When a retail investor makes his/her way into the world of stocks, the first factor to be considered is the price of stocks. However, just by looking at a low stock price one cannot tell the story of whether the stock is viable. A stock may have a low price but be high-valued. On the other hand, a stock may also be perceived as ‘expensive’ but may not result in profitable returns in the long-term. A new investor may not be able to tell the difference between a cheap stock and an expensive one. For this reason, you need a deeper understanding about the factors that determine the value of a stock.
Looking beyond share price – Understanding the value of a stock
The value of a stock is determined by whether it’s a good deal for the investor or not. A stock with an attractive valuation is one that comes from a worthy company and that will allow the investor to make handsome gains.
It is important for a retail investor to look beyond the price of a stock due to the following key reasons:
- A stock’s share price tells very little about its value. For this reason, you shouldn’t make a buying decision based solely on the share price.
- It is not strictly true that a stock with a low price is ‘cheap’ or one costing higher is ‘expensive’.
- The price of a stock does not indicate whether it will go higher or lower in the foreseeable future.
- Very cheap stocks, also known as penny stocks, may seem profitable. But the fact is that penny stocks have the highest risk associated with them.
A simple example
Let’s consider the simple example of a stock that’s available at an incredibly cheap price. Say the price of the stock was INR 60 and has now fallen to a price of INR 6. Now, the stock is considered a penny stock. But purchasing this stock is not recommended for two reasons:
- The price has fallen drastically which indicates poor stock quality.
- The price may further fall and achieve a INR 0 valuation due to its past performance.
Valuation ratios you need to know
To understand what the value of a stock entails, there are certain parameters called valuation ratios that you need to familiarise with
P/E Ratio (Price to Earnings)
PE Ratio is the ratio of the market price of a stock to its Earnings per Share (EPS). EPS for a stock is derived by dividing the net profit of the listed company by the total number of its outstanding shares.
P/B Ratio (Price to Book)
This ratio compares a stock’s valuation against its company’s worth or book value.
PEG Ratio (Price to Earnings Growth)
PEG ratio is obtained by dividing the PE ratio of a stock by the earnings growth rate.
Stock Price vs. Stock Value – Which matters when?
When stock price matters
Stock price matters only to indicate its current market value to buyers and sellers.
Price matters when you are aware of the company’s potential for growth.
Stock price matters in relation with the company’s capital cost and equity. If stock price plummets, it could indicate that the company may not sustain the capital market for long or may even shut down.
Price matters only in context of the stock’s market capitalisation and total number of shares allotted by the company.
Price matters for short-term traders rather than long-term investors since traders are more interested in price changes.
When value matters
The value of a stock matters to decide whether a stock is cheap or expensive.
Stock value will help you gauge whether an investment is worthwhile.
Judging the value will also give you an idea about whether you should sell or hold on to a stock in the long term.
New retail investors often fail to understand the fundamental difference between a stock’s price and its value. But with the right knowledge about valuation metrics, you can make the right decisions in purchasing high-quality stocks at their best price.