Stock Market Basics: Chapter 4

Hi Guys,

In chapter 3 of Stock Market basics, we understood why a company performs corporate actions like Bonus, Dividend, and split and how does it create value for investors. Now in this blog, we will understand what is?Market Capital,?Earning Per Share (EPS)?and how do we use EPS to calculate?Price to earnings (P/E), understand Book Value, and finally the?Price to Book Value (P/B.V).

Let’s understand the above concepts by taking 2 tyre stocks MRF and CEAT.

If we look at the current market price of MRF it is Rs 73880 /- and the current market price of CEAT is Rs 1135/-. Now investors think that both are tyre stocks but MRF is so expensive compared to CEAT so it would be a better option to buy CEAT instead of MRF, but that should not be our thought process when we want to purchase a stock. I will the thesis with the below facts, if you look into the returns these stocks have generated over the last 5 years, MRF grew by 39 % whereas CEAT de-grew by 11 %. So we should not blindly go by the stock price but also need to understand other factors like Market Cap, EPS, P/E, P/BV, etc.

Now let’s see what is Market Capital. In simple definition Market capital is the value of the outstanding shares of a company. Let’s say company X’s share price is Rs 100/- and it has 100000 outstanding shares, then the market capitalization of the company is Rs 100 * 100000 = 1 Cr.

So what is the significance of knowing the Market capitalization of a company? If we take 2 tyre stocks MRF and Balkrishna Industries(BKT), the current market price of MRF is 73880/- and Balkrishna Industries is 2200/-

Now a majority of investors think that MRF is a big company as compared to Balkrishna Industries looking at the share price. But in reality, it’s now, Balkrishna Industries is a big company compared to MRF, look at the market capitalization of these 2 stocks.

So we should not simply look at share price but also need to factor in the Market cap to decide whether the company is big or not in terms of Market Capital, but market capitalization does not alone make the share attractive to buy, we need to consider other factors also.

Earnings Per Share (EPS): In simple terms, EPS is the ratio of the earnings of the company and the total outstanding shares. Let’s say a company X has earned 1 lakh profit and the company has 1000 outstanding shares. So the EPS will be 100000/1000 = Rs 100 /-. So for every share of company X, it is earning Rs 100/-. Below are the EPS of some companies.

The main use of EPS is to calculate the P/E ratio which is also called as Price to Earnings ratio.

In simple terms, the P/E ratio is the amount investors are willing to pay for every 1 rs earned by the company. Let’s say a company X with a current market price of Rs 1000 /- has earned 1 lakh profit and the company has 1000 outstanding shares. So the EPS will be 100000/1000 = Rs 100 /-. Now the P/E will be CMP/100 = 10, So investors are ready to pay Rs 10 and buy the stock of X for every 1 Rs profit earned by the company. So generally a company with low P/E is preferred but we do need to consider other factors also.

Note: Never compare 2 companies in different sectors based on their P/E, we should not compare an FMCG stock with Energy or a Telecom stock with Tyre stock based on P/E, we should always compare 2 or multiple stocks in the same sector based on P/E because different sectors have different dynamics and hence different P/E.

Now let’s understand what is book value?

we have company X with a Current market price of 200 and the promoters want to close the company completely. Now if they want to close the company they need to clear all the debts they have. So they cleared all the debts and now they are left with 1 Cr money. So this 1 Cr is called the Total book value of the company, now if the company has 100000 shares of the company then the Book Value will be 1cr/100000 = 100. So the book value is 100.

Now the Price to Book value will be CMP/Book Value = 200/100 = 2. So investors should pay 2 rs for the company for every 1 rs they have. So always a lower P/B.V is preferred but we need to consider other factors also.

So this I hope we are clear on the above concepts.

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Cheers,

Chenna