Power of Price
Second, the ‘Power of Price’
We mentioned how it is the value that needs to be looked at when “selecting” future companies. That does not mean that price is to be disregarded. It is just that value needs to be looked at FIRST and then price.
So, what is the difference between the two?
Value is something invisible that is derived from the business and the story of the company. However, price is the value that the market assigns to that business.
It is important to know that good stocks do not always rally upwards. A good stock will drop when an irrational investor exits. That is when the rational investor needs to sit back and hold. You must hold a stock when you believe in the attractiveness of the business, rather than being swayed by the price movements.
It is imperative to analyse if the investment has the potential to provide expected returns in the intended time horizon. Let me introduce you to the Rule of 72 here which will help you to roughly calculate the time span in which your investment will be doubled. If a stock’s compounded annual growth rate is 40%. Then your investment in the stock will double in = (72/40) years i.e. 1.8 years.
[Formula: Years to double = 72/growth rate in percentage]
Now, suppose the P/E of a particular stock is 60 right now and it's earnings are expected to grow at a CAGR of 40%. Let the current price of the stock be P1 and earnings per share be E1. Therefore, P1/E1= 60. Five years later, let the earnings per share be E2. As the earnings grow by 40% each year for 5 years, E2= E1*(1+40%)^5
(1+40%)^5 = 1.4^5 = 5.38= 5 (approx)
Therefore, E2= 5*E1
So, 5 years later, if the price of the stock remains same, i.e. E1, the P/E ratio becomes P/E = P1/E2 = P1/5*E1 = 60/5 = 12
When estimating future earnings growth, another important thing to keep in mind is to estimate how much of this future growth is already discounted into the current price. For this, it is important to understand what all does the market overtly know. To beat the market, one needs to conduct in-depth analysis which can uncover a lot of hidden information about the company (both qualitative and quantitative). This information will not be factored into the current price and that gives the opportunity to a rational, well-researched investor to make money in the stock market.