What is a reasonable price for a stock? This will open your eyes

You often hear analysts and market commentators say stock prices have become reasonable after a correction and investors should try and tap those opportunities.

Ever wondered what is really a reasonable price? The essence of equity investing is buying (and staying invested in) only those stocks where there is a significant gap between value and price.

As Warren Buffett says, “Price is what we pay. Value is what we get.” Thus, the equity investing process may be simply reduced to assessing the value of a stock, comparing it with prevailing price and buying it as and when there is adequate margin of safety.

This means the price of a security should be meaningfully lower than the assessed value to account for the potential risks in investing.

For Delhi-based investor Ashish Chugh, stock price is nothing but a perception. “Valuation is important from a risk management perspective. But there is no one way of valuing different companies. A cement company, a consumer product company, a retail company and an ecommerce company will all require different valuation parameters. One size does not fit all,” says he.

In investing, most investors are focused on how much money they can make. However, for successful investors, risk management is more important. “A reasonable price for a stock is the price which takes care of this aspect, the one that tilts the fulcrum of risk-reward in favour of the latter,” Chugh says.

Stock markets tend to extrapolate earnings performance into the future. If a company is in a hyper-growth phase, the market is likely to end up extrapolating this too far into the future, bidding up valuations.

What’s the difference between valuation and pricing of an asset?

In this year’s annual wealth report of Motilal Oswal Financial Services, market veteran Raamdeo Agrawal concurs that price is a relative concept. He offers a new perspective on valuation, saying, “It is essentially a fundamental assessment of a stock’s intrinsic value, based on the expected cash flow arising from the same.”

“In contrast, pricing is more empirical and heuristic. The basis of such pricing is usually based on applying appropriate multiples – price-to-earnings, price-to-book, price/sales, EV/Ebitda, etc. Pricing is also likely to be relative rather than absolute, i.e. depending on how comparable stocks or benchmarks are priced,” he writes.

Agrawal says one can buy a stock with a high-quality business run by a high-quality management with healthy earnings growth to be sustained over a long period (at least 5-6 years) at a reasonable price, preferably at a PEG less than 1 times. And finally, one must seriously consider selling stocks that trade at 3 times PEG or 2 times relative to the market, whichever is higher.

PEG stands for price to earnings growth.

Kolkata-based investor Abhishek Basumallick says a reasonable price is what gives you the comfort to expect and make profits over a 2-3 year timeframe. And the profits should be higher than risk-free returns. From that perspective, there are some pockets in the market that are reasonably priced, but a vast majority of stocks are still overvalued.

“The fact that prices have fallen significantly and appear to be lower than what they were six months back is making people believe them to be cheap or fairly priced. But many may be not,” Basumallick said.

Noida-based full-time equity investor Vijay Malik says reasonable price of a stock is what factors in the risk of being in equities, the strength of the business model and what allows an investor to sleep peacefully after having bought the stock.