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All that's cheap is not good

Ashish Pai  |  Mumbai 

based on cost alone. Highly priced stocks may be expensive but provide better returns.

Whenever we buy a product or service, we look at its cost. Cheaper products seem more affordable and hence attractive to buy. The same applies to stocks. Low-priced ones attract more buying interest. However, do they give good returns? One must know how to compare stocks, the pricing and how to find value for money.

The simplest way to know if a stock is cheap or costly is comparing the price-to-earnings ratio (P/E ratio). Suppose stock A has a price of Rs 1,000 and its earnings per share (EPS) is Rs 100. Then, the is 10. Another stock B, has a price of Rs 200 and its is Rs 8. Then, the is 25. Stock B is said to be costlier than stock A.

Another method is to compare the price -to-book value (P/BV). Taking the case mentioned above, if the book value of A is Rs 500 and book value of B is Rs 40, the ratios are two and five, respectively. Again, stock B is costlier than stock A.

These two are the most common and universally utilised methods for evaluating the prices of stocks.

Let us see why some stocks are highly priced:

Growth in earnings: The stock of most top-rated companies such as HDFC, Bank, State Bank of India, Cipla, Infosys Technologies, TCS, ITC, BHEL, L&T, Tata Power and so on have been among the most expensive in the market and in their industries. But inspite of their high prices they have been able to give better returns. This is because their earnings growth is superior. They also have grown at a faster pace.

In contrast, many of their cheaper peers have been at low valuations for years, but this hasn't helped in increasing their market returns. What can explain this contradictory situation? One, the better rate of earnings growth. Two, the market always appreciates companies which deliver better than the industry returns.

Good business model: Companies with high prices are mostly leaders in their segment (Examples: SBI, and BHEL) or have been instrumental in pioneering a business model (Examples: Infosys, Asian Paints and Marico). The market appreciates their business model and innovation and this is reflected in stock prices.

Stocks Price as on
Nov 30, 2010 (Rs)
Current P/E
Price as on
Nov 30, 2005 (Rs)
return (%)
Stocks (High P/E)
HDFC 689 33 225 61
Bank 2,289 31 688 67
Tata Power 1,290 35 446 58
Asian Paints 2,643 34 525 101
Stocks (Low P/E)
GIC Housing Finance 121 14 46 53
Vijaya Bank 96 7 54 36
Gujarat Industrial Power Co. 103 8 67 31
Indoco Remedies 486 13 345 28
Note : is calculated on trailing EPS

Better resource raising: Most blue-chip stocks with high prices are of companies self-sufficient in capital and able to fund growth entirely through internal accruals. Either because of enormous generation of cash flows or because the business doesn't have much capital requirement. Their shareholders don't have to suffer equity dilution, nor would they have to raise high-cost funds which dampen equity earnings. As a result, these companies get much higher valuation than their cash-strapped peers and this is reflected in their high prices.

Good corporate governance: The companies with have a better valuation in the market. The prices of these stocks are always at a premium, as the community have a lot of respect for the management and believe in their business philosophy and decisions. Examples are Infosys, Wipro, Tata Group companies, HDFC. It is important to know about corporate governance when in a company.

Liquidity: Stocks with better usually get higher valuation and stocks which are less liquid have lower valuation. For example, Asian Paints and Kansai Nerolac, are both fundamentally good companies operating in the paints industry. However, the valuation for Asian Paints is higher as compared to Kansai Nerolac, as the latter's shares are less liquid.

Market perception: also helps in determining the stock valuation. Companies in sunrise industries like education, healthcare and telecom usually get a better valuation.

In the table given, we have taken some of the highly priced stocks not only in absolute terms but also in relative terms. And, compared their five-year returns with those of their low-cost peers.As can be seen in the table, the richly valued stocks have beaten their low-cost peers substantially.

Remember that if stock price was the only indication of whether a stock was cheap or not, nobody would have been buying stocks like Infosys, SBI, HDFC and so on. But these high-priced stocks have always delivered better returns than the market Conclusion: Retail investors should not be worrying only about the cost price. If any stock is providing value for money they should go for it, irrespective of the price. If in small-and mid-cap stocks, look before you leap.

The writer is a freelancer

First Published: Sun, December 12 2010. 00:12 IST