As we saw last time, PE ratio is one of the most popular ratios used in determining the value of the stock. However despite its claims of helping you choose the bargain stocks, this ratio does have its own share of drawbacks. Here are the drawbacks of PE ratio

• PE ratio varies from sector to sector. A PE ratio that is considered high in one sector may be treated as low in another sector. E.g. IT companies usually have higher PE ratios than manufacturing companies. This is because IT companies are expected to show more growth over the period of time than manufacturing companies.
• PE ratio is not totally neutral. If the company declares it has received a new order or bagged a new client, is enough to send the PE ratio soaring.
• Also low PE may mean the lack of investor confidence in the company. It can imply serious problems with the company. So always find out more about the company’s background.
• One of the factors used in calculating EPS is assumed. It is based on the expectation of the company’s future performance. But this can be a problem as the company may not be able to continue with its good performance in future. Moreover the business in which the company is operating can experience problems. This happened recently in the real estate sector.

So when selecting the stock, don’t just take a look at the PE ratio. You also need to look at various other ratios and aspects. We will cover it in next posts.

As we saw last time, P/E ratio plays a vital role in valuation of a stock. It indicates the margin of safety of the stock. It tells you about the relationship between the stock price and the earnings of the company. 

Let us say you buy a share of company A that gives you a return of 9% in one year.  Here the margin of safety is zero as a traditional bank account also offers you the same return, but without any risk.

So in order to lower the risk, the difference between both of them must be higher. The renowned investor Warren Buffett advises us this difference must be at least 1.25 – 1.5%.

But be warned: when the markets are on fire, each and every stock gets high price. Hence it makes the task of detecting stocks having higher margin of safety quite difficult. But during the bear run, it can throw up the plethora of opportunities for long term investors.

In the next part, we take a look at the drawbacks of this ratio.

In the last article, we saw that in order to earn profit in stock markets, the price at which you buy the share should not exceed its value. So it is very  important you calculate the value of the share.

Calculating the value of the share: First you must begin by reading through financial statements of the company. Acquaint yourself with the finer nuances of the stocks.

Then you need to understand the valuation methods of the share. There are 2 methods to do that.

First Method: Calculate the net liquid assets per share. It is done by subtracting the liabilities from the current assets and dividing the result by number of shares.

Net liquid assets per share = Current assets –liabilities / number of shares

Current assets include  cash, debtors, liquid investments etc

The great investor Warren Buffet recommends paying not over 2/3 this figure for a share.

Second Method: Consider the PE (Price to earnings) ratio. It is calculated by dividing the market price of the share by Earnings per share (EPS).
 
PE ratio = Market price of a share/ Earnings per share

If the PE ratio is 1, you can say the share has fair valuation. If it below 1, it is undervalued and if it exceeds 1, it is overvalued.

In the next part, we’ll take a closer look at PE ratio.

Related Link: The Mantra to Stock Market Success

What makes investors like Warren Buffet and Benjamin Graham successful in the stock market? Why is it that some people make money in stocks while others don’t? The answer – they follow the simple mantra of investing: buy low, sell high.

Though this mantra is popular amongst stock market investors, the question is how do you define low. What is low? How do you know that the stock price is at the lowest?

To understand that, check if the market price of the stock is lesser than its value. This is because market price is the price the market is ready to pay for the company’s share. The value is the price of the company’s business. Unlike the price of the stock which fluctuates from moment to moment, the value of the company’s business is stable, as the nature of the company’s business doesn’t change very quickly.

When we say buy low, we mean buy the stock when its price is lower than the value. This lets you get quality businesses at bargain prices.

E.g. if the value of the company’s business is Rs 200 and its price is Rs 130, the stock is said to be available cheaply.

It is called as “margin of safety” principle, advocated by Warren Buffet and Benjamin Graham.

In the next part, we’ll see how to calculate the value of the company.

Rahul decided to invest in a mutual fund to fund his planned foreign holiday trip. His broker asked him if would like to opt for dividend or growth plan. Rahul was confused. He didn’t know what to do. So if you are in this position, then read on to find out more about these options.

When you invest in a mutual fund, your money is invested by the fund in buying assets like stocks, debt or gold. In turn, you get units in the fund. When the value of the underlying asset goes up, the value of the unit (NAV or Net Asset Value) also goes up, thus helping you earn profit. You can opt to withdraw this profit or keep on holding on to it and 10 per unit, then the value of each unit will now become Rs 40, once the dividend has continue to earn more profit.

If you need cash, then opt for the dividend option. This will enable you to withdraw the appreciation in the value of your units. However remember, the value of the units will fall by the amount of dividend declared. E.g. if you the NAV of the fund is Rs 50 and the dividend declared is Rs been paid out.

On he other hand, if you are looking to build a corpus for a long-term goal like retirement or your child’s education, then growth option is right for you. Here you can benefit from the compounded growth, thus helping you achieve your goal.

As Rahul did not actually need money, but was building corpus for his foreign holiday, growth option was suitable for him. Always find out the reason for investing before actually investing in a fund.

Looking to save tax? Want secure yet tax-free returns? How about an investment option that is backed by government? Then PPF should be high on your priority. PPF a.k.a. Public Provident Fund is a savings account offered by Government of India. It can be opened at any public sector bank or post office. You can invest a maximum of Rs. 70,000 in a year. It carries an interest rate of 8%, which is tax-free.

Here are the main features of PPF:
• Absolute safety: As the amount deposited in PPF account is backed by Government of India, you can rest assured your money is in safe hands.
• Tax benefits: Investment in PPF attracts a tax rebate of 20%. You just have to show the proof of deposit and claim tax benefit.
• High interest: Though interest rate on PPF varies, it doesn’t change frequently. Present rate on PPF is 8%. Add to that the tax benefit you get, the interest earned is actually more than 8%.
• Low minimum investment amount: The smallest amount that you can deposit in PPF is Rs. 500.
• Loan facility: In case of emergency, you can take a loan against the balance in your PPF account. It is available from 3rd and 6th year. It can be up to 25% of the balance in your account and the interest rate charged on the loan is 2% more than the rate of interest earned on your PPF account. The tenure for the loan is 24 months.
• Extension available: Normally the tenure of PPF account is 15 years. After that you can extend it for further 5 years.
• Withdrawal facility: If in need of money, you can withdraw money from your PPF account. This facility is available to you from 7th year onwards. The withdrawn amount should be the lower of the 50% amount in your account at the end of 4th year and 50% of the amount in your account in the previous year.
• Eligibility criteria: Anybody can open the PPF account. However joint account is not possible. However if you think all is well with PPF, then you are wrong. It does have some drawbacks:
• Amounts over Rs 70,000 do not earn any interest.
• Interest rate may not catch up with inflation, thereby eroding the value of your money.
• If you are not to pay your yearly installment, then you are considered a defaulter. To regularize your account, you have to deposit Rs 500 as installment + Rs. 100 as penalty for each year of default.
• Government has plans to tax withdrawal from PPF in future. So you may end up paying tax ultimately.

Despite its drawbacks, PPF remains an excellent vehicle for long-term investment. So make the best use of it.

“Bank Fixed Deposits (FDs) are the safest investment option.” This is a common refrain we hear from our parents, friends and financial advisors. But is it really true? Are bank FDs really as safe as they are made out to be?

The answer – No. While FDs don’t face the volatility risk, unlike stocks, they do have inflation risk and liquidity risk. Let us se what each of these risks entails.

Inflation risk: Inflation is the increase in cost of living. Higher rate of inflation erodes the value of your money, as you need more money to buy the same quantity of items.  Normally the interest rates offered by the banks are lesser than the rate of inflation. E.g. the current rate on bank FDs is around 7-8%. But the current inflation rate is over 10%. So the returns from the FDs are not enough to cover the inflation, thus eroding the value of your investment.

Liquidity risk: FDs up to Rs 1 lakh are insured by Deposit Insurance and Credit Guarantee Corporation. Any amount over this limit is not insured. So if the bank sinks, you end up losing the balance amount. As many people tend to deposit their money in smaller banks, which are at the risk of crashing, they face a higher risk of losing their money.

While these are two major risks, there are other drawbacks like tax and higher lock-in period. You need to understand these risks before you opt for bank FDs. Also ensure you invest in these deposits for short-term as the rates are highest during that period.

You are in urgent need of cash. On one hand you have the option of withdrawing cash by using your credit card or opting for a personal loan. How do you choose the best  option? Which is the right choice for you?

The best part of taking cash against your credit card is that you don’t need any approval from the bank. You can get the cash whenever you want. All you need to do is go to your closest ATM and withdraw the cash. Also you can pay off the loan whenever you want. There are no prepayment penalties if you choose to pay the loan any time you so desire. But the major drawback of taking loan against credit card is exorbitant charges, levied by the bank. You not only have to pay cash withdrawal fees but also the interest on the amount withdrawn. This can make this loan very expensive.

On the other hand, personal loan needs your bank’s approval. You should have a good credit record to avail of this loan. Also if you are looking for immediate cash, this loan is not for you, as banks need some time to process your application. There is a processing fee, which is most cases is not refundable. So you end up losing money, in case your application is rejected. With the stiff competition amongst banks, you can look around for favourable loan terms. You may also have to pay prepayment penalty, if you decide to pay off the loan before its term is over. The advantage of loan is its comparatively low rate of interest.

Both credit card and personal loan do have their pros and cons. Which one you should go for? Well, it will depend on your circumstances. If you are need of immediate loan for very short period, then credit card is right for you. Otherwise personal loan is good for you, provided you have good credit record.

Visit any insurance broker, and you will be bombarded with various different types of insurance products. But one type of insurance that most of them don’t talk about is term insurance. Why do they do that? Simply because they don’t make any hefty commission from selling this insurance. However if you want insurance that offers you highest life cover at the lowest possible premium, then you cannot afford to overlook this insurance.

In simple terms, term insurance provides you only with life cover. You can compare it with car insurance. Just as car insurance insures your car against any damages, term insurance insures you against any calamities. If your car meets with an accident, you can claim compensation from the insurance company. But if nothing happens to your car, then you don’t get anything. Term insurance works the same way.

The main advantage of this insurance is that you can get higher life cover than any other insurance product. But the best part is that this cover is available at the lowest price. As a result, your premium payable is also very low, since there is no investment component involved in this insurance. So your whole premium goes towards buying your life cover.

The disadvantage of this insurance is that it is not available to people over a certain age limit. Also you can just keep on renewing it till you reach the age limit, after which you will not have any life cover.

Today with the stiff competition amongst the insurers, you can get the highest possible cover by paying the lowest possible premium. There are many insurance portals that compare the features of different term insurance products. It will let you get the best deal possible, that is right for your needs.