How is a stock valued??? This is the most basic question asked by any investor , especially if he is a newbie who is just cautiously putting his first $1,000 in stock market with the hope of applying the jargon "Let money work for me". There are zillions of books written about it and thousands make living selling there analysis in the form of research reports that would unearth the hidden gems and make you rich forever..... A basic formula that everyone applies to come up with a stock price is by multiplying a factor to the earnings per share (EPS) . This factor is commonly called as P/E. If its that simple then WHY :
1. The stock prices change every minute. Afterall we cant be that sloppy in our calculations.
2. Why the earnings multiple varies from stock to stock. For instance an insurance stock might be selling at 10 times the earnings , while a Tech stock might be selling at 40 times.
What is the easiest and least risky way of growing your money? Its by keeping your money with Uncle Sam. Yup, no kidding......Its not just Americans but the whole world's assumption that the least risky way of growing your money is by buying the Treasury Bills (T-Bills). But you can think yourself lucky if you can get an interest above 1% with this investment. So any investment product that will fetch greater than 1% is better than investing in T-Bill. But in order to get that one will need to take some risk. The excess return above 1% is called the risk premium.
Lending to Susie's Beauty Salon : So as an alternative to putting the money in T-Bill you decide to lend it to an upcoming local Salon called Susie's Beauty Salon. Its an upcoming place and its sole owner Susie is looking for extra capital to expand her shop. She promises the lender a 10% return. But there is a covenant to this deal, if the business goes bellyup the investor looses his capital. So the excessive 9% return is paid for the additional risk lender is taking by lending her the money.Because of her great managerial skills the business turns out good and all her lenders are paid in time. 5 years down the line her salon is ranked in top 10% in the county and creates a brand value recognized by young women. Her business becomes more predictable and less risky. So more lenders are ready to lend her now. Thus there is competition amongst lenders and the one that excepts the least interest rate gets to do business with her. Thus the new set of lenders have to settle for 5% rate because the less risk business is carrying
Investing in Susie's Beauty Salon : Next year she plans to go big and compete with the likes of Super cuts and create a national Beauty Franchise. She now invites investors to be her partners rather than just lenders and in return makes them eligible for there share of profits. The business issues 1 million shares of $10 each. The profits first year after going public is $1.2mn. This equates to $1.20 / share.A return of 12%. ($1.20 / $10).
Looking at these impressive numbers, new investors flock in and start approaching the present investors to sell the shares. Afterall who wouldnt like the gains of 12% in return of accepting a risk that is equivalent to 5% return.Its like heads I get 12 cents and tails I loose 5 cents.Thus the new investors offer a premium to the original $10 share price.
This premium keeps increasing till the earnings per share equate to 5% of the share price (Equivalent return a person can get by lending the money to a business with similar risk). Thus the share prices shoots from $10 to $24 . Making the P/E multiple as 20
This becomes hot news in the market.The Investors who missed the boat start following the business very minutely. They start monitoring the business closely and adjusting there estimates to Earnings per share accordingly .
On basis of its great brand value, Susie's Beauty Salon gets a lucrative deal of being a sole supplier of a leading beauty products company. The analysts estimate that the earnings would increase by 10%. The stock thus shoots up by 10% to $26.2. Making the current P/E as 22 with the assumption that the next year's P/E will be 20 because of 10% growth in earnings.
So now we know that the P/E multiple is made of two components :
1. Directly proportional to growth in future earnings.
2. Inversely proportional to return rate on bonds (debt instruments) on businesses with equivalent risk.
Following is another scenario that explains the above fact. As a growth strategy, Susie's Beauty Salon plans to acquire a hair restoration business. Hair restoration business seems to be more risky than her present one, Thus the lender demand an interest rate of 10%. The P/E multiple to match that will come down from 22 to 11 and the stock falls by 50% from $24 to $12.
RECAP OF THE CASE STUDY " SUSIE'S BEAUTY SALON":
1. When the business started the lenders demanded a 10% interest rate.
2. As the business grew and became more predictable and less risky , Susie got better deal and hence the interest rate dropped to 5%.
3. When the business opened up for new investors , the initial stock price was $10.
4. The first year's earnings per share was $1.20.
5. This was 12% return and the equivalent interest rate for the risk business possessed was 5%.
6. Thus to bring an equilibrium between interest rate and the multiple between the earnings per share and stock price, the stock goes up to $24.
7. The news of the company getting sole rights to market a leading brand of beauty poducts helps the stock go up by 10%, because the investors assume that this new development will increase the earnings per share by 10%. The stock price goes up to $26.2
8. With the acquisition of the hair restoration business, the original business becomes more risky and the interest rate for its debt shoots up to 10%. Thus the equilibrium for interest rate and P/E multiple is at 10.
9. The stock price thus falls 50% to $13.1.
The story goes on.....and Susie's beauty Salon becomes a highly traded stock in the market. Its stock price hovers around the news that changes one's assumption on the business risks and its future earnings potential.
