it is trading at a cheaper rate of 27 times its earning per share than company B which is expensive comparatively at Rs.150/- as it is trading at 35 times its earning per share. During market correction, the possibility of company B’s price falling is thus more.  We got a nice insight by looking at the PE and not just the CMP.

Some points to note :

  • Companies having stable ratio of equity capital base and debt carried by the company are ideally suited for comparison based on PE.
  • Companies of comparable size in the same sector can be compared based on the PE.
  • Comparison based on PE should done after figuring out the debt management of the company. The PE of a company by itself doesn’t reflect the debt of the company. For that you need to look into te D/E ratio.
  • PE doesn’t reflect the actual cash flow of the business.

We have seen a small part of valuation process and have seen how PE helps in valuation of a stock. There are other aspects to this valuation which we will cover in future posts.