Understanding Whether a Stock Is Cheap or Expensive
Determining whether a stock is cheap or expensive is one of the most challenging questions for any investor. It involves analyzing various factors such as earnings, market conditions, sector trends, and global risks. Let’s break down the dilemma with a real-world example to understand how to approach this problem effectively.
The Complexity of Valuing a Stock
Imagine a stock that started at ₹15 in 2006, rose to ₹70 by 2008, and then fell back to ₹40. By 2018, it surged to ₹340 but later plummeted by 80%. After a brief recovery, it dropped again, leaving investors puzzled. Was it cheap at ₹15? Was it expensive at ₹340? How do you decide?
The stock’s journey shows that relying solely on price-earnings ratios or other singular metrics can be misleading. Even when a stock seems undervalued, it might not move for years. Similarly, an overvalued stock may continue rising. Without a clear strategy, it’s nearly impossible to navigate these fluctuations.
The Case of Yes Bank
Yes Bank is a classic example of this dilemma. Once a favorite among investors, its price soared dramatically before collapsing to levels last seen 15 years ago. Investors who bought at high valuations faced significant losses, even after a decade of holding. This highlights the importance of having a clear buy-and-sell mechanism instead of relying solely on valuation metrics.
The Changing Metrics of Value
Market dynamics change over time. For instance, Nifty’s price-to-earnings ratio rarely drops below 11-12 now, compared to the past. Similarly, stocks like Nestlé, which traded at 70 times earnings, may still appear expensive even after a 30-40% drop. These shifts make it difficult to define “cheap” or “expensive” using historical benchmarks.
Investors often overlook the fact that valuation games are complex and require deep expertise in specific sectors and market trends. For most retail investors, attempting to outsmart the market through valuation alone can lead to poor results.
Why Following Price Is Simpler and Effective
If valuation analysis seems daunting, consider following the market price. The market reflects collective knowledge and sentiment. Price movements often signal underlying changes before they become public knowledge. For example:
If a stock’s price rises: It usually indicates positive developments, even if they are not yet visible.
If a stock’s price falls: It could signal trouble, regardless of its perceived value.
This approach aligns with the principle of “Price is God.” By following trends, you can simplify your investment process and reduce the stress of guessing a stock’s intrinsic value.
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