Updated: Aug 5, 2021
Before we begin I'm assuming you have prior knowledge about PE ratio, If not I would suggest you read our last blog on "PE ratio. The link is provided below: https://www.thehumaneopportunist.com/post/the-controversial-pe
Why it is important to buy a stock at the right price?
Well, In the last blog “The Controversial PE” we’ve discussed PE ratios and their relevance importance while weighing a stock.
Why it is important to buy a stock at the right price? We know that market works on discounting factor. Though we assume the market to be rational, in reality, it lags rationality in the short term. There are times when the market is overheated. And such irrational behavior in the market can push the stock price to its forward valuation. Buying the stock at its forward valuation over and above its fair value may lead your money to remain idle until the market identifies the value at which you bought to be fair.
In other words, assume the fair price of a stock is 1000rs but its current price is 1800rs. Assume valuation of the stock at 1800rs is the price of which should be after two years but you have bought the stock at 1800rs today. It means you will have to wait until two years to come to break even in terms of valuation.
And if you buy a stock at correction let’s, say the stock price corrected to 1200rs and you bought during correction after two years price reach to 1800rs you will be at a profit of 600rs which is 50%. The person who bought the stock at 1800rs will come to break even after two years.
When to buy a stock?
We know that market works on discounting factor if you are well gauged with financial knowledge and are familiar with the market's discounting mechanism. And if you uphold the knowledge of the relation between economy, industries, and recent development in the market, you can assume the company's sales growth through the EIC approach (Economic, Industry & Company) and find out the growth expected in the Company. And then looking at its past trend of valuation or PE ratio we can find out the reasonable price of a stock and thus invest at the right price.
In the above method, there is much complication because it not only requires perquisites knowledge of finance but also assumptions for discounting factor which are very important.
And believe me, if you have the above pre-requisite knowledge you are well gauged in the journey of investing and there are no substitutes for that.
But for beginners who are just stepped into the market and need a little word of advice, you can help yourself through this technique finding stock at the right price could be made a little bit simple if you don’t have any knowledge and you want to buy a stock at the right price?
First, let me shed some light on the truth regarding the right time to buy a stock. There is no such thing as the right time! Because you cannot buy a stock at its bottom and sell at its high. There are always the lower bottom and higher highs. What we can do? We only can buy at an average of a good range based on the past trend of data available. For example, if a stock is always trading above 50 EMA* at the weekly chart with an average PE ratio of 40. Based on past trends you have noticed that it has only touched 50 EMA* during correction and touches 100 EMA* only during the market crash. Now, assume today the stock has touched 50 EMA* and you know this is only during the correction, you know this is the right time to buy.
Let’s understand with an example:
Chart (weekly) of HUL | Indicators: 50EMA (red line), 100EMA (blue line), 200EMA (green line)
In the above chart, we can see that price of HUL touches at 50EMA during the correction. Hence, looking at past trends buying at 50EMA is the right price to buy. On 23rd march 2020, crash we can see a price touch to 100EMA. Thus, this is the best price to buy at.
How you will be benefitted?
Well, the first percentage of gain will be seen in the short term as soon as the aftermarket recovers, and thereafter gain will be due to growth in companies earnings as the market will try to maintain the trend of its average PE. With this method, you can maintain the margin of safety in your scrips and buy a stock at the right time.
Let’s understand with a chart:
Nifty 50 Chart (weekly) | Indicators: 50EMA* (red line), 100EMA* (blue line), 200EMA* (green line)
Now, I want you to take a look at the purple box indicating market correction. We can observe that right after the correction market bounces back to its old level and then as time passes by market and prices move together.
What does this mean? It means during correction market plunges but also bounces back to its original level after correction. which means if one has invested at the time, he would be benefitted from correction and will able to maintain a good margin of safety. Thus, reducing downside risk.
Note: The above-mentioned technique is subjected to certain limitations:
Use this method with only blue-chip and well-established reputed companies, if possible do your homework of thorough analysis.
Do check long-term median PE and current PE ratio before applying this technique.
Check the company's long-term price trend. If there is a long-term down-trend try to avoid such companies.
Try looking at the reason behind price fall. If it is due to systematic* reasons then you are good to go but if they fall in price is due to unsystematic* reasons try to figure out whether it is temporary or there are some serious fundamental issues with the company. In case of the serious fundamental issue try to avoid such companies.
* EMA: An exponential moving average (EMA) is a type of moving average (MA) that places a greater weight and significance on the most recent data points. The exponential moving average is also referred to as the exponentially weighted moving average.
*Systematic reason (Systematic Risk): Systemic risk refers to the risk inherent in the whole market or part of the market. Systematic risk is also called the undiversifiable risk, market risk, or volatility. It affects not just a particular stock or industry, but the overall market.
*Unsystematic reason (Unsystematic Risk): Unsystematic risk is the risk that is unique to a specific company or industry. It's also known as non-systematic risk, specific risk, diversifiable risk, or residual risk.
Conclusion: There are so many ways through which one can value a stock. It is just one of the technical ways of finding out stock to buy at the right price.
Until next time,
The Humane Opportunist.