Making sense of the geek talk: II

‘Earnings Per Share (EPS)’ and ‘Price-to-Earnings Ratio (P/E Ratio)’ are closely followed by ‘Price/Earnings to Growth Ratio’ or more commonly ‘PEG Ratio’. This ratio of a stock is derived when its P/E ratio is divided by the growth rate of its earnings. Growth rate is calculated through comparing the net growth in earnings this year with the total earnings of the previous year. If we can calculate the growth rates of multiple years, we could take an average of these to make more accurate predictions. A larger number of investors and analysts like to use the growth rates of at least three to five years to compute the average growth rate. Unlike in the past, we no longer need to do our own calculations meticulously and instead can use the estimated data available on online financial portals.

In the previous issue, I had said that during the bullish trend, P/E ratio of even the fundamentally weak scrip becomes high. But during the bearish trend, the P/E ratio of even stronger companies go low and lower. Low P/E ratio attracts long term investors into such scrips. But if a scrip with lower P/E ratio has negative growth, the investment will have questionable future. The remedy is to assess the PEG ratio. Lower PEG ratio shows that the stock is undervalued with respect to its estimated future earnings, while the higher PEG means the stock is overpriced in comparison to its growth potential. Generally, when the PEG ratio of a stock is higher than 1.0, it is assessed as overvalued and a stock with a PEG ratio of less than 1.0 is assessed as undervalued. PEG ratio assessment is no different to understanding that taking one too many peg will put your health at risk!

‘Return on Investment (ROI)’ measures the profitability of an investment. It calculates the estimated yield from an investment, in relation to the cost of investment. When we divide the yield (from an investment), by the cost of the investment, we determine the ROI. Positive ROI means the investment is worthwhile while negative ROI highlights the possibility of loss.

ROI is a popular tool among investors as its calculation is relatively easy. Also, it is easy to interpret and it has multiple usage. ROI is not only used in the stock market but also to assess the profitability of an investment project by both the public and private sectors.

‘Float’ in stock market means the number of shares available with the public for regular buying and selling purposes. This number is calculated by subtracting the promoter’s share, government owned share and the share under lock-in period—shares issued to the affected local public of the project site and shares issued to the employees of the company can be traded after a minimum three years—from the total shares outstanding. Float provides a picture of real supply situation of a particular stock. Lower float means less supply for regular trading and this at times leads to artificial demand, leading to unnatural price fluctuation. When one does not have an understanding of the float, there is a chance of him/her falling into buying trap.