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Buying stocks set to become more difficult? - Views on News from Equitymaster
 
 
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  • Mar 23, 2012

    Buying stocks set to become more difficult?

    Equities in general are considered a risky asset class. Government bonds are considered to be a risk-free asset class. As risks are lower in the latter, the returns are lesser as well. Vice-versa is the case for the former.

    As such, it would be natural to gauge and compare the risk-return correlation between these asset classes. This is where the concept of earnings yield comes in. Let's discuss this further with the help of a very simple example. Suppose a government bond has a coupon rate (interest rate) of 8%. This means that investing in such a bond would essentially allow one to recover (or double) his money over a period of 12.5 years (1 divided by 8%).

    Using this logic towards investing in stocks, essentially, an ideal P/E ratio for a stock would be 12.5 times. Or, one can say that in comparison to the riskiness associated with stocks, one should try not buy a stocks valued at a P/E ratio higher than 12.5 times.

    It should be kept in mind that this logic leaves aside the concept of a quality of earnings and factors such as future prospects or higher earnings. This logic would largely apply to companies with average prospects. It would be a good tool for value investors who would not be willing to take a call on the future earnings of a company and base their stock screening and picking decisions. This means that they are gauging the stocks based on their past average earnings.

    P/E ratio can be looked at as a price tag - how many times the earnings is the market willing to pay to be part of the company's fortunes. The reciprocal of the P/E ratio (dividing 1 by the P/E) would give the earnings yield on the stock. For example the P/E of a stock is 12.5, and then reciprocal works out to be 8% (its earnings yield). Similar to how we looked at the above example of earning yield on a bond, a stock can be gauged in such a manner.

    What this ratio also depicts is that if a company's earnings did not grow at all in the future, it would take the investor the P/E' number of years to get back the money invested into the company.

    Now, bond yields in India have risen post the budget. And with the government expected to borrow more (Rs 5.7 trillion rupees as compared to the expected figure of Rs 5.3 trillion) going forward and that too in a high interest environment such as now, bonds yields could rise further in the future.

    As per Bloomberg, the current yield India's government bond stands at 8.387%, translating into a yield of about 11.9.

    Below is a small chart showing the yields corresponding to the varying bond coupon rates.

    Coupon rate (%) Yield
    8.00 12.5
    8.25 12.1
    8.50 11.8
    8.75 11.4
    9.00 11.1
    9.25 10.8
    9.50 10.5

    Source: Equitymaster data

    What all of this essentially translates into is that it would make stock selecting and finally buying more stringent for value investors. It would be difficult to find good stocks with good long term track records at attractive valuations.

      Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

     

     

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