There are some myths that grip retail investors when it comes to investing in the stock markets. In this article, we focus on what is important when it comes to selecting a stock, i.e. the stock 'price' or the stock 'value'?
Based on the feedback we get from readers, it seems it is a common perception among retail investors that a company's share is supposedly 'cheaper' when it is trading at Rs 10 as against Rs 50, i.e. after it appreciates.
The interest level for low-priced stocks seem to be disproportionately higher these days because of two reasons.
One, the stock market has been going up, and, two, prices have run up significantly in the last two years, thus the craze for small and mid-caps.
The major attraction when it comes to mid-caps among retail investors, besides the upside, is that one could buy a lot more shares for the same outlay.
We take a practical example and bring forward what is important. Here we compare, Tata Motors and Ashok Leyland. Remember, we are not recommending any stocks by this comparison.
What is 'cheap'?
| FY04 | Tata Motors | Ashok Leyland |
| Valuation | ||
| Current price (Rs) | 414 | 21 |
| Face value (Rs) | 10.0 | 1.0 |
| Price to earnings (times)* | 12.8 | 10.9 |
| Price to book value (times)** | 4.1 | 2.5 |
| Key ratios | ||
| EBDITA margin | 13.5% | 12.6% |
| Net profit margin | 5.6% | 5.3% |
| Return on net worth | 24.2% | 20.9% |
As a retail investor, it is possible that with a sum of Rs 1,000, one can buy 47 shares of Ashok Leyland whereas for a similar outlay, investors can get hold of only 2 shares of Tata Motors.
But does that mean Ashok Leyland is 'more attractive' than Tata Motors?
The answer is a clear 'no'! ALthough one may be buying fewer shares of Tata Motors, this should not be the governing factor for investing. What matters is 'at a price', what is the underlying 'value' that the investor is getting.
The stock may be trading at a higher valuation also because the fundamentals are stronger.
Some caveats:
Price is governed by value: The stock price (governed by value) is supposed to indicate the long-term earnings growth potential of the company. What is history is already factored in into the stock price because everyone knows it. This long-term growth potential has to be 'valued', taking into account the industry dynamics, the past track record of the management and what the future looks like.
It is for this reason that high-growth sectors (software and pharma, for instance) generally tend to command higher valuation as compared to a textile stock.
FIIs do not care about pennies: If you think the penny stocks will go up because foreign institutional investors are going to buy into these, then we must point out that your are most likely to be wrong and are being misled if you are being told that this is true.
Serious FIIs and domestic mutual funds have stringent criteria's like floating stock (percentage of shares not owned by promoters and is liquid), minimum level of market capitalisation and sales turnover and so on.
If any broker suggests buying into a penny stock because growth prospects are goods and FIIs 'would' buy, then it is time to exercise caution.
Face value: Investors have also got to keep in mind as to the face value of the share they are buying. Like in the case above, Ashok Leyland may be trading at Rs 21. But its face value is Re 1 (if we equate it, the buying price is actually Rs 210).
Some companies change their face value to increase liquidity in the stock market with a good intention.
Same is the case with mutual funds: Just because the NAV (net asset value) of a mutual fund scheme is below par or at par (i.e. less than or equal to Rs 10), it does not become attractive.
To conclude, focus on the 'value' and not on the 'price'. So, what is attractive? Rs 10 or Rs 50!
Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.
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