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Tuesday, October 14, 2014

Valuation Parameters You Should Know - First time investors guide

Courtesy - Economic Times

Knowing them will enable you to buy stocks at the right price.


The price-to-earnings ratio is the most commonly used valuation parameter. A lower PE indicates either an attractively valued stock or one whose prospects are poor. You may compare the current PE of a stock with its own historical valuations (say, 5-year average), the industry average. the industry average, and the PE of a broad market index, such as the Sensex or S&P 500.
PE ratio can be of two types: forward and TTM (trailing 12 months). Forward PE is based on the earnings estimates provided by analysts. The advantage of using it is that stocks respond to the prospects of a stock. The risk is that earnings estimates often go wrong. TTM PE is based on past four quarters' earnings, so it can't be wrong. However, it is backward looking.

The price to book value compares the price of a stock with its book value (value of shares originally issued, plus retained earnings). The book value is a proxy for the liquidation value of the company. It is a good measure for judging the valuations of asset-heavy companies. It is also well suited for banking and other financial services companies. It is not a good measure for asset-light, service firms.

This valuation ratio compares the enterprise value of a stock with its EBITDA (earnings before interest, tax, depreciation and amortisation), a measure of a stock's operating profits. The EPS gets affected by 'other income', which is income not derived from the company's operations, but from, say, sale of an asset. This can artificially inflate the EPS and bring down the PE. This doesn't happen with EBITDA. The latter is, hence, a better reflection of a company's earnings capability. EV or enterprise value measures a company's value. It is the sum of the market value of the firm and its longterm debt, minus its cash.

Here you compare a company's PE ratio with its 3- or 5-year EPS growth rate. Sometimes, a company's PE may appear high compared to its own historical valuation or the industry average. This usually happens with high-growth companies. If you wait for its PE ratio to fall, it may never happen. The PEG ratio, by comparing the PE with the EPS growth rate, offers a justification for investing in such a stock. The PEG ratio should be be below 1. If it is less than 0.5, it is very attractive.

Before You Invest
No quick gains
At the very outset, investors must accept that the equity markets are not a route to quick riches. "Greed and speed are the worst enemies of sound investing," says investment analyst R Balakrishnan, a former mutual fund CEO. All direct investments in equities should be made with a time horizon of at least 3-5 years. If you ignore this tenet and adopt a high-churn strategy, you will soon come to grief. "You may get lucky on your first punt and make some quick money. Then, inevitably, you will buy something that will keep sinking," says Balakrishnan.

If the markets tank and the uneducated investor is left holding stocks of suspect quality, his corpus value erodes rapidly and does not recover for a long time, if ever. Many investors get so badly singed by their first such brush with the equity markets that they decide to stay away from stocks forever.

Educate yourself

Before you start investing directly in equities, make the effort to educate yourself. "If you won't invest time in educating yourself, then direct stock investing is not for you," says Balakrishnan. Learn the ropes of investing from an unbiased source with no conflict of interest. Says Dhawan: "Many brokerage houses today run short-term learning programmes on equity investing. Brokerages earn more when you transact more. Hence, they have a vested interest in teaching you investment strategies that involve a high churn," he says.

In our view, the approach with which you stand the best chance of making money is one based on fundamental analysis and buy-and-hold. Also, by reading investment classics, you may have the best chance of developing an approach that is time-tested.

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