A falling stock is not always cheap: Kotak explains the role of earnings and valuations

A falling share price does not necessarily make a stock cheap, just as a rising price does not, by itself, make it expensive. According to Kotak Institutional Equities (KIE), investors need to look beyond price movements and focus on the value of the underlying business, the earnings it is expected to generate and the valuation investors are willing to assign to those earnings.

In their report, Investing 101 and endless, pointless discussions, Sanjeev Prasad, Anindya Bhowmik and Sunita Baldawa of KIE argue that investors' preoccupation with market flows, ownership patterns and share prices has diverted attention from value, which they describe as the only relevant issue in investing.

The analysts contend that, without value as an anchor, investing can largely become an exercise in chasing rising or falling prices. They also challenge conventional explanations for stock price movements that attribute market trends to foreign portfolio investor (FPI) outflows, domestic inflows or money supposedly moving between stocks, sectors and market capitalisation segments.


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There is no money in the market; market cap can be anything, even zero

KIE reiterates that flows are irrelevant as an explanation for stock price movements. The brokerage argues that every transaction in the secondary market involves a buyer and a seller, with shares and cash changing hands between the two parties. The transaction itself does not change the company's number of outstanding shares.

"It is an incontrovertible fact there is never any money in the secondary market - for a trade, somebody has to buy and somebody else has to sell," the analysts said.

On this basis, the report argues that investors can stop attributing market movements to flows, including concerns over FPI outflows and domestic inflows.

KIE also dismisses the idea that money moves from one stock to another, between sectors or across market capitalisation segments as an explanation for price movements. According to the report, differences in the performance of stocks and sectors over recent months and years, as well as patterns of inflows into mutual fund schemes, reflect differences in company fundamentals and valuations, along with investor expectations.

The brokerage's argument is that buying and selling, by themselves, do not explain why a stock's price rises or falls. Instead, the focus should be on the factors that influence investors' assessment of a company's future prospects and the value they attach to it.

Money does not move between primary and secondary markets

KIE also challenges concerns that large initial public offerings (IPOs) necessarily drain liquidity from the secondary market.

"We would ignore market worries about large IPOs affecting liquidity (whatever that may mean) in the secondary market," the report said.

The brokerage argues that money cannot simply be described as moving out of the secondary market and into the primary market. While secondary-market transactions involve existing shares and cash changing hands between buyers and sellers, IPOs can attract fresh investment depending on valuations and market sentiment.

"IPOs will see interest and investment (new money) based on valuations and sentiment," the analysts state in the report.

KIE points to the scale of India's annual household financial savings relative to IPO issuances, noting that the former dwarf the latter. The report also observes that FPIs have been investing aggressively in the primary market.

So, what drives stock prices?

KIE's answer centres on two variables: earnings per share (EPS) and the price-to-earnings (PE) multiple.

The report describes a stock price as the market's aggregate view of a company at a given point in time. Changes in expectations about earnings affect future EPS estimates, while changes in expectations about a company's future prospects influence the PE multiple investors are willing to pay.

"Any change in expectations about earnings will change future EPS estimates, and any change in expectations about future prospects will change P/E," the analysts said.

According to KIE, investors buy when expectations improve and sell when expectations deteriorate. Buying and selling, therefore, follow changes in expectations rather than independently explaining the resulting price movements.

The brokerage also uses the discounted cash flow (DCF) framework to explain how share prices respond to changing expectations about future cash flows and the discount rate applied to them. Both can change with prevailing market sentiment, whether driven by fear, greed or more rational assessments of future prospects.

"A mental DCF is an easy way to appreciate stock price changes - market expectations of future cash flows or discount rate (linked to prevailing sentiment of fear, greed or rationality) or both could and will change," the analysts said.

The report draws a distinction between the time horizons over which earnings and valuation multiples influence share prices. "Earnings are relevant in the long term and multiples in the short term for stock prices," the analysts said.

Disclosure: This article has been written by Kumar Gaurav, who is not a Sebi-registered Research Analyst or an Investment Adviser. Gaurav and their ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective Sebi-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclaimers here