Many investors who invest in stock markets are ill-informed
on how the stock prices are determined
in the market and the reasons for their fluctuations. This lack
of awareness put many investors in trouble, as they invest in
stocks without knowing their correct valuations and ultimately
end up losing their money or getting stuck with the stock for
many years. Since investors form the demand side of the stock
market, it is essential for them to be well-informed of the
various facets of stock markets, to manage their investments
wisely. Stock markets offer better returns on investments in
the longer term, much higher than bonds, Certificates of Deposits,
annuities, commodities or real estate.
Price to Earnings Ratio
Stocks usually trade on multiples of their earnings, which is referred to as P/E ratio. The P/E ratio of a stock is determined by dividing the price of the share of a company with its earnings per share. It is used as a measure to arrive at the valuation of a company in the stock market. Earnings per share (EPS) is calculated by dividing the net income of a company for a specific period, with the number of shares outstanding.
For example, if a company is trading at $10 in a stock market and the EPS of the company for the preceding financial year is $1, then the P/E ratio of the company is 10 (arrived at by dividing the share price of $10 with the EPS of $1)
The P/E ratio of a companies will be based on the business potential of the company, its earning guidelines, the sector it belongs to etc., The P/E ratio of a company, which is expected to grow at over 20-25% in the next few years, would be much higher than other companies that are expected to grow at 10 -15%. Similarly a company in the Information Technology sector would have a higher P/E ratio than a company in the Textile sector, as the IT field has more growth potential than the textile industry.
A higher P/E ratio of a company indicates that investors are expecting more from the company in terms of profits. However, P/E ratios could be misleading if other factors are not taken in to consideration, as they could also be based on rumors and other news in the stock market.
Evaluating stock prices based on their P/E ratio:
P/E ratio is considered to be one of the best factors for evaluating a stock price. But at times market expectations on a stock could go up irrationally high, stretching its P/E ratio to a value, beyond the actual worth of the stock. Investing in such stocks could land an investor in trouble. On the other hand, all companies with a lower P/E ratio are not worth investing in, if the fundamentals of the company are not good enough. So before making an investment decision based on the P/E ratio, an investor should research the following,
• Fundamentals of the company its past financial performance, its growth
rate, debt history, new product lines, earning guidelines for
the future, business potential of the sector to which the company
belongs to etc., All these information could be gathered from
the websites of stock exchanges, the website of the company
and other financial sites
• Valuation of the stock when compared to its peers - always check the valuations (P/E ratios) of the peers/competitors of a company before investing in its stock. If the valuation is much higher or much lower, then research the reason for the difference before making the investment decision.
• Invest in those companies with a lower P/E ratio and good fundamentals, as they could attract more investors in future when compared to companies with higher P/E ratio
• Check for the dividend yield of a stock, if you are investing with a long-term perspective. If companies with low-growth rate offer consistent and higher dividend income, they are worth investing in.
• Check for the average P/E ratio of the industry or a sector to which a company belongs to, before investing in it, since it indicates the growth potential of the company.
Fluctuations in Stock Prices:
The fluctuations in stock prices are determined by the law of Supply and Demand• like in commodities. A stock price is directly proportional to its demand, which determines the direction of the price (either up or down). However, in some cases many other factors like, the economy, financial results, order book etc., can influence the movement in stock prices. An investor can judge the demand for a stock by analyzing its delivery volumes in the stock markets. If the delivery volumes are high over a period of time, then the stock prices may start to move up as its demand is high. On the other hand, if the delivery volume of a stock is low for a considerable period of time, it indicates the lack of demand for the stock, which could push its prices down.
Investors who are well-informed of the above factors tend to make profit in
the stock market, while others do not. So it is essential for
every investor to understand how stocks are priced in the market,
in order to capitalize the edge provided by the equities over
other types of investments.
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