“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1." - Warren E. Buffett

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Monday, December 08, 2008

A Simple way to Invest

I read this article by shyam.P on The Hindu, recently titled "simple ways to invest" where the author explains point blank on the bulls eye. Not only the article is titled as simple ways to invest, the article itself is so simple that any lay person could understand why his investments vanished and how to invest safe and see his investment fetch at least something if not bringing him billions. I reproduced an extract of the big article (you need not worry about the balance I have reproduced here is the cream of the article) which I recommend you to give certainly a read full rather than an overview, you will certainly understand the basic idea how to invest. You must read this article whether you are a beginner, or experienced.

The secret to profitable investment is to ‘Pay Less’

A simple rule for deciding when to invest in the stock market can be developed based on the ‘Price-to-Earnings Ratio’ or ‘P/E Ratio’ of the Index. But before going into the P/E of the Index, let me first explain how to calculate the P/E of an individual company.

P/E of a company = Share price of the company/ Earnings per share

where, the Earnings per share = Net Profit made by the company during the previous year/ Total number of shares in the company

The Index is nothing but a weighted average of the share prices of underlying companies. The National Stock Exchange’s ‘Nifty Index’ represents 50 of the largest companies listed on the Stock Exchange, spread across sectors. Similarly, the Bombay Stock Exchange’s ‘Sensex’ is a collection of 30 of the largest listed companies in India. The Index can be taken as a representative of the entire stock market. This is why when the Index is down, most probably your portfolio of stocks is also down.

The P/E ratio of the Index compares the share price of all the underlying companies to the annual profit (earnings) of these companies. Whenever the share prices change, the P/E ratio also changes. Let me give you an example: In Jan 2008, the P/E ratio of the Nifty Index was 28. Arithmetically, P/E= 28 or after cross-multiplying P=28*E. i.e the share price of the underlying companies was 28 times the annual profit (earnings) made by the companies (per share). In other words, you had to pay 28 years’ profit upfront to buy their shares (without considering growth in profit). Doesn’t that sound terribly expensive? You bet! Especially if I were to tell you that today, the same companies are available at a P/E of 12.

As you would have guessed by now, the power of the P/E ratio (of the Index) is that it acts as an indicator of how expensive (overpriced) or how cheap (under priced) the market is. A logical extension of this is to set a lower limit for the P/E ratio, below which you can invest in the stock market and an upper limit, above which you can start selling your holdings.
Below is a graph of the P/E ratio of the Nifty Index plotted over the last 10 years. What comes out clearly is that the tops are attained above a P/E ratio of 25 while the bottoms are attained below a P/E ratio of 15. By investing in the stock market when the P/E is below 15 (Bottom Band) and liquidating your investments when the P/E is above 25 (Top Band) you would have not only protected your wealth but also reaped above average return on your investment.

Disclaimer - Hindsight is always 20/20 and future performance may not reflect the past. But hey! This simple technique will at least help you stay away from the trap of “buying high and selling low”

Let me leave you with a closing quote: “Be greedy when others are fearful, be fearful when others are greedy” (Warren Buffet)