01 February, 2008

How to justify the right price of a stock

I have been trading for quite some time.. however i always wanted to know whether the price which am paying for the stock is right or not. Or is it heavily priced ??
This was always a subject of my interest to interpret a financial statement and finally i came across a article which came to my rescue.

There are two important ratios which can partially help you to understand the right price of the stock

1. P/E Ratio (Price to Earnings ratio)
2. EPS (Earning Per Share)

You calculate the P/E by taking the share price and dividing it by the company’s EPS.

P/E = Stock Price / EPS

For example, a company with a share price of Rs 40 and an EPS of 8 would have a P/E of 5 ( Rs 40 / 8 = 5).

What does P/E tell you? The P/E gives you an idea of what the market is willing to pay for the 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 (under) value stocks, many investors made their fortunes spotting these “diamonds in the rough” 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.

Earnings Per Share is calculated by dividing a company's net revenues by the outstanding shares. This gives you a number you can use to compare the earnings of companies since it is unlikely any two companies will have the same number of shares outstanding.

Apart from this if you have faith in the comapnies fundamentals, in sector which they are currently in and the booming economy then even a high valued stock can give more returns if holded for a good period of time.

Tip: Its better to invest in a expensive stock which runs on good fundamentals and has good number of investors rather then looking for a penny stock which struggles for investors attraction.

Courtesy : My understanding :)

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