Thursday, January 17, 2019

What is P/E Ratio? Why is it relevant to investors?

There are numerous financial ratios used by traders and investors to evaluate performance and financial health of a company. One of the common ones is P/E ratio i.e. Price-Earning ratio. Here's my attempt to explain you the P/E ratio in the simplest words-

To discuss P/E, let's understand EPS (Earnings per Share) first. If all the profit of a company is paid out to all of its share holders, then the net income earned on each share by its share holders - would be the company's EPS. So basically EPS is the profit earned for each outstanding share of a company. EPS is not to be confused with increase in share-price of a company during a specific period. Earnings declared in quarterly results are used for calculation of EPS.

If EPS of company ABC Motors is INR 10 while EPS of XYZ Motors is INR 5. We cannot simply conclude that ABC motors is a better investment just because it's giving us a higher earning on each share. In this case share-price of ABC could be INR 1000, giving us INR 10 for a period - while share-price of XYZ could be INR 150, giving us INR 5 for the same period. Therefore investors consider the share-price (market value of a share) as a factor for financial analysis. That brings us to P/E ratio.

P/E ratio is a number that indicates how much investment in a company gives you a return of INR 1 (or one unit of any currency). The formula to calculate P/E ratio is - 

P/E Ratio = Share-Price / Earnings Per Share

P/E ratio can only be calculated as long as a company is profitable, i.e it has a positive EPS.

Generally the period considered for calculation of EPS is twelve months (past four quarters) and therefore in this case, EPS is also called trailing EPS, commonly referred to as TTM (Trailing Twelve Months). P/E ratio calculated using trailing EPS is called trailing P/E

As we know that earnings of companies are released quarterly while price of a share can change multiple times in a day. Therefore investors also use forward P/E aka leading P/E which is calculated using estimated earning of a company, typically for the next twelve months.

It can be understood from the formula of P/E ratio that P/E ratio of a company will go down if EPS (Earnings per Share) of the company is higher. Let's get back to trailing P/E ratio with an example.

Let's say you hold 5 shares of ABC company at current market value of INR 10 per share. The company has a total of 200 outstanding shares and it declared a total earning of INR 1000 in the last four quarters. EPS in this case would be calculated by dividing total earning of the company by number of its outstanding shares. Hence EPS for ABC Company would be INR 5 (1000 divided by 200).

To calculate P/E ratio of ABC company in above example we need to divide the current market value of share (INR 10) by EPS (INR 5). Hence we can calculate the P/E ratio of ABC company is 2 (10 divided by 5). In other words, an investor needs to pay INR 2 to earn INR 1 from investment in ABC company.

P/E ratio is commonly used for comparing a company's current performance with its past performance or performance of its parallel peers in the same industry. It can also be used to compare performance of a company with the performance of its industry group or a benchmark index.

We learnt that P/E ratio shows us how much an investor is ready to pay for a company to earn INR 1 (or one unit of any currency). Here one can also say that if P/E ratio of a company is higher, that'd mean that investors are expecting growth in earnings of a company in the long run - as they are willing to pay a higher amount to earn INR 1. However a higher P/E ratio could also mean that the company's share is overpriced - as we can see in the P/E formula, higher price of a share would lead to an increased P/E ratio. Similarly a lower P/E would indicate either an undervalued share or poor expectations from a company.

Therefore P/E ratio cannot be relied upon as a standalone criteria. One need to use P/E ratio with other valuation methods to understand the correct status of a company. Different investors have their own techniques of utilizing P/E ratio for financial analysis. There are various other factors that also need to be considered for arriving at an investment-decision.

Happy Investing!

Ashish Agarwal
Posted By Ashish AgarwalThursday, January 17, 2019

Wednesday, January 16, 2019

CAGR, IRR and XIRR - Understand the Calculation of Returns on Your Investments

An investor knows it's important to compare different investments and learn how much a fund has lost or gained during a period. Various forms of returns are used by investors for calculation of returns on investments - Absolute Returns, Annualized Returns, IRR (Internal Rate of Return), XIRR (Extended IRR) and CAGR (Compounded Annual Growth Rate). Brokers, Mutual Fund Distributors and Investment Advisors use these terms frequently to boast about returns on their products. Why there are so many rates of returns? Why not a standard rate of return to easily compare different investment-products. Here's why-

Let's say you opened a Fixed Deposit account with your bank three years ago, which gave you an annual return of 7% - compounding quarterly for three years. You had also invested the same amount in a Mutual Fund, which at the end of three years gave you a return of 28%. And you had also started an SIP (Systematic Investment Plan) where you monthly deposited a sum - giving you an absolute return of 25% at the end of three years. Which one of your investments gave you better results?

In this article I will discuss some commonly used methods which investors use for calculation and comparison of return on their investments. My intention is to provide a brief of these methods to the budding investors in lay-man words - why there are multiple methods for calculation of returns on investment and what do they calculate. I will publish a separate article for calculation of these returns using tools like Microsoft Excel or Google Spreadsheet.

First, we have Absolute Returns. This is the simple return on your initial investment. To calculate point-to-point or absolute returns, we don't consider the holding period as a factor. So if your initial investment was INR 50,000 and after a certain period, say three years, your fund becomes INR 75,000. The absolute return from your investment comes to 50%.

In the above example you have 50% return for three years. To calculate Average Annualized Return, one can simply divide the absolute rate of return (50%) by the holding period in years (3). Nothing too complicated here. YET!

Let's move to CAGR (Compounded Annual Growth Rate). To calculate CAGR, apart from the holding period of an investment, the compounding-factor is also considered for calculation. Hence it is preferred to Average Annualized return.

CAGR is only suitable for lump-sum investments, where funds are invested and redeemed only once over a certain period.

XIRR on the other hand is useful for investments made in instalments. Let's say you have started an SIP of INR 1000 per month for a period of 3 years (36 instalments). Here each of your instalment of INR 1000 is invested for a different period of time, i.e. your first instalment remained invested for the whole holding period (36 months), second instalment for 35 months and similarly your last, 36th instalment, was invested only for a single month. In case of XIRR, considering the final return on entire investment, using a complex approximation method, a common CAGR for each individual instalment is calculated in such a way that the total of return on each instalment is the same as the final return on the investment at the time of redemption. Here one should know that CAGR can only be calculated for a sum invested and redeemed only once - hence calculated individually for each instalment. That adjusted CAGR which is the same for each instalment is, XIRR.

To make an investment decision or to estimate profitability of an investment, another commonly used tool is Internal Rate of Return (IRR). IRR is actually an annualized rate of return on an investment. Say, you purchased a car today for INR 5,00,000 and rented it out for three years. You earned INR 2,00,000 in the first year, INR 2,50,000 in the second year and INR 1,00,000 in the third year. Now you sold the car for INR 2,00,000. In this case you can use IRR to evaluate profitability of your investment in that car.

In another example, say you've deposited INR 10,000 in an investment product which in return promised you a fixed amount INR 6,000 over the next two years. Here also, IRR is useful for calculating annualized return.

I hope above explanation clarifies why various rates of returns on investments are used. I intend to publish a separate post about calculating these forms of returns using tools like Microsoft Excel or Google Spreadsheet. Link to the same will be shared shortly.

Happy Investing!

Ashish Agarwal
Posted By Ashish AgarwalWednesday, January 16, 2019

Sunday, March 13, 2016

Algo Trading for Absolute Beginners

Image - What is algo trading -
Here's an attempt to describe the Algo Trading business in layman's terms. Let's split the phrase into words - 'Algo' and 'Trading'. As you may already know, the word 'Trading' here stands for the action of buying and selling stocks in the capital markets. The another word 'Algo' here stands for the term 'Algorithmic'. If you already know what an algorithm is, you can skip the next paragraph.

An algorithm is a clearly defined step-by-step set of operations to be performed. Let's say if you are assigned a task to drink water from a bottle, the algorithm or set of operations for that will be - to get the water bottle, open the cap, drink the water, close the cap and place the bottle at the right place. Simple. Similarly in a computer system, when you need a machine to do something for you, you explain it the job clearly by setting instructions for it to execute. And that process is also called 'programming a computer'.

Now, many of you might already know that before the electronic trading took over, the stock trading was mainly a paper-based activity. There were actual stock certificates and one needed to be physically present there to buy or sell stocks. You can read what was it like to trade before electronic trading took over. And then there was dematerialization (DEMAT). Actual certificates were slowly being replaced by their electronic form as they could be registered or transferred electronically. It increased the fluctuations in the stock-prices because now the trading process was faster. But then with the technological developments came the next big thing - ALGO TRADING. Now, you can write an algorithm and instruct a computer to buy or sell stocks for you when the defined conditions are met. These programmed computers can trade at a speed and frequency that is impossible for a human trader. This process can be semi-automated or completely automated and this is why the terms automated trading and algo trading are used interchangeably. But there is a small difference between algo trading and automated trading.

If you are an experienced stock trader with a trading strategy, you can best utilize the algo trading by setting instructions for a computer (write an algorithm) to trade when the defined conditions are met.

Knowledge of technical analysis of stocks/trades plays an important role in developing a profitable trading strategy. Technical analysis is academic study of chart patterns and trends of publicly traded stocks. Soon, I will provide content here to help you understand the technical analysis. Feel free to comment! Cheers!

Happy Trading!

Ashish Agarwal
Posted By Ashish AgarwalSunday, March 13, 2016