Stock Market – Gambling or Educated RisktakingApril 1, 2010
My brother often tells me that the stock markets are for gamblers. There is a lot of merit in that argument otherwise what would explain the sensex falling to one third of its value in less than a year from its dizzying January 2008 highs; and what could possibly explain it bouncing back and doubling in a matter of six months? If you would have had invested ten rupees in January 2008, you could have been part of a rollercoaster ride and seen your investment become a paltry three rupees fifty paisa and back to about seven rupees now. What can possibly explain such madness and thrill but the sumptuous pleasures of betting? But, what isn’t a gamble? We bet all the time, albeit a bit conservatively; on education and on assets. Like many other things, it can be argued that there is some method to stock market madness and based on my modest failures and successes, there are possibly ways to understand it better and at best, place reasonable bets.
One of the fundamental units of account in stock markets is a share (or stock –often used as a synonym or plural), which in layman terms signify ownership in a company. So, if you buy stock in a company that is traded in a stock market, in effect, you become an owner of the company, however partial or minimal. There are various factors based on which a share (or stock) can be valued. Here are a few of them that I find interesting:
Financial Metrics: One of the very fundamental ways of measuring the value of a share is called the PE ratio or Price to Earnings ratio. This is the measure of the price paid per share to the annual income or profit per share. In simple terms, a higher PE ratio signifies that you are paying more for a share and lower PE ratio signifies you are paying less. Let us take a simple example of how to make sense of this. Imagine a restaurant that has annual sales of ten rupees and an annual profit of two rupees. What should be the value of the restaurant? How much would you pay for it? Most people usually hazard a guess of the value between ten rupees to fifty rupees. Assuming profits to be always constant, it will be possible to recover the investment through profits in five years and still retain the restaurant if one pays rupees ten to buy the restaurant. In this scenario, you will be paying a price to earnings ratio of five. However, if you pay rupees fifty for the restaurant, it will take you twenty five years to recover the investment and keep the restaurant. In this scenario, the price to earnings ratio is twenty five. In such a simplistic scenario, it is easy to see why investing with a low price to earnings ratio makes good economic sense. Now consider this, if the restaurant has assets including land and property worth fifteen rupees, will it influence the price? What if the probability of profits doubling every year is very high due to its prime location? Most of such common scenarios including value of assets, valuing profits and growth, existing debts etc are calculated using standard metrics in the stock market like PE ratios, PB ratios, Debt to Equity ratios etc. Understanding these metrics help in approximating the value of a company.
Fundamentals: How often have you heard advice about investing in a company because its fundamentals are good? Though there is no easy answer to what fundamentals mean, it can be a combination of various factors, be it quality of management, financial stability of the company, outlook for the industry or sustainability of its offerings. It is a good idea to arrive at one’s definition of fundamentals and then invest in companies with good fundamentals. It is important to remember that the way to make money in the markets is to buy low and sell high. Hence buying a fundamentally good company at an exorbitant price is probably not a good idea. Consider this: there are three eggs — a normal egg, an organic egg and a broken egg. A broken egg has no value and should not be bought. A normal egg probably deserves a somewhat ordinary price say two rupees, while an organic egg deserves a premium say rupees four. If you pay more than any of them deserves, you stand to lose money. Same is the case with companies.
Promoters: When you buy a stock, you are actually buying a part of the company. A significant amount of ownership of a company is typically with one or few individuals, usually referred to as promoter(s). As a shareholder of the company, it is important to understand the promoters of the company. It is not hard to deduce that good promoter/promoters will ensure that the company performs and meets or exceed expectations. What makes a good promoter? Again, this is subject to individual interpretation but a few ways to judge would include qualifications, expertise, ethics, reputation, stake in the concern and so on.
If you ask even the world’s greatest investor, he or she will not be able to predict with absolute certainty how a particular stock will behave in a certain period of time. This is because a complex spaghetti of factors can influence the price of a stock, some understood numerically, some subjectively and then some, that few can predict or control. In that sense, it is a gamble, but knowing the game a bit always makes for reasonable bets. There are probably a host of such analysis points about every share and for investments in the stock market to be based on prudency and not mere luck, it is advisable to understand them. It is also probably a good idea to enter the stock market with a reasonably low amount of money and spend the initial six months understanding the nuances. I have learnt it the hard way.