Financial ratios.

More about Market-caps.

Hi there,

Market capitalisation or “market cap” is a simple indicator of the value placed on a company by the market at today’s prices. The computation of market capitalization and its meaning has been explained in beginners lessons 3:Market capitalization. Now let’s get into more details on market-cap. Stocks are classified into large, mid or small cap, based on their overall market cap. Indices such as the BSE Sensex and the CNX Nifty represent a basket of large-cap stocks.
However, What was a small-cap stock a few years earlier may graduate to a large-cap status, as the company ramps up in size and gains greater recognition from the market.

WHERE SHOULD YOU INVEST?

Well, that’s a difficult question to answer since much would depend on an investor’s attitude, age, financial capacity, investing aims and his ability to take risks. What I can do is to give you some pointers as to what you can expect by investing in these different caps.

WHAT TO EXPECT FROM LARGE CAPS.

1.Steady growth: Large-cap stocks usually represent well-known companies with a sizeable scale of operations; they often carry the potential for steady growth in line with the economy.
2.Less volatility: Earnings of Large cap companies will seldom grow in leaps and bounds, but may exhibit fewer surprises from quarter-to-quarter or year-to-year, as they are tracked by a veritable army of analysts!
3.Darling of FII’s: Foreign institutional investors seeking to dip their toes into the Indian markets often make their first investments in large-cap stocks. If you are the conservative type, and would like to buy and hold for the long term, you should probably pick your investments from the basket of large-cap stocks.
4.Leader of the pack:Large-caps are usually the first to lead any market recovery, while mid- and small-cap stocks tend to join in later.
5.Above par performance in bullish market: Large-cap stocks will usually perform well than mid and small caps during bullish periods.
6.Dividends:large cap companies generally have the history of paying out regular dividends.Small and mid-cap companies may not pay regular dividend since they keep investing the surplus in more ambitious projects.

WHAT TO EXPECT FROM MID CAPS AND SMALL CAPS.

1.High growth :Mid- and small-cap stocks usually represent companies that are in nascent businesses or those that are lower in the pecking order, within a sector, in terms of revenues or market share.
2.High volatility: Earnings of mid-cap and small-cap companies will grow in leaps and bounds and they may come up with surprises from quarter-to-quarter or year-to-year, resulting in high variation in stock prices.
3.Multi-baggers hide here: If you are hoping to find multi-baggers, you must invest in mid- and small-cap stocks.
4.High returns and high risk: Midcaps offer potential for higher returns because of their ability to register earnings growth at a faster pace. At the same time , you should be aware that they often carry higher risks than large caps. Their earnings could suffer bigger blips because of vulnerability to a downturn in the business.
5.Less liquidity: Small and mid-cap stocks are often not traded as actively as large caps, dwindling volumes could magnify the decline in prices of such stocks in the event of a market meltdown. It is, therefore, important to put your choice through a liquidity filter (check for the stock’s historical trading volumes over a couple of years) before investing in mid- or small-cap stocks.
6.First to fall in a market crash: If you are booking profits on your portfolio because you expect a big correction, your mid- and small-cap stocks should probably go first, as they would be most vulnerable to any meltdown in prices.
7.Below par performance during uncertainty: Mid- and small-cap stocks will usually under-perform large caps during periods of high uncertainty.
8.Least preferred stocks during uncertainity:Global events impacting FII flows , political upheavals or financial instability often prompt a “flight to safety” which results in liquidity fleeing mid- and small-cap stocks into the tried-and-tested large-caps.

TIPS FOR BALANCED APPROACH

If you now have a grip on how large-, mid- and small-cap stocks behave, here are a few additional pointers on investing based on market cap:
Tip #1:Maintain a balance: Maintaining a balance between large-, mid- and small-cap stocks in your portfolio is as important as spreading your investments across different sectors and businesses. Typically, you should have 60 % of your money invested in large caps, 30% in mid caps and 10% in small caps.
Tip #2:Never stick to a single cap: Making investments only in small and mid-cap stocks could make for high volatility while sticking only with the large-caps could deliver modest results.
Tip#3:Analyse your risk tolerance capacity: Decide on your allocations to each group based on your appetite for risk and to adhere to this, irrespective of market conditions.
Tip#4:Do your home work: shift your allocations between large-, mid- and small-cap stocks based on market conditions. That would give you maximum results. But practicing such a strategy is not for beginners. It can be quite difficult and may require timing skills and analytical abilities.

Have a nice Day !

1 Comment

Measurement of size- market capitalization

Now Let us forget about ratios and concentrate on another important aspect.Size.

If I tell you the price of two companies – say, company A Rs 150 and company B Rs 75. would you be able to tell me which is the bigger one? Is it company A? No. why? because, you cannot guess the size of the company by looking at it’s share price.

So, the question is how to measure the size.The answer lies in finding out something called “Market capitalization” of that company.

Market capitalization or market Cap is calculated by multiplying the current stock price by the number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market.

For Example: A stock trading at Rs 55 with 100,000 outstanding shares would have a market cap of Rs 5.5 lakhs.

Since the per-share price keeps changing and since each company has a different number of outstanding shares, the market capitalization of a company keeps changing everyday.

Here’s an example: lets’s take tw companies – A ltd and B ltd

A Ltd’s Stock price: Rs 50 Outstanding shares: 50 Lakhs

So , Market cap works out to : Rs 50 x 50,00,000 = Rs 2500,00,000

B Ltd’s Stock price: Rs 10 Outstanding shares: 3 Crores

So Market cap works out to : Rs 10 x 300,000,000 = Rs 30000,00,000

This is how you should look at these two companies for evaluation purposes. Their per-share prices tell you nothing by themselves. This is exactly why Reliance industries with a share price of Rs 1100 is a bigger company than say, MRF Ltd whose share price is around Rs 7500.

Having said that, let us look into how the companies are classified according to its market capitalization.

LARGE CAP

There is no standard definition of Large Cap and it varies from institution to institution. But as a general rule, in India, if a company has a market capitalization of more than Rs. 5000 Crores, it is considered as a Large Cap.

A Large Cap company is normally a dominating player in its industry, and has a stable growth rate.

It should be noted that almost all the Large Cap companies from India would be considered as Mid Cap or Small Cap companies in a global scenario, as globally, companies are usually classified as Large Cap if their market cap is more than $10 Billion (roughly Rs. 39,000 Crores).

MID CAP

If a company has a market capitalization of between Rs. 1000 Crores and Rs. 5000 Crores, it is considered as a Mid Cap

A Mid Cap company is normally an emerging player in its industry. Such a company has a potential to grow fast and become a leader (a Large Cap) in the future.

Mid cap companies can show very high growth rates (in percentage terms), because they have a small base – since their size is small, even a small incremental increase in revenue / profits can be a big figure when expressed in terms of percentage.

SMALL CAP

If a company has a market capitalization of less than Rs. 1000 Crores, it is considered as a Small Cap

A Small Cap company is normally a company that is just starting out in its industry, and has moderate to very high growth rate. Such a company has a potential to grow fast and become a Mid Cap in the future.

CONCLUSION

Focus on the market cap to get a picture of the company’s value in the market place. Per share price may not give you the actual picture about the company’s size .

2 Comments

More about P/E

Hi there,
Let’s catch up with P/E ratio in detail. Before that, here’s a re-cap of what P/E is all about.

WHAT IS P/E RATIO?

  • Price to Earnings ratio is jargon used by investors and analysts.
  • P/E is one of the most commonly used valuation methods in the world of investment.
  • It is used to measure how cheap or expensive a stock is.
  • It has the ability to explain long-term return potential of a stock. P/E is ‘market price of the share’ divided by ‘earnings per share’.
  • It is the amount of rupees the market is willing to pay for one rupee of the company’s earnings or to put it in another way, it is the number of times the share of a company is priced in the stock market compared with its earnings.
  • The inverse of this ratio is known as the earnings yield.
  • The commonly used time-frame to calculate price-earnings multiple is the trailing 12-month period.

  • DETERMINANTS OF P/E RATIO

    The P/E multiple of a company is determined by many factors but the key determinants are (a) Expected Growth Rate (b) Current and Future Risk and (c) Current and Future investment needs.
    (a) Expected Growth Rate -Companies with a higher expected growth rate in business normally trade at a higher P/E multiple, as the earnings are expected to be more attractive in future. When the estimated EPS is higher, the forward P/E is lower compared with the current P/E. So, when the market gets this information, the share price goes up as then investors would be willing to pay a higher price for the stock. Therefore, companies with higher growth rates trade at higher P/E multiples.
    (b) Current and Future Risk -Companies perceived as risky usually trade at lower multiples, as the market expects fluctuations in their operating results.
    For instance, companies with higher operating leverage (higher proportion of fixed costs to total costs) and higher financial leverage (higher debt/equity ratio) are perceived to be riskier, by the market.
    (c) Current and Future investment needs-P/E ratio is also affected by the reinvestment needs/requirements of a company. For example, a company with higher reinvestment needs is perceived as riskier, as it would then require the company to borrow more funds. This may lead to a higher financial leverage or earnings dilution for existing shareholders depending on the method adopted to raise funds.

    TYPES OF P/E

    Trailing  P/E Ratio – Current market price divided by its last year EPS.
    Forward P/E Ratio – Current market price divided by its estimated next year EPS.

    WHICH ONE TO USE?

    While these two are the most commonly used P/E ratios — as both are based on actual earnings and hence the most accurate — it is forward PE that holds more relevance to investors when evaluating a company.

    PRACTICAL TIPS WHILE USING P/E

    Tip 1.Note that the P/E multiple comes down drastically due to the steep increase in the forecast EPS; the opposite holds true for a steep decline in the forecast e EPS number. All the variants of P/E are based on the same numerator (i.e. market price per share) but use different denominators (i.e. earnings per share- historical, trailing, forward and future). You can also consider taking the 6 -12 months median market price of the share for computing the price to earnings multiples.
    Tip 2.Value investors tend to adopt a low PE as a rulebook for an investment. While a low PE multiple is desirable, it would be inappropriate to adopt this ratio as a stock-picking tool across industries. Technology stocks tend to quote at trailing 12-month PE multiples between 30 and 40 compared to basic industry stocks that usually have single-digit PE multiples. As such, investors would be better off adopting this tool for peer comparisons within the same sector.
    Tip 3.This tool bypasses investment opportunities in companies that are making losses and are on the verge of a turnaround. So that’s another area to be careful about while analysing companies.
    Tip 4.Adopting moderate price-earnings multiple as a filter, an investor would also miss out on companies with substantial growth prospects.
    Tip 5. Companies that are just out of the red would be off the radar as they tend to command high PE multiples. Take the case of an investor who had adopted this tool in September 2003. SAIL, which traded at Rs 40, would not have been on his radar then as it quoted at about 60 times its trailing 12-month (standalone) earnings. Within a span of three-and-quarter years, the stock doubled to about Rs 80 (commanding an earnings multiple of 8).
    Tip 6.Going by a low PE would also filter out most stocks in the retail, media and technology space and leaving only those in the basic industries. A good number of stocks with a low PE are those perceived to have little opportunity for earnings growth or are highly volatile.

    Therefore, while the PE multiple is the most commonly used valuation metric, it cannot be the only one you use to decide on an investment
    Have a nice Day !

2 Comments

Price to Earnings ratio or P/E ratio

Hi  there ..

In the last post I discussed about earnings and earnings per share. You learnt that Earnings per share is useful to compare two or more companies of the same category and industry. In this article we will look into a more important ratio called the P/E ratio. That’s the Price / Earnings ratio more commonly called the P/E ratio. The P/E Ratio is  a widely used ratio for valuing shares prices. It also know by different term such as P/E multiple, earnings ratio , Price earnings ratio, P/E ratio etc..

WHAT IS IT?

The ‘P’ in the formula stands for the market price of the share.The “E” in the formula stands for the Earnings per share. If you see a stock trading at  50 per share on the market, and that stock had an EPS (earning per share) of  2.50, then according to this  formula, the P/E Ratio of this stock is 20.

HOW TO CALCULATE P/E

The P/E looks at the relationship between the stock price and the company’s earnings. You calculate the P/E by taking the share price and dividing it by the company’s EPS as shown in the above example.

WHAT DOES THE P/E TELL YOU ?

The P/E gives you an idea of what the market is willing to pay for a share of company’s earnings. The higher the P/E the more the market is willing to pay for the company’s earnings. Some investors read a high P/E as an overpriced stock and that may be the case, however it can also indicate the market has high hopes for this stock’s future and has bid up the price.

Conversely, a low P/E may indicate a “vote of no confidence” by the market or it could mean this is a sleeper that the market has overlooked. Known as value stocks, many investors made their fortunes spotting these “sleepers” before the rest of the market discovered their true worth.

WHAT IS THE RIGHT P/E?

There is no correct answer to this question, because part of the answer depends on your willingness to pay for earnings. The more you are willing to pay, which means you believe the company has good long term prospects over and above its current position, the higher the “right” P/E is for that particular stock in your decision-making process. Another investor may not see the same value and think your “right” P/E is all wrong.

MORE TIPS ON P/E

  • If a stock has a P/E of 15, that means the market is willing to pay 15 times its earnings for the stock. For this reason, P/E is sometimes referred to as a multiple. In the above example, the stock has a multiple of 15. Also denoted as 15x .
  • Companies with good growth potential will have a higher P/E because investors are willing to pay a premium for future profits.
  • High-risk companies will typically have low P/Es, which means the market is not willing to pay a high price for risk.

IS THE P/E FORMULA PERFECT TO VALUE STOCKS?

Unfortunately, P/E alone cannot be used as a single measure to value stocks.  The reason is that an individual company’s earnings figure  can be skewed by accounting abnormalities which may temporarily inflate or deflate the actual earnings. A low P/E does not necessarily mean a stock is cheap and l a high P/E doesn’t mean a stock is expensive! You have to compare apples to apples. You have to put a stock’s P/E ratio into the proper context.So you cannot make a buy or sell decision strictly on P/E, but it can be used to get greater insights into a sector or stock price.

  • Different industries have different P/E  ratio ranges that are considered normal. For example in the recent years of IT boom, information technology companies had high P/E ratios compared to other sectors.
  • P/E ratios are available are available sector wise. This helps in finding out which sectors are more expensive at a particular point of time.To know when a sector is overpriced,   the average P/E ratio of all of the companies in the industry is compared to the historical average. If the average climbs far above the historical average, you get the hint that the sector as a whole is overpriced.
  • You can use the P/E  ratio to compare the prices of companies in the same sector. For example, if company A and company B are both selling for 50 per share, one might be far more expensive than the other depending upon the underlying profits and growth rates of each stock.

    That’s about P/E ratio. In my next post , i will detail more about the types of P/E ratio and some more tips on how to use it.

    Bye for now !

2 Comments