Understanding Uncertainty
Certainty and stock investing don’t go hand in hand . You can do nothing to prevent uncertainty, but you can protect yourself against it by better understanding.
What’s Volatility ?
Volatility is a measure of fluctuation in the price of a stock, market index or value of any asset. If the price of a share rises to a high of Rs. 27, falls to a low of Rs. 17 within a day and finally closes at Rs. 20, its volatility for the day is 50%. Generally it is taken to be proxy for risk: the higher the volatility, the riskier the investment in the asset. But higher risk, caused by high volatility, does not always mean lower return. On the contrary high volatility can co-exist with high returns, and the reverse can also be true.
What causes Volatility ?
Globalization – On 28th February stock prices went into a freefall following the fall in the Chinese stock markets. A few days later a rise in the yen’s value created panic in the market. Effects of globalization – largely good, but not always hunky dory.
Interest Rate – A fall or rise in interest rates effect returns from debt investments, which becomes more or less attractive. This can have a domino effect on stock investments too. If debt is less attractive, more money will go into equity r vice versa .
Events – There are predictable events like the union budgets or a company AGM that could trigger market volatility. Then there are unexpected political events or just a statement by a global leader that could set off a market frenzy overnight .
Checking Volatility
Volatility can’t be prevented, but it can be moderated to some extent. Stock exchanges have circuit breakers for certain types of shares- which mean that trading is suspended in the stock for a specified period if it – falls by pre-defined percentage. The percentage varies across different categories of stock and is also extended to the market indices.
Fall – No copy book definition, but a drop in the indices (sensex and nifty) over the previous day’s closing value can be termed a fall, especially if it recovers lost ground the next day .
Crash – Again no fixed definition, but a crash is a huge and sustained fall. The 565 point (11%)fall in the sensex two days after the UPA government took over reins in Delhi in May 2004 was a Crash suspended trading.Its better to look at percentage - rather than absolute fall to distinguish a fall from a crash .
Correction – A short, measured fall in prices, especially one that shaves off some gains from a continued rally is a correction. It is considered good because during a correction, the ownership of shares moves from weak hands (short term investors) to strong hands (long-term investors).
Beyond volatility
One way to ride volatility is to understand the critical link between a company’s performance and its stock price. Here are several ratios to help you do that –
The Ratios
1) P/E
What it is – Price to earning ratio measures relation between the price of stock and the company’s earnings(profits).
What it means – A high P/E suggests investors expect higher earnings growth in the future compared to companies with a lower P/E.
Calculation - (market price per share)/ (earning per share)
2) PEG
What it is – Price/earnings to growth ratio takes into account projected growth in the company’s earning.
What it means – A lower PEG ratio generally indicates undervalued stock. Reliability of PEG depends on credibility of earnings forecast.
Calculation - (price/earning ratio) / (Projected EPS growth)
3) EPS
What it is – The key difference between a company’s profit and its profitability, it shows profits per share.
What it means – The most important variable in determining a share’s price. It’s useful in comparing companies, especially in same industry.
Calculation- (Net profit) / (Total number of shares)
4) P/S
What it is – Share price of a company relative to its sales, or market value to revenue ratio.
What it means – Varies substantially across industries; useful only in comparing similar
Companies. The lower the P/S, the better the value .
Calculation – Share Price / Revenue per share
5) P/BV
What it is – Ratio of the market value of a company and the value of a company’s asset, after
adjusting for liabilities.
What it means – Difference between the market value of a company and the value of the
Company assign itself. Low P/BV means better value.
Calculation- (Market capitalization) / (Total assets-liabilities)
6) ROE
What it is – Return on equity, also known as return on net worth, shows the efficiency of capital use by a company.
What it means – Shows how much profit is generated with the money shareholders have invested, excluding the debt.
Calculation- (Net Profit)/(Shareholder equity)
7) CURRENT RATIO
What it is – Measures a company’s ability to pay short term obligations.
What it means- A ratio under I suggests the company would find it tough to pay off its short-term debts.
Calculation- (current assets)/(Current Liabilities)
