Ask common men, they will say that – stock’s price go down more than it goes up. 🙂 Why we think like this? Because we don’t know how to predict if a stock will go up or down.
This is not only our problem, even experts of stock market face a similar dilemma. Read: Why does stock price fluctuate?
In short term (span of 2-3 months), stock price movement is mostly speculative. If there are more buyers, price goes up. If there are more sellers, price falls.
What triggers buying or selling? Quarterly or annual reports publication by the company. If results are positive, stock’s price will go up. If results are negative, it might trigger a fall.
But in real world, factors effecting share price is more complex. It not only depends on the fundamentals of the company it represents, but also on hosts of other factors. It is a complex puzzle, and for common men like us, it is a hard nut to crack.
- #1. Influence of FPI/FII and DII.
- #2. Influence of company’s fundamentals.
#1. Influence of FPI, FII & DII on Stock Price (Index)
Sorry for the jargon, but these are type of investors who invest in Indian Financial System. FPI: Foreign Portfolio Investors. FII: Foreign Institutional Investors. DII: Domestic Institutional Investors. Apart from the above three types of investors, there are another investors who are classified as Retail Investors. “We” are retail investors.
Stock market investments are dominated by three players, FPI, FII and DII. If they are buying in stock market, the index will move up. If they are selling, index will fall. [P.Note: The effect of FPI/FII is more dominant on stock market index than any other type of investors.]
Compared to FII/FPI/DII, the volume of stock trading (in terms of numbers or values) done by retail investors is negligible. Hence most of the time, impact of retail investors on stock market is irrelevant.
But on contrary, FPI’s and FII are the stock market’s movers and shakers. Let me show you a graphical representation of how how Index moves with respect to FPI/FI investment.
FPI/FII Net Investment (buy vs sell trades) and Nifty50 Index
In the above chart you can see that between 24th-Feb’20 and 03rd-Apr’20, FPI/FII investment has gone in negative (below the zero line). It means, FPI/FII’s are selling their holdings more than they are buying. Hence it is causing the Nifty50 index to fall.
Nifty50 fell from 11,829 levels to 8,084 levels in this period (a falls of -31%).
You can note that Nifty50 index is almost imitating the buy-sell trend of FPI/FII’s. Tracking net investment of FPI/FII happening in NSE/BSE can help us predict if a stock will go up or down.
From where to get the value of FPI/FII investment? It is published on NSE’s website on daily basis.
#2. Influence of Company’s Fundamentals on Stock’s Price (Index)
We cannot simply buy any stock based on FPI/FII/DII data alone, why? Because we will eventually end up making losses, or only mediocre gains. Why? Because we need to do something more.
We must always remember that stock is a ‘speculative asset’. What is a speculative asset? It an asset type whose market price has a tendency to become overpriced. Price of “overpriced” stocks has a tendency to go down – no matter what.
How we can say if an asset is overpriced? Asset is said to be overpriced when its current price is higher than its “fair price‘. This is where the need of stock analysis comes into play.
Fundamental analysis of stocks, along with FPI/FII/DII data, can give a fair idea about a stock’s future price trend – whether it will go up or down.
2.1 About Fundamental Analysis
Why to do fundamental analysis? This way we can ‘estimate fair price‘ of stocks. Once fair price of a stock is known, it can be compared with its market price to understand if the stock is ‘overpriced‘ or not.
But there is a problem. The problem lies in estimating fair price of stock. What is the problem?
To estimate fair price of stocks, one must know how to read and comprehend ‘financial statements’ (like balance sheet, P&L a/c, & cash flow statement). How to read it? This is what we will see in this article
Idea is to “understand the correlation between the company’s financial results, it’s fundamentals, and it’s fair price (also called intrinsic value).”
Knowledge of fair price gives an idea about how to predict if a stock will go up or down. Undervaluation will pull price up, overvaluation will bring the prices down (see this flow chart)
2.2 Correlation Between Financial Reports, Business Fundamentals & Fair Price
This is the crux of fundamental analysis of stocks. If we can learn to establish a correlation between financial statements, its business fundamentals, and its fair price – it all about it.
How this can be done? It can be done by the three step process shown in the above flow chart. The end goal of these three steps is to identify a fair price. Allow me to explain each of the three steps in only few words:
- Financial Statements: Learning how to read financial statements is key. When I say reading, I also mean understanding. One must not only read the financial reports, but after reading, should be able to frame a bigger picture about the company. Why bigger picture? Because it helps in comprehending its business fundamentals. Read more about reading a balance sheet.
- Business Fundamentals: What factors dictate business fundamentals of a company? Future growth prospects, management’s efficiency, profitability, current financial health etc. While reading a financial report, one must also simultaneously comprehend the fundamentals. Read more about fundamentally strong stocks.
- Mathematical Model: In the above two steps what we have done is mostly “study” of the company. In this step we will convert the our study into a hard fact number. In value investing this number is called fair price or intrinsic value. But how to convert the numbers into fair price? To do this one must also master a mathematical model (like discounted cash flow model).
Why we are doing so much work? We want to know if, from the current price levels, a stock will go up or down. The best indicator of this is stock’s fair price. When fair price of a stock is below its current price, the stock has good possibility to go up in times to come.
How soon it will go up? It depends on the degree of undervaluation. As a rule of thumb, a popular stock which is trading at a discount to its fair price (say at 2/3rd levels), can go up within next few months.
If one does not want to go into the complexity of fair price calculations, using mathematical models, then I’ll suggest an easier alternative in this article. I call it Future PE-EPS method (check here). Though it is a crude method of gauging stock’s future price trend, but it works for beginners.
2.3 Two Methods to Predict Stock Price
There are two ways one can predict stock price. One is by evaluation of the stock’s intrinsic value. Second is by trying to guess stock’s future PE and EPS.
Method #1: Intrinsic value estimation of a stock is a skill. Only people like Warren Buffett, and Peter Lynch can say for sure that their estimated intrinsic value is accurate. Balance all of us can only make a random guess. I’ve developed an MS EXCEL based tool which can estimate intrinsic value of stocks. Check the below infographics to know how it works.
Method #2: This is a second method which a beginner can use to predict if a stock will go up or down. This is a crude way to guessing a stock price. But the logic’s that will be used to implement the process is sound. I’ve personally used it to guess price trends during my earlier days. I’ll share the procedure in detail for only academic knowledge of my readers.
2.4 Future PE-EPS Method
This method of predicting future price of a stock is based on a basic formula. The formula is shown above (P/E x EPS = Price).
According to this formula, if we can accurately predict a stock’s future P/E and EPS, we will know its accurate future price.
We use this formula day-in day-out to compute financial ratios of stocks. But instead of future price, we use it for current price. Here the P/E and EPS data that we use is based on trailing four quarters.
We will use the same formula and try to predict future price. How to do it? Please check the 3 step process shown below. We can also use this method to crudely quantify if the current stock is undervalued or not (check the conclusion).
But before that, let’s know how to predict future price of stocks.
Estimate P/E of Future (P/E after 3 years from today)
- #1A. Historical Price: First note down monthly price of stock posted in last 3 years. You can get the price history from investing dot com. This website allows you to download the historical price in csv format. You can follow this path: Go to your Stock Page > Historical Data > Time Frame (monthly). Download the last 3 years price (36 months) for your stock. Check this video guide where price downloading is shown.
- #1B. Quarterly EPS (EPS Q): After price, we will need the stock’s historical EPS data. This data we can get from the stock’s page in moneycontrol. You can follow this path: Go to your Stock Page > Financial > Quarterly Results. Note down the quarterly EPS for last 3 years (12 quarters). Read about high EPS companies.
- #1C. Calculate Last 4 quarter EPS (EPS-4Q): Calculation of last 4 quarter EPS is easy. First prepare a table of all 12 quarter EPS you have collected from moneycontrol. To calculate last 4 quarter EPS, just add the EPS of last 4 quarters. Please see the below table prepared for an example stock.
- #1D Calculate Last 3Y P/E: From the above prepared table, P/E calculation of stock in each of the last 3 years is easy. PE can be calculated by dividing Price (P) by last 4 quarter EPS (EPS-4Q). The same is represented in the calculation table shown below:
- #1E Estimate P/E of Future: Before estimation we will make an assumption that the stock is going to at least replicate in past 3 years performance (if not improve it). What we will do? We will calculate the Average P/E of last 3 years. Now we will assume that the stock will have this P/E after 3 years from today (calculated value is 21.25). Our assumption: After 3 years from today, the stock will have a PE of 21.25. Read more about P/E ratio.
Estimate EPS of Future (EPS after 3 years from today)
- #2A EPS Growth Rate: In this step we will estimate the growth rate at which the EPS of our stock will grow in next 3 years. How to do it? We will have to fetch some data from moneycontrol. After the data is fetched, we must calculate the growth rates of the fetch data. Based on this calculation will be estimate future growth rate of EPS. See the sample calculation shown below. Here the estimated EPS growth rate is 1.72% p.a.
- #2B Estimate EPS of Future: We have two numbers to this estimation. We know last 4 quarter EPS. We have also estimated the EPS growth rate for the next 3 years time horizon. We will use these two numbers to estimate EPS of the stock after 3 years from today. Check the formula used for future EPS calculation. Read about profitable stocks.
Predict Future Price of Stock
We will use the PE-EPS formula to predict future price of stock. What we have done in step #1 and Step #2 above is estimation of Future P/E (21.25) and Future EPS (93.28). With two numbers in hand, we are now ready to apply them to our formula.
What we can conclude from the above numbers?
- What will be the future price? Expected future price (after 3 years) of our example stock is Rs.1,982.2 We have arrived this by using the P/E formula (PE x EPS = Price).
- What is the current price? The current price of the stock is Rs.1,737.8 (see snapshots used in PE calculation above).
- At what rate the price will grow? Current price of stock is Rs.1,737.8. Expected future price is Rs.1,982.3 (after 3 years from today). It means, the stock is expected to grow at a rate of 4.48% per annum. Use this formula for growth rate calculation: [(future price/current price)^(1/ years) – 1].
Access the price data, and financial report of you stock as suggested in the above article. You can use these numbers to predict what will be the future price of stock – after 3 years from today (Check the 3 steps).
One can also use these numbers to interpret if the current price of your stock is undervalued or overvalued. This understanding can also give a hint that if at current price levels, the stock shall be purchased or not. How to make this decision? Read about companies with high moat.
Suppose your expected ROI is 12% p.a. from a stock. Hence you did its price trend analysis as shown above. You found out that the analyzed stock can yield a return of 4.48% p.a. in next 3 years. As the stock’s yield is below your expectation, hence for you, this stock is overvalued.