For a financial layman, like I was a year ago, the price of a stock is a mystery. Why does Microsoft trade at $25 whereas Google trades at $450? And why do analysts mean when they say Google is cheap at $450? Isn't MS dirt cheap at $25 then?
That's the first rule. The price by itself doesn't tell you anything. What you need to know is the price of a stock relative to its value – another term relentlessly abused by the financial press and analysts. Let me try and debunk this mystery.
Buying a stock is an investment so you expect some returns. Think of a bank term deposit. Let's say, you put in $1000 for a year, the bank pays you some interest. The interest is your return from the deposit. Of course, the big difference between the two is that the returns of a stock are not well-defined. Let's dig deeper.
If you hold a stock, your return can either be capital gains or dividends. Capital gains are simply the profits you make when you sell the stock at a price higher than what you paid to purchase it. For example, if you buy MS at $25 and sell at $40, your capital gains are $15. Dividends are cash payments made to you by the company at regular intervals, usually annually or quarterly. For example, MS recently announced a quarterly dividend of $0.13 per share.
Now that we know the types of returns, the big question is, how do you know if a stock will deliver any returns? And are those returns good enough? Let me answer the second question first. Your stock has to at least beat the 5% APR offered by your bank, if not, what's the point? Might as well invest your money in bank deposits and sleep in peace. But, are you happy if the stock returns exactly 5%? No, because you are taking on an appreciably higher risk by investing in the market. When you take that kind of a risk, you expect to get rewarded. So the return from a stock has to be definitely higher than your bank rate. But, how much higher?
For a moment, let's set our stock aside and take the stock market as a whole (or simply the "market'). The market is represented by indexes such as Dow Jones, NASDAQ and S&P 500 – there are many more, but these are the popular ones. These indexes are comprised of multiple stocks from various industries. So you will have stocks from FMCG, tech, telecom, infrastructure etc. Some of these cos will be good, some bad, some growing and some declining. Let's say you want to invest your money in the "market" - in other words, think that you are buying 1 stock of the S&P 500 index. What should be your return? There are ways to derive this, but the simplest way is to look at the returns delivered by S&P 500 in the past. Take the year-end values of S&P 500 over the past 30 years, find out the annual return (annual growth, to put it crudely). Now, determine the difference between the S&P return and your bank rate. This delta is called the Market Risk Premium, which is the additional return you are expecting because you took the additional risk of investing in the stock market rather than the safer term deposit.
But remember that the stock market has many companies so the negative effects of some stocks are offset by the positive effects of others. For every Sun that fails, there is an Apple or a Google that delivers stellar performance. So the risk of investing in the "market" is different from that of buying a specific stock. Some stocks are safer than the market and others are riskier. For example, P&G has been making hair and body care products since forever. And unless we dramatically change our ways of personal hygiene, it is fair to assume that P&G will continue to sell its products. So, it is a safer bet. Contrast it with Google, which is threatening MS and Apple today, but could just as easily be threatened by Facebook or MySpace. Therefore, Google is riskier than the market.
To determine the relative risk of a stock versus the market, analysts use a term called Beta. Without getting into the details, it is a factor to arrive at the risk premium for your stock, which is a product of your stock's beta and the Market Risk Premium. (By the way, the Beta of the market is 1.) Beta for cos such as Google will be >1, and that of Unilever etc is <1. Now add this to your bank rate to find out the return you must get from the stock. Let's take an example.
Say, annual returns of S&P over last 30 years is 8%
Beta of Google is 1.17
Your bank deposit rate is 5% (Technically, this should be the rate on US treasury bonds, but this is a fair approximation.)
Therefore, Market Risk Premium (MRP) = 8% - 5% = 3%
Risk premium for Google = Beta * MRP = 1.17 * 3% = 3.51%
So expected return for Google = 5% + 3.51% = 8.51%
In other words, Google is an attractive stock, if and only if, it offers returns above 8.51%. The next part will discuss how to determine this.
To be continued…
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