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One real life habit we foolishly forget in stocks

Feb 16, 2010

As it happens often, many investors end up doing things in the stock market they would never otherwise even think of doing in real life. Take paying an advance for example. We seldom like to pay for something before we receive it in our custody. We would much rather pay for it once we get it in our hands and have checked if everything is alright with it. As much as possible, we do this for everything that we buy. Whether that is something as trivial as clothes, or something more expensive and complex like a television. It is our hard earned money we are spending afterall. We have to be careful isn't it?

But when it comes to the stock market, things change. And quite surprisingly so. Investors do not mind adopting an attitude completely opposite to the one mentioned above.

Here, it is not uncommon to see investors pay for the extremely seductive 'growth' factor even years in advance. Many expensive, and sometimes even preposterous valuations are paid for without as much as a thought. All in the name of the future growth that a company is expected to show. Many a times, this expected future growth of the company is paid for so much in advance, that it almost unbelievable.

Let's take the example of Wipro, one of India's brightest and most profitable software companies. The company's stock was selling at mind boggling price to earnings ratio of 784 times in February 2000. This means that for every one rupee of annual profit that the company was making, investors were willing to pay Rs 784 to attain the ownership of that rupee. In other words, investors were willing to settle for a yield of just about 0.1% per annum (Re 1 divided by the per share price of Rs 784).

Even if one considers that the company would growth its profits consistently at the rate of 50% per annum (which is extremely difficult by any standards), it would take the investor almost 11 years for him to start earning even a decent yield of 7% on the price he paid for the stock.

Below is a tabulation of that calculation -

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11
Earnings per share 1 1.5 2.3 3.4 5.1 7.6 11.4 17.1 25.6 38.4 57.7
Growth rate 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Yield on cost price 0.10% 0.20% 0.30% 0.40% 0.60% 1.00% 1.50% 2.20% 3.30% 4.90% 7.30%

In real life, that would be like paying for a television whose delivery you expect to receive 11 years from now. Let alone the fact that depending on the way things turn out from now until then, you may not even end up getting its delivery in the first place.

No wonder then that Wipro is still a far cry from the high of Rs 1,604 it touched about a decade back in February 2000. It is important to note here that the company is still alive and kicking, and is infact doing very well by itself. But for the investors who placed such extreme expectations on the company, and readily paid for such expectations years in advance, there was no option but to be met with disappointment.

Indeed, when future expectations are restricted only by the generosity of one's emotions and imagination, heartbreak is, more often than not, just around the corner.

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