Understanding Price to Earnings Ratio
If there is one number that people look at than more any other it is the Price to Earnings Ratio (P/E). The P/E is one of those numbers that investors throw around with great authority as if it told the whole story. Of course, it doesn’t tell the whole story (if it did, we wouldn’t need all the other numbers.)
The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.
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 $40 and an EPS of 8 would have a P/E of 5 ($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 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.
Understanding Earnings Per Share
One of the challenges of evaluating stocks is establishing an “apples to apples” comparison. What I mean by this is setting up a comparison that is meaningful so that the results help you make an investment decision.
Comparing the price of two stocks is meaningless as I point out in my article “Why Per-Share Price is Not Important.”
Similarly, comparing the earnings of one company to another really doesn’t make any sense, if you think about it. Using the raw numbers ignores the fact that the two companies undoubtedly have a different number of outstanding shares.
For example, companies A and B both earn $100, but company A has 10 shares outstanding, while company B has 50 shares outstanding. Which company’s stock do you want to own?
It makes more sense to look at earnings per share (EPS) for use as a comparison tool.
You calculate earnings per share by taking the net earnings and divide by the outstanding shares.
EPS = Net Earnings / Outstanding Shares
Using our example above, Company A had earnings of $100 and 10 shares outstanding, which equals an EPS of 10 ($100 / 10 = 10). Company B had earnings of $100 and 50 shares outstanding, which equals an EPS of 2 ($100 / 50 = 2).
So, you should go buy Company A with an EPS of 10, right? Maybe, but not just on the basis of its EPS. The EPS is helpful in comparing one company to another, assuming they are in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it. For that information, we need to look at some ratios.
Before we move on, you should note that there are three types of EPS numbers:
* Trailing EPS – last year’s numbers and the only actual EPS
* Current EPS – this year’s numbers, which are still projections
* Forward EPS – future numbers, which are obviously projections
Market Cap is the True Measure of a Company's Value
Why is a stock that cost $50 cheaper than another stock priced at $10?
This question opens a point that often trips up beginning investors: The per-share price of a stock is thought to convey some sense of value relative to other stocks. Nothing could be farther from the truth.
In fact, except for its use in some calculations, the per-share price is virtually meaningless to investors doing fundamental analysis. If you follow the technical analysis route to stock selection, it’s a different story, but for now let’s stick with fundamental analysis.
The reason we aren’t concerned with per-share price is that it is always changing and, since each company has a different number of outstanding shares, it doesn’t give us a clue to the value of the company.
For that number, we need the market capitalization or market cap number.
The market cap is found by multiplying the per-share price times the total number of outstanding shares. This number gives you the total value of the company or stated another way, what it would cost to buy the whole company on the open market.
Here’s an example:
Stock price: $50
Outstanding shares: 50 million
Market cap: $50 x 50,000,000 = $2.5 billion
To prove our opening sentence, look at this second example:
Stock price: $10
Outstanding shares: 300 million
Market cap: $10 x 300,000,000 = $3 billion
This is how you should look at these two companies for evaluation purposes. Their per-share prices tell you nothing by themselves.
What does market cap tell you?
First, it gives you a starting place for evaluation. When looking a stock, it should always be in a context. How does the company compare to others of a similar size in the same industry?
The market generally classifies stocks into three categories:
* Small Cap under $1 billion
* Mid Cap $1 - $10 billion
* Large Cap $10 billion plus
Some analysts use different numbers and others add micro caps and mega caps, however the important point is to understand the value of comparing companies of similar size during your evaluation.
You will also use market cap in your screens when looking for a certain size company to balance your portfolio.
Conclusion
Don’t get hung up on the per-share price of a stock when making your evaluation. It really doesn’t tell you much. Focus instead on the market cap to get a picture of the company’s value in the market place.
Trading in Futures Derivatives (F&O)
Idea about futures derivatives
Future trading can be done on stocks as well as on Indices like IT index, Auto index, Pharma index etc
Stock future trading -
Let’s first understand what the meaning of futures trading is. In simple language one future contract is group of stocks (one lot) which has to be bought with certain expiry period and has to be sold (squared off) within that expiry period.
Suppose if you buy futures of Wipro of one month expiry then you have to sell it within that one month period.
Important - Future contract get expires at every last Thursday of every month.
If you buy October month expiry future contract then you have to sell it within last Thursday of October month. Likewise you can buy two months and three months expiry period future contract.
You can buy maximum of three month expiry period.
For example - suppose this is month of October then you have to buy till maximum month of December expiry and you have to sell it within last Thursday of December month. You can sell anytime between these periods.
Lot size (group of stocks in one future contract) varies from future to future contract.
For example Reliance Industries future lot size has 150 quantities of shares while a Tata Consultancy service has 250 shares.
In the same manner all futures have different lot sizes decided by SEBI (Securities Exchange Board of India).
The margin (in other words price of one lot size) varies on daily basis based on its stocks closing price.
Future trading can be done on selected stocks listed under Nifty and Jr. Nifty and not on all stocks.
The price of future contract is determined by its underlying stock.
Important - You can’t buy future contract of expiry period of not more than 3 months.
Indices future trading
As you can do future trading on stocks likewise you can do trading on different indices like Nifty index, IT index, Auto index, Pharma index etc.
Successful trading in futures
Future or derivative trading is the process of buying or selling stock future or index future for a certain period of time and squaring off before the expiry date.
Expiry period can be of one month, two month and three month and not more then of three month.
Its not compulsion that you have to square off your positions on the expiry date or wait till the expiry period but in fact you can square off at any time even, at the same day, or you can hold as long as you want but remember to square off before expiry date.
Most of the times on 3rd month expiry future you may see very less trading volumes.
Generally most of the traders/investors trade or invest on current month future or second month future contract and you may see very low volumes on last month means third month expiry .
But on Nifty index contract or on other index contract you may see good trading volumes even on 3rd month expiry future also.
You can also buy and sell or sell and buy future contract on the same day of any expiry month. This is called as day trading or intraday in futures.
Selling future contract before buying is called short selling. Short selling is allowed in futures trading.
Major Advantages of Futures Trading over Stock Trading
1) Margin is available -
In future trading you get margin to buy (but can hold only up to maximum of 3 months), while in stock trading you
must have that much of amount in your account to buy.
For example - If you plan to buy stock XYZ at Rs. 100 and quantity 1000 shares then you have to pay 1 lakh
rupees (RS 100 x1000 qty). But if you plan to buy XYZ future contract and that contract lot size has 1000 quantity
of shares then instead of paying 1 lakh rupees you have to pay just 20% to 30% of whole amount which comes to
20 thousand to 30 thousand rupees.
In short in future trading you have to pay just 20% to 30% of the whole amount what you pay if you buy stock of
that price. But limitation for this is your expiry period. Means if you bought future of one month expiry then you
have to square off within that one month likewise you can buy maximum of three months expiry.
2) Possible to do short selling -
You can short sell futures- You can sell futures without buying them which is called short selling and later buy within
your expiry period, to cover up your positions.
This is not possible in stocks. You can’t sell stocks before buying them in delivery (you can do in intraday). You can
short sell futures and can cover off within your expiry period.
For example - If expiry period of your future contract is of 1 month then you have time frame of one month to cover off
your order like wise if your future expiry period is of two months then you have time frame of two months and this
continues till three months and not more then three months.
In short selling of futures also you get margin as you get in buying of futures.
3) Brokerages are low -
Brokerages offered for future trading are less as compared to stock delivery trading.
Disadvantages of Future Trading over Stock Trading
1) Limitation on holding -
If you buy or sell a future contract then you have limitation of time frame to square off your position before expiry
date.
For example - If you buy or sell future contract of one month expiry period then you have to square off your position
before your expiry date of that month, so in this example you got one month period. So likewise if you go for two
month expiry period then you get 2 months and if you go for three month expiry then you will get 3 month expiry
period to square off your position.
2) Level of Risk -
Due to margin facility in future trading you may earn huge profit by investing fewer amounts but at the contrary side
if your trade goes wrong then you may have to suffer huge loss.
3) Limitation on stocks -
You can’t do future trading on all stocks. You can only do on listed stocks on Nifty and Jr. Nifty.
Important points to Remember while doing future trading
1) First up all you have to decide whether you want to buy stock derivatives or index derivative. After this you have to
select the expiry period. Once you buy certain expiry period then you have to sell (cover off) your order before that
period.
Its no need to wait till the expiry period, you can even square off on the same day (if you are getting profit) or
anytime whenever you feel to book profit, no compulsion to cover off your order on the last day of expiry.
2) Check out for Futures current market price.
3) Futures Lot Size (number of shares in that particular Lot).
4) Futures Lot price (this is the amount you must have in your account to buy one lot of future) also called as margin
amount.
5) Selection of expiry period - you want to trade on expiry of one month, two month or last 3rd month.
6) No need to wait till expiry period can book profit wherever applicable.
Method of Short Selling
Short selling (selling before buying in future trading)
In future trading you can do short selling and buy (cover) later when price comes down from your selling price you can short sell stock future as well as index future. But again same restriction will apply and that is of expiry period.
