Have you ever wondered what exactly a share of a company means? Or do you just want to know how you can calculate EPS, Book Value, & P/E Ratio for Nepalese companies? Then you have found the right article. Here, I will do my best to explain these terminologies in a simple but effective way. After reading this article (maybe a few times), you will be able to understand the following :
- What is a share & shares outstanding
- EPS (Earnings Per Share) and Book Value of a stock and How to Calculate them
- P/E (Price to Earnings Ratio) and how to calculate It
- Why do I think we are prone to buy into a bad business or overpay for a stock?
What is a Share & Shares Outstanding
Let us continue from the last article. In the previous article, we discussed how the owner decides the market price of the company. Let’s say he is willing to sell the company for Rs.1,00,000. In such a case, if nothing changes, then you can expect to make a 20% return on your investment in the following year. We also discussed that the margin of safety of the company is low because the equity of the business is only 10% of the market price.
In such a case, the owner can decide to divide his company into small pieces that many can buy. Let’s say the owner chooses to divide the business into 10,000 Pieces. Which means each piece will now have a market price of Rs. 10. The 10,000 Pieces are the shares outstanding, and the individual piece is called a share. Hence, when you own a stock of a company, you own a piece of that company. For, e.g. a company like Nabil Bank has 100932664 Shares outstanding. So when you own a single share of Nabil bank, you own (1/100932664)the parts of Nabil bank.
Hence from our example, we have concluded three things
- Net Income of the Business = Rs 20,000
- Equity of the Business = Rs. 10,000
- Market Price of the Business = Rs 1,00,000
EPS (Earnings Per Share) and Book Value of a stock
To understand these terminologies, we have to consider each individual piece (shares) of a business as a separate small company. Hence EPS is the same as the net income. i.e. the net income of a single share. EPS is calculated as:
- EPS = (Net Income/ Shares Outstanding)= i.e. Rs. 2 as per our example.
Similarly, Book value is the same as the total equity. i.e. equity of a single share. Book value is calculated as :
- Book Value of a Stock = (equity/ Shares Outstanding)= i.e Rs.1 as per our example.
Because Book value is similar to equity, it can quickly help you calculate the margin of safety of owning a single piece of that business. In our case, it will be Rs. 10 (Market Price) – Rs.1(Book Value) = Rs.9 (Hence margin of safety is low).
Hence from our example, we have concluded three things
- EPS = Rs. 2
- Book Value = Rs. 1
- Market Price of the shares = Rs 10
P/E (Price to Earnings Ratio)
Price to earnings ratio is a critical factor a lot of investors see before even starting to analyze a company. P/E ratio of a company can quickly give you an idea of how expensive or cheap it will be to own the stock of that company. P/E ratios are deemed so valuable that many investors use the P/E value alone for making a decision to invest. Let, us first see how the P/E ratio is calculated to properly understand it:
- P/E Ratio = (Market Price/ EPS) = (10/2)= 5
What this value helps us to understand is that, if you spend Rs. 5 buying a single share of the company you can expect to make a profit of Rs.1 a year later. Hence, if the P/E ratio of a company is high, then its shares may be too expensive to buy. And as we have already discussed in the last article, the premium you pay for owning the stock will eat away at your return.
Why do I think we are prone to buy bad businesses or overpay for stocks?
There are many reasons as to why people overpay for a stock. But, I would like to highlight two significant reasons as to why I think we are so prone to buy a bad business or overpay for a stock.
Firstly, we disregard proportions entirely. To understand this, let’s look at a hypothetical scenario. If a stock selling at Rs 100 rises to Rs 200, then that is a 100% rise in price. But if a stock selling at 1000 rises to 1500, then that is only a 50% rise in price.
Let’s consider the fruit business, will you pay Rs 10,00,000 for the company? You might be saying, “Don’t be crazy”. Fine, then let’s say, would you buy the entirety of Nabil bank for Rs. 1 Kharba. You will probably scratch your head with this one. That is because Nabil Bank is a huge company. But in both cases, the prices are outrageous. They are both 10 times the total market value. My point is our ability to understand big numbers is completely screwed up. The only way to solve this problem is to look at Percentage Change rather than the change in Numbers.
Secondly, the role of media and the availability bias we all have as human beings. Most of the time, we make emotional decisions based on the information that is readily available to us. If you heard the news about a plane crash, then you will most likely be afraid to fly on a plane the very next day. Even though the facts do not support your fear. This is why news provided by the media can influence investment decisions. And most of the time it does. If a bad company is really good at marketing, then the good news being published in the media can certainly make people overvalue the stocks of that company. People hike up the prices, and others do the same, also known as Herd Mentality.
And the opposite is also true. If a good company is poorly portrayed in the media, then its shares may be undervalued. That is why we have to be careful about the actions we take based on the information we get from the media. Always Make your decisions based on financial reports of the company, and you will be able to outmanoeuvre this fallacy to a large extent. Sometimes the roles that media play can actually be beneficial to an individual investor. The bad news of a company can help you buy stocks at a bargain price.
Last articles on Value Investing
- Shares are basically pieces of a company that you can own.
- EPS is the net income for a single share
- Book value is the total equity of a single share
- P/E ratio is an excellent indicator to define the price you will be paying to own a stock
- We are prone to make stupid decisions when buying a stock because we as human beings have a hard time understanding big numbers
- and that we fall for the availability bias
In the next post, I will be discussing how you can use these ideas to analyze a company here in Nepal. We will be diving deep into where you will be able to find these terms and how to use them to better understand a company here in Nepal.
For more research: you should check out https://www.theinvestorspodcast.com/ as I am sharing the ideas I learned from his videos.