The Secret Life Of Cheap vs. Expensive Stocks

Perhaps the most elusive of all shadowy things in the market is the ever fleeting concept of cheap vs. expensive stocks. Was Amazon priced fairly before the tech bubble? There are some stocks out there that have market capitalisation of 100 times their revenue. Why on earth would that happen? That is less a function of complex arithmetic and more a feature of the esoteric human brain. One thing most stalwarts agree, is that prices rise away from the intrinsic value towards irrational exuberant levels. Then they would fall to depressingly levels only to return to the intrinsic value again. Stock prices are a reflection of the value of the underlying company. Yet, even if two companies are similarly valued, their prices differ. This is often because of the size of the company along with other factors. So, just because a company’s share costs Rs 100 while another costs Rs 1,000, it does not mean the first stock is cheaper. In such a case, how do you find out if the stock you are purchasing is really cheap? Here are five ways to figure out the value of your stock:

The PE Ratio – The ratio of the company's share price to its EPS

You cannot compare apples with oranges. You need a common benchmark. The Price-to-Earnings (PE) ratio helps you understand how much you are paying for each rupee a company earns. This, thus, can act as an efficient measure to compare the valuations of two or more stocks. The PE ratio is calculated by dividing the share price with the company’s earnings per share (EPS). A higher PE means you are paying more. However, a word of caution – every industry’s average PE multiple differs. For example, tech firms usually have high PE ratios.  Let’s get our hands a dirty with a bit of Nifty PE, we can see in the chart below the PE ratio of the entire index that is the Nifty (as at 10^th September 2014)

Just by eyeballing you can tell that the ‘average’ PE is around 18, isn’t that amazing? Since the PE is currently around 21.68, we are trading right above the average. The chart also tells us that around 24-26 the market usually is overstretched and then attempts to return to mean.

The PB ratio – Stocks price compared with the company’s assets

After the PE, stalwart investors consider thePrice-to-Book (PB) ratio of firms. This compares the stock’s price with the value of the company’s value in terms of its assets. The book value is the amount the company would receive if it sold off all its assets. It is expressed as multiple (i.e. how many times a company’s stock is trading compared to the company’s book value per share). However, the PB ratio cannot be used for companies with a lot of intangible assets like brand value. For example ‘Tata’ has an arbitrary, highly debatable but likely extremely high brand value (intangible). Heard of Warren Buffet? Well, he follows value investing and looks for stocks trading below their intrinsic value. Of course, it’s not as simple as finding a PB ratio and buying a stock.

PB Ratios – Stuff You Should Know

1. If P/B is less than one, it indicates that either the market believes the asset value is overstated, or the company is earning a very poor (even negative) return on its assets.
2. As stated before, this is not a very good judge for companies with a lot of intangible assets like IT. So it’s best used on firms that involve heavy asset lifting like infrastructure.

Return on equity - the Company’s profit as a percentage of its total equity

This measure takes into account the company’s value in terms of its profit growth. Ideally, the ROE should not be considered individually. Combine it with the PE or PB ratio. A high ROE with a low PE ratio is the perfect combination. This is because, it indicates the company is growing, but the market is yet to appreciate its value.

Price/earnings-to-growth ratio - PE divided by growth of earnings

This is similar to the PE ratio, yet there is one key difference. Instead of the earnings per share (EPS), it uses the growth in earnings per share. Thus, it helps you identify companies that are growing fast, but are cheaply valued.

Dividend yield- dividend per share divided by dividend per share

From the time you buy your stock to till the time you sell it, the key source of earnings from your holdings will be dividends. This is the portion of profits that companies distribute to shareholders. Investors often prefer companies which dole out high dividends. The dividend yield measure helps you identify companies which give out high dividends in comparison with the stock price. It is calculated by dividing the dividend per share to its price, and written in percentage format. It is another measure to understand the stock’s value.