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Beware! Some numbers that can fool you - Views on News from Equitymaster
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  • Dec 9, 2009

    Beware! Some numbers that can fool you

    Numbers rule the financial world. Anything to do with the world of finance and the first thing you have to deal with is a fortress of numbers. For the layperson or amateur, it can be quite an intimidating task. It is not surprising then that many an unsuspecting investor finds himself frequently misguided by this deceptive characteristics of numbers.

    Lest you become one of them, we present to you some common illusory or confusing situations involving numbers. And how to untangle yourself from the mess. After all, as an investor, the last thing you would want is to make in investing decision on the basis of some such number only to later realize that things were not what you earlier thought they were.

    Low base effect: Year on year growth figures are most often used by analysts and media to express the growth of something. Growth in GDP, car sales, company earnings, revenues, inflation, share prices, IIP, stock indices etc are all frequently measured and published. Since the 'growth' factor is given so much of attention and importance, a good growth figure or a bad one may often push you to make an investing decision.

    But caution is required in interpreting a growth number. A growth number is arrived at in the following way -

    If earnings of a company in the September quarter last year were Rs 5 m and are Rs 9 m this year, you would get a year on year (YoY) growth figure of 80%. But the most important thing to remember about this '80%' is that it was arrived at by a division calculation in which the denominator is the previous period's figure. Thus, if the previous year's figure is one which is affected by some abnormal phenomenon, the 'growth' figure itself may end up being one which distorts the true picture. It is essential then that one not look at only the growth figure independently to arrive at its meaning, but also study the usefulness and relevance of the other two figures involved in the calculation - the numerator and the denominator.

    Very high or low P/E ratio: The P/E (price to earnings) ratio is one of the most popular tools to gauge how expensive or cheap a stock is. But if you have the habit of only looking at the single P/E ratio number and passing a judgement accordingly, you will need to approach things a little more carefully. This is somewhat an offshoot of the earlier point. The P/E ratio is arrived at by dividing the price of a stock by its earnings per share (EPS).

    Thus, having a long hard look at the quality of the EPS that goes into the calculation is extremely important. The company may have had an exceptionally good year or an exceptionally bad year. Or it may have had some non recurring gain or loss during the period. These factors can cause the P/E ratio to look unduly low or abnormally high. And thus make the stock look too cheap or too expensive respectively even though that might not actually be the case. Here again, one needs to closely study the quality of the EPS figure that goes into the calculation. This is the only thing that will help one decide how seriously that P/E ratio figure should be taken.

    Gauging your returns - Point to point v/s CAGR: 'Returns' are foremost on an investor's mind. But when it comes to calculating how good or bad one's returns have been, investors frequently find themselves at a loss. There are two popular methods. One is the 'point to point' method where you just divide your gains by the initial amount you invested to get your returns. So say you initially invested Rs 1 lakh, and are now getting back Rs 1.5. Your gains in this case are Rs 50,000 and your point to point return would be 50% (50,000 divided by 1 lakh).

    The other method is the compounded annual growth rate or CAGR. Its calculation is as follows -

    {(Ending value/beginning value) raised to (1/number of years)} - 1

    So if your 1 lakh became 1.5 lakh after 5 years, your CAGR return according to the above formula would be 8.4% annually. This means that if you had made 8.4% returns in a year on the 1 lakh you invested and reinvested the initial amount and the year's return to earn another 8.4% the next year and so on, you would end up with Rs 1.5 lakh after 5 years.

    Whether point to point or CAGR is a better way to gauge your returns depends on your ultimate objective. However, it must be noted that CAGR gets the all important element of time value of money in the picture, which is important when judging your investing returns.

    High growth rates / upward trend of earnings: When judging the growth potential of a company which has been growing consistently over the past few years, it is tempting to extrapolate that growth into the future too while valuing the company. This can be very dangerous and one should be particularly wary of doing so when times are good. One needs to put a lot of thought into exactly why the company's earnings have been growing and the sustainability of that growth. It is indeed a difficult task to do so. But nonetheless, one of utmost importance. This is where the qualitative analysis of the company and its business will come to the forefront and deserves careful scrutiny by the investor.

    Price of a stock: Many lay investors think the absolute price of stock conveys how attractive it is. For example, a stock worth Rs 25 would be considered to be cheap. Whereas a Rs 1,000 stock would be considered to be expensive. Nothing could be more further from the truth. A stock's attractiveness is gauged through other methods and ratios like price to earnings (P/E), price to book (P/B), dividend yield, discounted cash flows etc. While we will not get into the details of each of those, if you are one of the above, we suggest you do some quality reading on the above methods before forming any opinion about the price of a stock.

    Billions and millions: Many find themselves utterly confused about the interchangeability between million, lakh, billion and crore. So here's a quick note on the conversion. 1 million is equal to 10 lakh. And 1 billion is equal to 100 crore. This nomenclature is only to do with the grouping of numbers, and has nothing to do with currency. Hence, converting rupees to dollars should not be mixed with converting from one thing to the other as shown above.

    We hope the above discussion has helped give you a good head start in minding your way in the confusing world of numbers that finance is built on.



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