Hi I am Arjun Parthasarathy speaking and this podcast is on “Idiots Guide to Market Valuations”
Over valued markets is a term that you come across frequently today. Globally, the fact that S&P 500 and Nasdaq are trading at record high levels have give rise to talks of over valuations. In India, many mid and small cap stocks are trading at record highs and market experts issue caution on over valuations.
Now for an ordinary investor looking to invest in equity markets to grow savings, market valuations when high as proclaimed by experts, is contrary to what they hear everyday i.e invest in equities for growing your savings. On one hand you are asked to sell equities because of high market valuations and on the other hand you are asked to buy equities, as it will grow your wealth!!
Let’s look at market valuations this way so that you will understand what it is about in a better manner. When you buy a stock, you buy it so that its price will rise or you will receive a dividend, which in relation to the price of the stock will give you better returns than a fixed deposit.
Why will a stock price rise? The price will rise if the market believes that a company deserves higher valuation than what it is worth right now. This can come about if the company is growing its sales, profits or paying higher dividends. Market may also give higher valuations if it believes that a company is worth more to another company inducing prospects of takeovers.
Now, valuations become subjective i.e it is the belief of many market participants on what a company is worth. If many believe it is higher, then price of stock will rise, if many believe it is lower, price of stock will fall. High valuations is when experts believe that the company has overrun its fundamentals and low market valuation is when experts believe that the stock price is not justifying its fundamentals and can go higher.
When there are so many experts talking about high and low market valuations, then it should make sense that markets are always correctly priced as prices will stabilize based on the valuations experts think is right. If this is right, then you will never see good returns in equities. Fortunately this never happens as you would have seen, with markets rising much further than expected by experts for a much longer period of time or markets falling much lower than expected for a much longer period of time.
To give you an example, leading upto to the dot com bubble in 2000, markets were justifying sky high valuations with Nasdaq PE at closer to 200x but now at a PE of just around 32, markets are talking about overvaluation!! Go back and see what experts said about Amazon ten years back, many would have said overvalued but now, there are very few saying overvalued.
How do you then justify investing in a market when it is being called as over valued or selling when it is called under valued? This is again very subjective and if you believe that a company will continue to deliver growth and or profits over a period of time despite a high valuation tag, you can invest in the stock and on the other hand if you believe that a company will degrow and show less profits or losses for a time to come, then you can sell the stock.
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