The share price of a company depends on a variety of factors, including the intrinsic value of the firm. Before we go through a few of them, let’s talk about “efficient markets” first. You must have heard a number of investors say, “The market is forward-looking,” or “The market is always efficient, there is no lottery ticket to be found here.”
But, what is a forward looking market?
In simple terms, the market estimates the present value of the firm by taking into account its predicted future earnings.
Let’s understand this with an example.
Take the case of Eicher Motors (NSE: EICHERMOT), which witnessed a strong equity rally in 2014. Between 2014 and 2015 most of it was driven by a re-rating of the stock, where the market believed that the company was worth more than the current price. The P/E ratio almost doubled during this period!
Note: The price/earnings ratio is the ratio of a firm’s stock price to the firm's earnings per share.
After a brief period of record highs, the market was of the consensus that the share price now reflected the correct value of the stock, and as expected, the earnings caught up with the market expectations. The stock continued the rally, but this time, it was driven by a solid increase in earnings per share. The P/E ratio came back in line with the pre-2014 levels.
You should note that while the P/E ratio is not the only indicator of the financial well-being of a company, it can be useful for making a knowledgeable assumption of the company’s growth trajectory.
All right, but if you say the market is forward looking, are you saying they knew that there was a real estate bubble in 2007 and nobody did anything?
One has to understand that we are, after all, humans. There are times when the market is swayed by emotions which can create an unsustainable growth trajectory.
However, this is also one of the important characteristics of a market, it corrects itself periodically.
So how does an investor benefit from the forward looking characteristic of a market?
There are some traders who take advantage and time the markets in such a way that they create a portfolio of stocks nearing earnings announcement, go long a few days before the event date and close out the positions one day prior. This strategy has been known to generate positive returns in the case of Indian equities.
To illustrate this point, we can take an example of Mahindra and Mahindra financial services’ earnings report. Before the release of the report, analysts had predicted the net profit of the company to be Rs. 240 crore but the actual net profit reported was INR 164 crore. Thus, the share price of the company declined from INR 270/share to close at INR 253/share.
The next day, it declined further to INR 239. Thus, If an investor had bought the stock a month prior at INR 297 and sold the stock one day prior to the earnings report at INR 326, that would lead to a profit of (326 - 297) = INR 29 per share.
Given the fact that companies beat analysts’ estimates more often than not, one should know that it can be a highly risky strategy.
Isn’t this against the very notion of the Efficient Market Hypothesis?
Not exactly.
We are not saying that the market is inefficient if the traders booked a profit. The efficient market hypothesis states that the share price reflects all the available information. But, there lies a time gap before the market corrects itself due to new information being processed. Herein lies the concept which day traders follow, timing the market.
Knowing when to enter and exit the trade is important for a trader. Here news plays a vital role.
The caveat over here is that a recent study supports the fact that consistently beating the market is not possible.
Understood. So how does the market decide if the share price of a company is underpriced or overpriced?
One method is the price discovery mechanism. The basic premise is that the market brings both buyers and sellers together, and based on their mindset and expectations, a price is discovered for a company. It should be noted that price discovery is not a valuation of the company, but an assumption of its performance.
Thus, traders consider both valuation and market value of the company to decide if it is underpriced or overpriced. Interestingly, price discovery mechanism supports the characteristic of a forward-looking market.
You have talked about market correcting itself as new information/news is released. Can you explain this in detail?
It is not just news, it is the reaction to the news which also plays an important role in the share price. The reaction to the news depends on different factors as well as the markets themselves.
Let us understand this with a study of the present scenario in the NBFC sector of India.
We know that IL&FS is currently under the scanner for mismanagement of funds. Thus, investors were keeping a close eye on the NBFC sector for a while. Incidentally, DSP sold DHFL papers worth 300 crores at a high yield of 11% in the secondary market, leading to speculation that DHFL would default on its payments, and as a result, DHFL share price declined by 50%. However, a clarification by DHFL of their sound financial health helped stem the decline and the share price seemed to recover.
In times of high volatility and ambiguity (high uncertainties about volatility), the market reacts more strongly to bad news than good.
Also, the market can become too optimistic or too pessimistic sometimes.
Tesla gets a lot of media attention, thanks to its billionaire CEO Elon Musk. When Elon Musk tweeted that he was taking Tesla private at $420 share price, which was much higher than the existing price, it led to a frenzy of activity with the share price gaining 10%. However once it was found that Elon Musk did not have a firm plan, the share price declined sharply.
Thus, the job of an investor is to evaluate each new information and judge the possible reaction of the market as well. As the great economist, John Maynard Keynes suggested:
“Successful investing is about anticipating the anticipation of others.”
These were a few factors which impact the share price. As a responsible investor, one should take into account the business environment as well as the macroeconomic factors which could result in a revision of the company's share price.
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