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Hi John
A company’s EPS and PE ratio are used to determine the right price for buying the stock
After you have identified the stock you wish to buy, in order to decide when to buy you must take in to account the Earnings Per Share (EPS) and the Price to Earnings (PE) ratio of the company.
EPS is the total earnings or profit made by a company (during a given period of time) calculated on a per share basis. It aims to give an exact evaluation of the returns that the company can deliver. EPS = Net Profit Divided by the total number of shares issued by the company.
Example: If the Company XYZ has issued 10 lakh shares to its share holders and has earned a net profit of Rs. 10 lakh, it has an EPS of Re 1 (Rs 10 Lakh Divided by 10 Lakh shares).
However, for determining how cheap or expensive a particular stock is, EPS must be used in conjunction with the current market price of the share. This is known as the Price to Earnings (P/E)
P/E = Market Price of the Share Divided by the EPS
Example: If the current market price of the company XYZ’s share is Rs. 15 per share and it has an EPS of Rs. 1, its P/E ratio will be 15 (Rs. 15/ Rs. 1). This implies that the company’s stock is selling at a multiple of 15 times its earnings.
P/E is a tool that offers an indication of whether the stock is overpriced, under-priced or adequately valued. However, this method is not fool proof.
In certain cases, the P/E ratio does not offer appropriate results.
Example: In case of a new company with very good business potential, although the company may be currently loss – making, the stock price will be high, resulting in the high P/E ratio. In this case, although the P/E ratio is high it would make sense to invest in the stock. It is advisable to use the P/E tool in conjunction with your overall analysis of the stock, its industry and the overall market trend.
similarly Assessing when to Sell
You must sell the share when it reaches its target price
OR
When it reaches its “stop loss” price
Once the stock reaches its ‘Target’ Price, before making an investment, your stock study should help you assess the price at which you will be ready to book your profits. This is called the ‘target price’. The target price can be computed by assessing the company’s estimated financial performance over the next 3 to 5 years, computing its EPS and using and acceptable P/E ratio to compute the future market price. Based on this future estimated market price and your required return on your investment, compute your target price.
When the price reaches ‘Stop Loss’ it is advisable to always consider the possibility of loss before making your investment. You should decide how much loss you are willing to book in the stock. This lower price i.e. the price at which you are willing to curtail your loss, is called ‘Stop Loss’.
Rafi Ahmed
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