Page 346 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 14: Portfolio Revision

Notes

Task Analyse the limitations of formula plans and give a brief write up.

Case Study What is the P/E Ratio?

amesh: Manubhai, I read in your report yesterday that you are recommending
HLL. And your report said you like it because it is cheap. But it is 2,400 rupees per
Rshare. Better than that, why don’t you recommend Henkel Spic instead? It is only
130 rupees.
Manubhai: Ramesh, price mut dekho. Price earnings ratio dekho. Speak to my analysts.
They will explain that you cannot judge cheap or expensive by price.
What is a price-earnings ratio?
The normal reaction when we look at share prices is that a 40 stock is cheap, and a 1,000
stock is expensive. Let’s say we were buying onions. One subziwala said 20; another said
50. Would we simply jump and say that 20 was a great deal? What if one was saying
20 for half kg of onions and another was offering 5 kg for 50? There’s a lesson here: Price
itself is not enough. It actually takes a ratio to determine cheap or expensive. And the ratio
is price per unit of whatever we are buying.
But someone might still say that stock prices are already (AQ?) per share. So 40 per
share and 1,000 per share should be comparable. This is where we need to look beyond
the piece of paper (or with demat stocks, not even the paper). What are we buying when
we buy a share?

When we buy a company’s share, we buy a share of the company’s profits, both current
and future. As an example, let’s take HLL. During the period January 1998 to December
1998, HLL made a net profit of 805 cr.; it currently has a total of 20 cr. shares. Each share
(and therefore its owner) owns 40.3 ( 805 cr. divided by 20 cr. shares) of HLL’s net profit.
This 40.3 is then referred to as earnings per share of HLL.
So, when we buy one share of HLL, we are buying 40.3 of net profit, together with the
right to future net profits. If HLL were to make a net profit of 500 cr. this year, and were
to issue another 5 cr. shares, the earnings per share for next year would be 40: 500 cr.
divided by (20cr. old shares + 5cr. new shares = 25cr shares) = 40 per share.
Keeping this in mind, now let’s go back to our original problem. How do we figure out if
a stock is cheap or expensive? If we buy a share for 500, and the earnings per share for the
company is 50, then we are paying 5 for each rupee of net profit we buy into. If we buy
a share of another company for 40, which has earnings per share of 2, then we pay 20
for each rupee of net profit we buy into. Which one is cheaper?
When we look at a share price, we should also look at earnings per share. Looking at both
of them is the only way to determine whether the share is cheap or expensive. To make it
easy for themselves, research analysts have created a simple formula: Price Earnings Ratio
= Price per share/Earnings per Share where, Earnings per Share = Net profit/Number of
issued shares. So when they want to know whether a share is cheap or expensive, they just
calculate this ratio. And lower the ratio, cheaper the stock is.
Contd...

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