Role of Price & Earning in the Stock Market – Fundamental Analysis

The share market recently witnessed a huge fall because of the corona pandemic, so is it to be taken as a ‘threat’, or is any hidden ‘opportunity’ there. Let us find out in our today’s blog. The fluctuation in the share market depends upon the play of Price & Earnings in the market. In the near future if the earnings of the companies increase then the prices of their shares might increase as well. Similarly, in the near future if the earnings of the companies decrease then the prices of their shares might decrease too.

If you wish to be successful in the share market, it is very important to check the market valuation before trading or investing. How do we check the market valuation to know whether the market is expensive or not? For this, you need to check the Nifty PE. If the check the history of the market till date, we will find that the Nifty PE has always moved in the range of 10 to 30. So whenever the Nifty PE has been in the range of 10 and 15, the market valuation has said to be ‘Low’ whereas whenever the market valuation has gone beyond 25, the market valuation has said to become ‘Expensive.’ From the past 2 years when the PE was around 28, we had already said that the market valuation is expensive so invest less. Now, due to the corona pandemic, the market witnessed a huge fall and due to this, the market PE fell down to 20. That states the market is at moderate valuation currently. Now, while it may look like the market valuation is moderate but the market might be expensive right now.

Due to the ongoing lockdown, the production of most of the companies has come to a standstill due to which their sales are halted too and so they may not earn that much of profit they otherwise do and all these factors will further affect the Price Earning Ratio.

Let us understand this Price Earning Ratio with a simple example. Consider a company named XYZ limited whose share price is Rs. 200 per share. Now, if we divide this share price by the company’s earnings per share then we’ll get the Price Earning Ratio. So if we divide the company’s total earnings by the number of shares then we will get the company’s earnings per share (EPS). Co sider the company’s EPS is Rs. 10. So now, 200 divided by 10 is equal to 20. So the company’s Price Earning Ratio is 20. What does this mean? So if we buy all the shares of this company and become its owner then the percentage of returns that we get on all the money that we have invested; in this case, the PE 20 tells us that if we invest Rs. 20 then we are earning a profit of Re. 1 here. That’s equal to 5% of the earnings that we’ll be having here. Now, in the near future if the earnings of the company grow rapidly then the returns that we earned here might increase even more. But for this to happen, the earnings of the company should grow. In another case, if the earnings instead of increasing goes down then? The above trade which we felt was moderate will start looking expensive.

Now the Nifty PE is at 20 where the market valuation looks moderate, so then how and when will the valuation look expensive here. Let us understand. When the share price was Rs. 200 and when it was divided by 10, the PE came out to be 20. Currently, there is a lockdown in the country; due to which the production of the companies is halted and there is no growth in either sales or profit. Here, the Price earnings that we calculate are of the previous period or previous year. So in the upcoming year due to lockdown, there will be a fall in the Earnings of the companies. Hence, here if the divide the share price i.e. 200 by 7 instead of 10 then considering the earnings decreased by 30% then the company’s PE will become 28.5 where earlier it was around 20. Now, here PE of 30 means that we’ll be earning Re. 1 by investing Rs. 30 which means the earnings have fallen down to 3% meaning that if the earnings of the company decrease, the PE increases. That means if we become the owner of a company by buying all its shares in this current situation then it isn’t a good deal.

So while investing in any company for the long-term, it is important to think in this manner that we own a company not just buying a few shares. The world's most successful investor Mr. Warren Buffet quotes, “I never own stocks, I own business.” So in the near future due to lockdown, where the PE currently is at 20 and where it seems like it is moderate so as the earnings will fall, even more, the PE which looks moderate will start looking expensive.

So lockdown is a temporary phase. The Government of India and RBI are trying that after the lockdown the companies make quick U-shaped recoveries.  This means that after the lockdown when the companies will start their earnings again, and if they are able to attend this U-shaped recovery and their earnings increase rapidly then again this expensive market valuation may start looking moderate or in-expensive. Ugh! This seems like a very complicated analysis. But it is important to note that if we divided 200 by 10, the answer comes down to 20 and if we divide 200 by 7, the answer comes roughly close to 30. When the earning falls down, the PE increases.

Now, due to lockdown, there might be a decrease in the earnings. Hence even though the market is at moderate valuation it still seems expensive. So should we invest in the market or not? The entire share market is divided into certain types of companies. So the first category has a few such companies whose top line, as well as the bottom line, are growing despite an ongoing lockdown. Simply, that means despite lockdown their sales are still growing and due to which their earning is on as well. Hence, after the lockdown, they will post a quick recovery. The second category includes those companies whose top line as well as bottom-line both are not functioning due to lockdown. They will take some time to recover.

So while investing we should plan accordingly as the market might fall down further. So we should invest only 50% here that too by analyzing the risks involved. And we should invest in those companies that are showing some growth in their top line as well as bottom-line as these companies will post a quick recovery later. So the best sector now is Fast Moving Consumer Goods (FMCG). Now be it HUL, Nestle, Marico or Britannia Industries, etc. (All these names are for educational purposes only), so here you can analyze and then invest accordingly. We should invest only 50% and not more. If the market goes up, you’ll make a profit if it goes down, you’ll have another opportunity to invest.

While investing, you need to view the market valuation by checking out the Nifty PE and while investing in a company, its business model is way more important than its PE. If you analyze the data from the year 1994, even at that time Nestle was functioning at the PE of more than 60, so if analyze it data of the next 20-25 years, the company has still managed to give excellent returns because it has a sustainable competitive advantage with it. So if you take care of all these details then you’ll be able to earn good returns from the market.

Coming to trading, till Nifty is above 8,821; the momentum is positive. Even in the last week, the Nifty momentum was positive, at that that some pharmaceutical stocks like Davis Labs came out of the box and gave a positive signal. What is this box theory? A dancer named Nicolas Darvas had made millions in 18 months using the box technique. We have already uploaded 2 blogs on this topic earlier, do give it a read.  So while trading even we use the same box technique. In the 2016 CNBC competition, I had used the same technique and performed exceedingly well.

Talking about this week, even though the momentum is positive, we couldn’t find any share according to our technique which has freshly come out of the box. It is possible that in the upcoming period some shares might come out of the box, at that time you can trade by carrying out proper money management, analyzing the risk properly, and setting a stop-loss as well to earn good returns. If you wish to make money via trading by using our copyright method then we have an app Aryaamoney which consists of two powerful training programs Gateway to Wealth and Smart Investor Programs. You can check them out. So if you subscribe to the program, then you even get a charting tool like handholding support to guide you in the market. So you can create opportunities out of this pandemic situation too.

Until next time…

Happy Trading, Happy Investing!!!

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