Stock markets can certainly be a risky game sometimes. We definitely know that we should pick up stocks when the price is low but how can we predict a stock’s price?
One good suggestion is to weigh the current price of the stock against its “value in the market at the time”.
What is the difference between the price and the value of a stock?
Basically, during trading the price is determined by the market at that particular moment. The price can change in minutes i.e. it fluctuates. The value of any given stock is the value (worth) of its core business. It is highly stable when compared to the price of the stock, as the worth of companies cannot vary overnight. It is a good choice if you can buy the share at a lower price than the share’s actual value price. For e.g. the share’s value price is 200 and the current price is just 100 you can get the same share at 50% discount. The probability that the shares actual value can drop below 100 is quite rare.
Warren Buffet and Benjamin Graham are known as great legendary investors and the above mentioned theory also known as ‘margin of safety’ is found in their teachings. First and foremost read the all the financial statements that relate to the stock that you want to purchase.
If you want some good advice that may help you in the long run then just go through these suggestions
The Net liquid assets per share should be evaluated.
Net liquid assets per share = (Current assets – liabilities) divided by number of shares.
Where current assets are sum of cash, liquid investments, debtors etc.
The thumb rule: according to Warren Buffet, you should preferably pay around two- thirds of the value of the stock and preferably not more than that.
Look at the PE growth ratio, where PE growth ratio = (Market price/ Earnings per share) divided by Annual EPS growth.
And Annual EPS growth = (EPS (Current year) – EPS (previous year’s) x 100) divided by EPS of the previous year
Thumb rule: if the PE growth ratio is lower than 1, then it means the share is undervalues, if it is higher than 1, then it is overvalued and if it is 1 then it is an indication of a reasonably valued share.
PE: it gauges the safety margin
Let us suppose that a share at price of Rs 550 is bought by you. The EPS of the share is Rs 50. So after a year you only earn 50 Rs in the investment of Rs 550 which is a return of nearly 9%. A bank deposit can also fetch you this amount and it is risk free. So in the above case the safety margin is nearly nil. So to minimize the risk, we should opt for a higher gap. The thumb rule: according to Warren Buffet this gap has to be n the range of 1.25-1.5 %.
It is seen that that in a prosperous bull trading market, practically all the shares are up and investors do end up paying a higher price for the share. So it is cumbersome to find stocks that have a high safety margin.