Are you investing in IPOs?

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The Indian stock markets continue to make newer highs on the back of strong FII inflows, which is a factor of the
seemingly strong economic prospects in sight for the country. Stock prices continue to soar and are making new 52-week
highs consistently. There is everything positive at the current juncture for Indian equities and this has been attracting
investors to equity markets.
Taking advantage of this gung-ho environment in the stock markets, many companies time their IPOs during such periods,
as they are able to 'price' higher than they would have otherwise when the scenario is not favourable for equities. In this
article, while we would refrain from commenting on whether one should invest in an IPO or not, we look at one important
aspect of investing in an IPO and jot down a few points that investors need to remember.
As per reports, Indian markets are likely to see IPO offerings worth Rs 250 bn in 2005. Considering that approximately
25% of every issue is for retail investors, it implies that this category of investors would need more than Rs 60 bn to invest
in the same. Further, considering that in bullish times, IPOs could get oversubscribed several times (including the retail
portion). This, in turn, gives rise to larger amounts being invested by investors so as to increase the chances of allotment
in case of over-subscription. But the question is, does the retail investor have so much money to invest?
This is where IPO Margin Financing (IPOMF) comes into the picture. It must be noted that while an individual may have
limited funds, there are various banks and financial institutions that are willing to lend money, at a certain interest rate, so
that you can invest in an IPO. Thus, IPOMF basically facilitates an investor to invest beyond his/her capacity (leveraged
investing). An investor prefers to apply for more shares during bullish times not only to increase his chances of getting
some allotment but also on the belief that he will be able to make handsome return on his investments. However, it is not
as simple as it seems. This factor needs to be considered in a little more detailed manner so as to understand how
IPOMF will affect your returns.
Company

XYZ

Offer price (Rs/share)

100

You want to apply (nos. of shares)

1,000

Investment required (Rs)

100,000

You have (Rs)

25,000

IPO Margin Finance (Rs)

75,000

Interest & other charges on margin finance

Interest & other charges (Rs)

2%
1,500

The table above indicates the details of an investor wanting to apply in the IPO of a company XYZ whose offer price is Rs
100 per share. The investor intends to apply for 1,000 shares for which the investment required is Rs 100,000. Since he
does not have the capacity to invest the full amount, he opts for IPOMF of Rs 75,000, wherein the interest and other
charges add up to 2% per month on the borrowed funds i.e. Rs 1,500. Below are discussed a couple of possible
scenarios considering that an investor gets some allotment.
Case 1
Allottment (nos. of shares)
Total investment incld. interest (Rs)

1,000
101,500

Cost of acquisition (Rs/share)

102

Selling price (Rs/share)

110

Returns on investment (%)

8.4%

Case 1 above assumes that the investor is lucky enough to be allotted all the 1,000 shares he had applied for (a scenario
very unlikely during such bullish times). Thus, taking into consideration the interest on the borrowed funds, the cost of
acquisition per share would be Rs 102 (rounded-off) and not Rs 100. It must be noted here that the entire interest
expense of Rs 1,500 is spread over 1,000 shares. Now assuming that the stock lists at Rs 110 (10% premium to the offer

price) and the investor decides to book his profits, he would be happy with the 8.4% gains he has made on his
investment.
Case 2
Allottment (nos. of shares)
Total investment incld. interest (Rs)
Cost of acquisition (Rs/share)
Selling price (Rs/share)
Returns on investment (%)

100
11,500
115
110
-4.3%

Now let us consider another scenario (case 2) wherein an investor is allotted only 100 shares (a much more likely
scenario, especially in times when even 'me-too' IPOs get oversubscribed multiple times). In this case, the interest cost
(already pre-determined and fixed) is spread over the 100 shares. It must be noted that the interest charged by the
lending entity applies to the entire borrowed funds, irrespective of whether you are allotted all, few or nil shares. This
effectively increases the cost of acquisition per share to Rs 115. Thus, at Rs 110, the investor is actually at a loss of 4.3%.
While both the above cases are hypothetical and the final scenario would depend on various parameters like shares
allotted, interest on IPOMF and selling price, we have made an attempt here to bring out the complexities. Further, it must
be noted that there is always a possibility that an investor may get carried away and over-leverage himself, thus putting
his financial viability at risk.
While the above is just one of the parameters that must be kept in mind while investing in an IPO through the margin
financing route, there are various other fundamental parameters that must be borne in mind even otherwise. These
include:
1.

Who are the Lead Managers to the issue? Do Lead Managers act as an indicator of the quality of the issue?

2.

What is the promoter holding in the company? Is there any participation from financial institutions or a venture
capital firm?

3.

Where is the company investing my money? Is it going to give me good returns?

4.

Which sector does the company operate? What is the growth prospect of the company vis--vis the sector?

5.

Do the promoters have enough experience?

6.

Will the money invested yield maximum returns? Are the profit projections achievable?

7.

How do I justify the price of the issue?

8.

Does the company enjoy tax benefits?

All these questions are explained in detailed in our article: Checklist for IPO investors
To conclude, we believe that before investing into equities (either through personal or borrowed funds, through secondary
or primary markets), certain key issues like assessing one's own risk bearing profile, the investment time horizon and
fundamentals of the company must be strictly adhered to. After all, its your money, honey!.

Markets and economy: The stumbling blocks!

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'India is not on autopilot to greatness. But it would take an incompetent pilot to crash
the plane'. These words of Mr. Edward Luce very aptly define the contours of the
Indian economy. The economy has been growing at an average annual growth rate of
nearly 6% since the 1980s, and at over 8% during the last three years. Besides, India
has also shown considerable resilience during the recent years and avoided adverse contagion impact of several shocks.
This has precipitated to increased confidence in the country's financial markets with a consistent increase in gross
domestic investment rate from 23% of GDP in FY02 to 30% in FY06. The gross domestic saving rate has also improved
from 24% to 29% over the same period, contributed by a significant turn around in public sector saving. A case in this
point is that the inflows into mutual funds alone have multiplied 10 times in the last decade and is currently at all time
highs!
For this buoyancy to sustain, the country will have to tide over several stumbling blocks.
Inherent flaws...
First, the poor state of the physical infrastructure, both in terms of quantity and quality. While with the healthy
fundamentals of the domestic financial sector and the enhanced interest of foreign investors, funding should not pose a
problem, issues relating to regulatory framework and rapid execution need to be addressed by the government.
Second, fiscal consolidation. The recent budget of the central government targets a gross fiscal deficit of 3% of GDP by
2009. This requires fiscal empowerment, which is possible through two routes (i) elimination of subsidies or (ii) elimination
of tax exemptions. While in any economy fiscal consolidation is hard, it is particularly so in our setting
Third, India is set to remain one of the youngest countries in the world in the next few decades. This 'demographic
dividend' cannot be used to the economy's advantage unless prerequisites such as skill-upgradation and sound
governance to realise it are put in place.
Fourth, there is a need to shift the emphasis from foreign institutional investment to attracting foreign direct investment,
which is less volatile. This requires a more favourable investment climate in general both for domestic and foreign capital.
Global Imbalances...
As India does not depend on the international capital market for financing the fiscal deficit, the extent of adverse
consequences of the global developments would be muted. However, there could be a spillover effect of global
developments on domestic interest rates and thus on fiscal position. Also, a faster rise in rates overseas could lead to a
shift in investor confidence to the international markets. Further, should there be a reversal of capital flows, asset prices
may decline. With this there is a risk that rise in interest rates in general could impact the housing market and expose the
balance sheet of the households to interest rate risk, increasing the risk of loan delinquencies for banks. Banks in India
have invested significantly in government debt and other fixed income securities. If a rise in international rates gets
reflected in domestic interest rates, banks will also have to mark down the value of their investment portfolio.
Multilateral confidence...
Finally, there needs to be the confidence of the investor community on multilateral aspects such as political stability,
terrorism combating ability and significance at global economic platforms (such as the IMF and World Bank).
While we do not intend to sound pessimistic about the continued resilience of the economy to global and internal shocks,
investors investing in the India story should assess these grounds before judging the 'market risk' to be assigned to a
stock. Weighing this with the premium expected to be earned over and above the risk free rate (10 year GSec yield), will
help you correctly align your portfolio as per your risk profile.
Margin trading: Are you into it?
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Markets have plummeted over the past few days and various reasons for the decline have cropped up. Margin pressure is
one amongst them. In this write-up, we try and explain margin trading, its impact on equity returns, the mechanics and
how it leads to chaos.
What is margin trading?
Margin trading, a leverage investment mechanism, is trading with borrowed funds/securities. Margin trading is a means of
investing beyond one's means. It generally leads to overtrading and can, at times, enhance one's speculative tendencies.
While trading with borrowed funds, the client is required to deposit initial margin (good faith deposit).
Margin trading can have amplifying impact on returns. Returns are enhanced if the stock price moves on the expected
lines of the client. While if price move contrary to expectations, losses surmount.

Some examples...
Example 1: If client wishes to buy share worth Rs 100 but is left with only Rs 50 in his pocket, he borrows Rs 50 from his
broker. If the price of the security moves up by 10%, leaving interest to be paid on the borrowed funds out of the analysis,
the return for the investor will be 20% (table below). While if the stock price goes down by 10%, then the investor will lose
20%. Thus, it can be said that margin trading is a 'double-edged sword'.
Example 2: Suppose there are two investors - 'A' and 'B', both having invested Rs 100 in a portfolio with a similar return
profile. Client 'A' used own funds only while client 'B' borrowed to the extent of 50% of the initial investment. The return for
the investor under various return scenarios is as follows:
Own Vs borrowed money...
Particulars

Investor 'A'

Own money

100.0

100.0

50.0

50.0

50.0

50.0

Total

100.0

100.0

Return on portfolio

20.0% 10.0% 20.0% 10.0%

Debt (at 15% interest)

Investor 'B'

100.0 100.0

Return (Rs.)

20.0

10.0

20.0

10.0

Interest cost

7.5

7.5

20.0

10.0

12.5

2.5

Net profit
Return to investor

20.0% 10.0% 25.0% 5.0%

(Note: Composition of portfolio is 10 shares of 'X' at Rs 10 each.)

Going forward with the same example, if the value of portfolio changes, the impact of the same on returns for 'Investor B'
will be as follows:
Impact of change in value of portfolio on the profitability
Owned Margin Cost of Value of
Surplus after Profit/Loss Return
Funds
Debt portfolio portfolio repayment of debt
50

50

100

50

-50

-100%

50

50

100

60

10

-40

-80%

50

50

100

70

20

-30

-60%

50

50

100

80

30

-20

-40%

50

50

100

90

40

-10

-20%

50

50

100

100

50

0%

50

50

100

110

60

10

20%

50

50

100

120

70

20

40%

50

50

100

130

80

30

60%

50

50

100

140

90

40

80%

50

50

100

150

100

50

100%

If the return on the portfolio exceeds the rate of loan, then the investor stands to gain and vice versa. Also, the returns are
differential for a portfolio at different level of margin (own funds). A lower margin along with volatility in value of the
portfolio has a greater 'leverage effect'. This can be seen from the table given below:
Profitability at different level of margins
Particulars

Self financing

Extent of margin
25%

50%

75%

25

50

75

Loan at 10%
Total
Return on portfolio
Profit (Rs)
Interest payable (Rs)
Net gain
Return

75

50

25

100

100

100

20%

20%

20%

20

20

20

7.5

2.5

12.5

15

17.5

50.0% 30.0% 23.3%

The mechanism of margin trading: Client interested in margin trading are required to sign an agreement with the
authorised intermediaries (broker) and decide about the terms of agreement like interest rate (margin rate), extent of
margin and the rate of compounding. Consequently, a margin account is opened and the investor deposits the required
initial margin with the broker. The broker, based on the directives of the investors, executes the purchase order and
shares purchased are collateralized with the broker. In addition to the initial margin, the investor is required to keep
minimum equity in the account. The equity here means the net value of portfolio (value of portfolio minus the value of the
debt) This equity is a specified percentage of the total value of the portfolio and is called maintenance margin. Once the
level of funds in the account falls below the maintenance margin (due to the fall in value of shares), the investor is called
to bring upon the shortfall.
Extending the Example 2 (initial margin of 50% and maintenance margin of 25%), the investor purchases stocks worth Rs
100. Assuming that the value of the portfolio falls to Rs 60, the amount of equity reduces to Rs 10 (Rs 60 minus Rs 50).
As per the terms with the broker, the value of maintenance margin was 25% i.e. Rs 15 (Rs 60 multiplied by 15%). Since
the value of the portfolio has declined, the broker calls for additional margin. If the margin call is not obliged, the broker is
authorised to sell the securities without the prior information of the investor. In some cases, where the value of the
portfolio becomes nil, the broker sells the entire lot of stocks without informing the investor.
We will cover more aspects of margin trading as we go forward. But one thing is for sure. Equities are a risky asset class
and volatility is the name of the game in the short-term. If one takes a long-term view on equities, without resorting to
borrowing money to earn money, the relative return is likely to be higher than other asset class.
The devil is in derivative!
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Yesterday, the financial world was jolted by news of a big hedge fund, which lost more than US$ 3.5 bn in a gas futures
contract. While the news did not get as much media attention as the 1998 debacle of the LTCM hedge fund where it had
Nobel Prize winners on its rolls, it nonetheless highlights the danger of dealing with financial instruments such as futures
or more generally derivatives.
Mind you, these were not the only cases of misuse of such instruments and the subsequent nasty outcomes. Prominent
debacles include the 1994 bankruptcy of Orange County, one of California's richest, due to investments in some ultrasophisticated derivatives and the 1995 failure of the 200-year old Barings Bank as a result of unauthorized futures and
options trading by a rogue employee. Besides, the fear of a lot more financial institutions losing their shirts owing to such
leveraged positions continues to loom large.
Infact, this is what Warren Buffett, widely acknowledged as one of the shrewdest investors ever, had said about
derivatives in Berkshire Hathaway's 2002 annual report.
"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and
number until some event makes their toxicity clear. [They] are financial weapons of mass destruction, carrying dangers
that, while now latent, are potentially lethal."
And Buffett is not alone in deriding derivatives; a lot of other value investors share his views. One would now ask 'What is
it that make these instruments so risky?' The answer lies in the fact that derivatives are financial instruments that have no
intrinsic value but derive their value from something else. They are mainly utilised for hedging the risk of owning things
that are subject to unexpected price fluctuations e.g. foreign currencies, food grains, commodities and even equities.
Let us take an example to clarify things further. Consider the case of Mr. Chandar. He is a farmer and is certain that he
can harvest 20 tons of rice. Currently, rice is trading at Rs 5 per kg. At current price levels, he will earn Rs 100,000 that

will cover his yearly expenses. But he knows that if there were a bumper crop of rice all over the state, he would be forced
to sell his rice at as little as Rs 2 per kg. In that case, he would fall short to meet the expenses.
So Chandar goes to the local rice merchant, Thakur, and enters into an agreement that three months hence, he will sell
his twenty tons of rice to him at the rate of Rs 5 per kg. Now, our Thakur is not a simpleton and knows that three months
hence, all the farmers would be selling their produce, and the rates that would be then would be about 15% to 20% lower
than what it is now. So, Thakur offers to buy the rice at the price of Rs 4.2 per kg.
At this, Chandar argues that it is equally likely that in event of a poor crop, the price of rice may be higher than what it is
now. Thakur and Chandar finally agree to a price of Rs 5 per kg of rice for 20,000 kgs to be delivered at Thakur's shop
after three months.
This is what we know as the most primitive kind of a derivative contract. Such contracts are called "Forwards" (or a
Forward Contract) and is one of the simplest type of a derivative contract. In order to cater to a large number of Chandars
and Thakurs and to make sure that both the parties honour their commitments, boards or exchanges have been set up
across the world which oversee derivative contracts in virtually every commodity and financial security.
So far so good! So long as the purpose of such contracts is to hedge against a possible fall or rise in prices, derivatives
can prove to be an extremely useful tool. However, if speculators board the bus to benefit from the discrepancy in prices,
then we might have huge problems in our hands. Speculators have no other interest apart from making bucks by
benefiting from the gyration in prices. They just hope that the seller is wrong temporarily so that they can sell the contract
at a higher price to some other guy and profit from the same. It is when these bets go wrong, hedge funds like Amaranth
or LTCM, which use ultra-leveraged money to invest in such kind of contracts, vanish without a trace thus eroding
considerable amount of wealth in the process.
These short-term contracts go against the very grain of value investing, which is based on principles that 'existence of
value in the absence of assets' and 'predicting short-term price movements' can both prove to be a risky proposition. No
wonder, it does not find a place in the investing world of value investors. As long as the purpose is to hedge against price
fluctuation of some underlying asset, then the use is justified but if it is used as a source to earn quick money, then we
might be in for some nasty surprises.
In these turbulent times in the Indian market, a lot of investors might be tempted to use such instruments in view of the
fear that since it has run up quite a bit in the recent past, a correction is long overdue. Hence, any further purchase of
equity should be hedged against a possible fall in order to minimise the damage. There is little wrong in this approach
except for the fact that if it is being used for quick money making then be prepared to watch your hard earned money go
down the drain. Infact, given its inherent risks, try and avoid it altogether. Happy investing!
Free cash flow: Is it free after all?
MYSTOCKS | FREE NEWSLETTER

The best things in life are said to be free and the same holds true for cash flow! Investors love companies that produce
plenty of free cash flow (FCF). It signals a company's ability to repay debt, pay dividends, buy back stock and facilitate the
growth of business all important undertakings from an investor's point of view. In the past we have given our readers a
perspective on valuation parameters like price to earnings (P/E) and price to book value (P/BV). While both these
valuation parameters reflect the present earning capabilities, they do not signal the future prospects.
How and what of FCF
The formula for calculating Free Cash Flow (FCF) is as:
Net Profit + Depreciation Capital expenditure Changes in working capital Dividend
FCF takes into account not only the earnings of the company but also the past (depreciation) and present capital
expenditures, capital inflows and investment in working capital. Growing free cash flows are frequently a prelude to
increased earnings. Companies that experience surging FCF due to revenue growth, efficiency improvements, cost
reductions, share buy backs, dividend distribution (from subsidiaries) or debt elimination can reward investors in the
future. Better free cash flows are therefore a reason for the investment community to cherish. On the other hand, an
insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough
FCF may not have the liquidity to stay in business
From a companys point of view
A better FCF definitely indicates better efficiency on the part of the company. But what is pertinent for investors to note is

that simply assessing the FCF on the basis of its absolute value is not prudent. It is imperative to also assess as to what
components have contributed to the same.
Let us take a hypothetical example of two companies, A and B, both of which have garnered the same FCF for the current
financial year.
Estimated free cash flow
(Rs)

Company A Company B

Net profit

75

120

Add: depreciation / amortisation

20

15

Less: Capital expenditure

Add/ (Less): Decrease /(Increase)
in wkg capital

10

(10)

Less: Dividend

20

20

Free cash flow

80

80

Prima facie although appearing similar, if you delve a little deeper there is a stark difference in their performances. While
company A, despite having lower earnings has benefited by adding back depreciation and decrease in working capital,
company B has invested in capex and working capital. This indicates that while company B is investing for future
growth, company A is not sufficiently geared up for the impending challenges. This also means that investors in company
B can expect rewards in future while those in company A should sit up and take notice of what is ailing it.

FY06E

Price

FCF

P/FCF

SBI

612 203.9

3.0

ONGC

874 131.3

6.7

Tisco

354

26.2

13.5

BHEL

831

31.6

26.3

2039

51

Infosys

From a sectors point of view

As explained earlier, cash flows are dependant on the capital expenditure and
working capital liabilities borne by the company. This however, differs as per the
dynamics of the sector in which the company is operating and should be seen in that
light. While sectors like banking require minimum expenditure on capex (as a % of
their turnover) those in pharma, engineering, FMCG or commodity sectors require to
invest a substantial amount in R&D and capacity expansions. Thus, you would find
SBI trading at a very attractive price to free cash flow valuation of 3 times, while an
equally competitive Infosys is trading at 40 times (due to lower cash flows).

40.0 To conclude...
FCF is not only a mirror image of the present but also a sneak preview into the
Ranbaxy
965 19.6 49.2
future. The implications of the components of cash flow may not be explained in the
HLL
132
1.9 69.5 annual reports, but is left to the investors prudence to diligently scrutinize the same
and try to read between the lines. The legendry investor Benjamin Graham once
said, The individual investor should act consistently as an investor and not as a speculator. This means that he should be
able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that
he is getting more than his money's worth for his purchase.
Free cash flow, is not free after all
P/E What is it all about?
MYSTOCKS | FREE NEWSLETTER

The most commonly used valuation metric by investors is the price to earnings ratio or commonly referred to as the P/E
ratio. Though commonly used, it is also misunderstood for various reasons. Here is an attempt to simplify this valuation
metric.
How is P/E calculated?
It is calculated by dividing market price of a stock by EPS (earnings per share). EPS in turn is calculated by dividing the
net profit of the company by the number of shares outstanding.
Having calculated the P/E, what does it stand for?
Lets assume a stock is trading at Rs 100 and its EPS is Rs 20. The P/E multiple is 5 (100 upon 20). Assuming that the

companys EPS is likely to be Rs 20 each year, it will take 5 years for the investor to realize Rs 100. Of course, the
assumption here is that the companys EPS is not growing at all.
Now taking the example of commonly traded stocks like Infosys and Tisco. While the former trades at a P/E multiple of 25
times, the latter trades at 7 times. Why is it so? It is believed that the stock price of a company tracks its long-term
earnings growth potential. In an economy, some companies (or sectors) are likely to grow at a faster (like say software or
pharma) rate. So, the P/E multiple of companies from these sectors are likely to be higher and vice versa. Depending
upon growth expectations, the P/E multiple could vary.
There is one crucial factor here i.e. expectations. Though Infosys may be trading at 25 times earnings, if EPS is expected
to grow by 25% per annum, the investor could realize the money in four years.
P/E Is it a discount or a multiple?
There are two ways of quoting P/E valuations:
1.

Tisco is currently trading at Rs 350 discounting its earnings by 5.5 times

2.

Tisco is currently trading at Rs 350 at a P/E multiple of 5.5 times

Which is right? The answer to this lies in the formula for calculating P/E itself.
P/E is Market price divided by EPS. If we were to reverse the formula,
Market price = P/E multiplied by EPS. Stock prices reflect future earnings potential and not past performance.
Discounting the current price with historical EPS is not a right way to analyse companies.
Take a hypothetical case. If Tiscos EPS for the next year is expected at Rs 50 and the growth in EPS is around 15%, the
market price is calculated by multiplying Rs 50 with 15 times i.e. Rs 750. When determining the stock price, one does not
discount earnings but multiply earnings.
What is the right P/E multiple for a stock?
The answer to this question is not easy. In the previous example, we have assigned a P/E multiple of 15 times because
EPS is expected to grow by 15% in the immediate year. Is this the right way? Not necessarily. Here, it is important to
understand industry characteristics of the company.
For a commodity stock like Tisco, EPS tends to grow at a faster rate when steel prices are recovering or are at the peak
and the EPS is likely to decline at a faster rate during downturns. To qualify this statement, if we look at EPS growth of
Tisco from 1994 to 2004, the compounded growth in earnings is 17%. However, the CAGR growth in the last three years
was 193% (the recovery phase). So, if one believes that steel demand is likely to trace long-term economic growth and
that 15% growth is unsustainable, the P/E multiple should be ideally much lower than 15 times. Similarly, the long-term
growth prospects for software companies could be much higher than commodities. So, the P/E multiple for software
stocks could be at a premium.
Determining the P/E multiple for a stock/sector also depends on:
1.

Historical performance Why does Infosys trade at a higher P/E multiple compared to Satyam? By historical
performance, we mean, focus of the management (without unrelated diversifications), ability to outperform
competitors in downturn/upturns and promise vs performance. This can be gauged if one looks at the last three
to five year annual reports of a company.

2.

The sector characteristics Margin profile, whether it is asset intensive and intensity of competition. Less
asset intensive sectors (say, FMCG) are considered defensive and therefore, could trade a premium to the
overall market.

3.

And more importantly, expectations. Take the case of textile stocks. Expectations of significant growth
opportunities post the 2005 quote regime phase out has resulted in upgradation of P/E multiple of the textile
sector.

When is P/E not useful?

1.

Economic cycles - In FY02, Tisco was trading at a P/E multiple of 20.5 times its FY02 earnings. Was it
expensive? Based on FY05 expected earnings, Tisco is trading at a P/E multiple of 5 times its earnings (at Rs
250). Is it cheap? If one ignored Tisco in FY02 on the basis that it was expensive on the P/E multiple in FY02,
the opportunity loss is as much as 350%. Businesses operate in cycles. During downturn, EPS will be low but
P/E will be inflated and vice versa. At the same time, during expansionary phase, corporates invest in
capacities. In this case, high depreciation costs suppress earnings. P/E, in this context, may mislead investors.

2.

Not actively tracked There are number of companies in the Indian stock market that are not actively tracked
by investors, analyst and institutions. For example, Infosys average price was Rs 2 in FY94 and the P/E
multiple was 17 times. At times, P/E multiple may be lower because some sectors/stocks are not in the
limelight.

3.

Expectations On the downside, some stocks may be trading at a significant premium because earnings
expectations are higher. High P/E also does not mean a good stock to buy. What if the expectations are
unrealistic? One needs to exercise caution to this extent.

4.

Means little as a standalone number P/E, as a standalone number, means little. Besides P/E, it is also
important to look at margins, return on net worth, cash generating ability and consistency in performance over
the years to assign a value to a stock.

5.

Market sentiment During bear phases or when interest in stocks is low, valuations could be depressed. Since
equities are considered less attractive during these periods, valuations are likely to be below historical average
or below earnings growth prospects.

When is P/E useful?

A powerful metric Unlike metrics like discounted cash flow method and so on, P/E is relatively a simple and at the
same time, a powerful metric from a retail investor perspective. Though the factors behind determining the right P/E
multiple are important, a historical perspective of a stocks P/E could make this exercise less complex.
To conclude, valuation of stocks involves subjectivity. A person X may assign a higher P/E multiple to the stock as
compared to a person Y depending on the risk profile and growth expectations. In the end, it all boils down to how the
company is likely to perform.
It is not that stock market is always right when it comes to valuing a stock! As Mr. Benjamin Graham puts it in the short
term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and
partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue
(business) is recorded by an exact and impersonal mechanism. Watch the earnings!
Mr. Market and YOU
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"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.' This
was how Benjamin Graham defined 'investment'. And rightly so! At these times, when the markets are witnessing high
levels of volatility, it becomes an ardent need for stockbuyers to understand this difference between a speculative activity
and investment. It requires just a misguided step for investor to turn his investment venture into a speculative
misadventure.
In this regard, Graham's parable of 'Mr. Market' stands in good stead. This is, probably, one of the best metaphors ever
created for explaining how stocks can become mispriced. Through this parable, Graham asks investors to imagine a nonexisting person called Mr. Market who is your (investor's) partner in a private business. He appears daily and names a
price (stock quotation) at which he would either buy your interest or sell you his. Now, despite the fact that both Mr. Market
and you have stable business interests, his quotations are rarely so. At times, he falls so ecstatic that he sees only the
favourable factors affecting business. And this is the time he would name a very high buy-sell price because he fears that
if he does not quote such a high price, you would buy his interest in the enterprise and rob him of imminent gains.
And then there are times when this very Mr. Market is so depressed that he sees nothing but trouble ahead for both
business and the world. These are the occasions when he would name a very low price, as he is terrified that if he does
not do so, you would burden him (sell him) with your interest in the business.
Now, Graham says that if you were a prudent investor or a sensible businessman, you would not let Mr. Market's daily
communication determine your view of the value of your interest in the enterprise. You may be happy to sell out to him

when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But at the rest of
the time, you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company
about its operations and financial position.
What Graham tells investors through this parable of Mr. Market is that they should look at market fluctuations in terms of
the Mr. Market example. They should make these fluctuations as their friend rather then their enemy. This means that they
should neither give in to temptations that rising markets bring with them nor should they think of doom when the markets
are falling incessantly.
Coming back to the abovementioned definition of an investment operation, investors need to have a long-term (two to
three years) perspective when making their investment decision. Only then would the promised safety of principal and an
adequate return accrue to them. Now, the term 'adequate return' typically varies from investor to investor. A high-risk
investor would demand a high return from his investment from the extra bit of risk he is taking. On the other hand, a lowrisk investor would settle for a relatively lower return. Having said that, in a rising market, expectations tend to be on the
higher side without a fundamental premise. Here is where 'Mr. Market' could mislead you. If you believe that 15% per
annum is an 'adequate return', then stick to that irrespective of whether it is a bull market or a bear market. Otherwise, you
are changing i.e. risk profile is changing, which is not required.
As Graham says, '...in the short term, the market is a 'voting' machine whereon countless individuals register choices that
are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which
the value of each issue (business) is recorded by an exact and impersonal mechanism.' Happy investing!
Note: Characters in italics are quotes from Benjamin Graham