Now let’s play with the growth and risk numbers a little. Let’s say that a lot of competition is coming in from overseas and that growth may slow from 5 percent to 4.5 percent. How will this change in growth affect price?

Here are the new numbers:

D1 = 10.45, g = 4.5 percent (0.045) and r = 10 percent (0.10)

This means the price of the stock today is:

Po = 10.45 / (0.10 – 0.045) = Rs. 190

The share price falls from Rs.210 to 190 as news of external competition gets out.

This is roughly a 10 percent drop because the expected corporate growth rate fell by 0.5 percent. See the impact of leverage here?

Immediately you will have pundits on the Idiot box telling you how it has hit a new low and that it is NOW worth selling at 190. Sadly, the market has already done what the pundits are now saying. So selling this share at Rs. 190 may not make sense at all – the price is already discounted. Why is there a big range of price? because each person’s ‘r’ or ‘expectation is very different. If an American investor decides to ignore the currency risk, his expectation from Indian equities will be much much lower than you and me who are Indian investors.

Now, assume that SEBI announces that it is going to launch some prosecution against the company for some share market irregularities. Anytime Sebi starts looking at something, it MAY mean more risk to the company aka the shareholders. This means new investors must be compensated for the new risk. This means that the new (or even existing shareholders) will ask for higher returns. HIGHER return means lower price. Since the growth rate is not changing, the only way to get a higher return is from a lower price.

Rather than using a 10 percent required return for risk (as we did yesterday), let us  assume today the new required return is 12 percent, at least until the Sebi probe is done with.

How does this change in required return for risk affect the stock price assuming the growth rate is still 5 percent?

Here are the numbers: D1 = Rs.10.5, g = 5 percent (0.05) and r = 12 percent (0.12)

This means the price of the stock today falls to:

Po = 10.5 / (0.12 – 0.05) = Rs.150

That’s roughly a 28 percent drop in the share price just because the government decided to investigate the company. Remember Maruti fell exactly by this %age when they announced the Gujarat plant – to be wholly owned by the Japanese Suzuki? Most of us were left wondering why such a huge fall when NOTHING fundamentally changed, right?

You would then have many pundits coming and saying ‘it is sentiment’ and all that bull shit.

Shares are BASICALLY very highly leveraged investments — any bit of good or bad news can have a MUCH HIGHER effect (aka leverage) on current prices. It may affect its growth rate or risk, or both, and these changes can cause big fluctuations. Those large price changes get adjusted as more information becomes public. IT IS IMPERATIVE THAT YOU KNOW HOW TO REACT. Normally sitting tight during such periods – especially in case of good management like Sun Pharma, Lupin, Unilever, Coromandel International, Cholamandalam, Asian Paints, Cummins, Siemens…makes sense. However if it is an iffy kinda company, exiting may be more prudent.

The same factors that impact individual shares also affect the entire stock market. Higher expected growth (India) and lower economic risk (US) is good for shares in both the countries. Expected changes in the corporate growth rate or perceived economic risk are the two reasons that share prices fluctuate more than earnings or dividends. Also as the capacity utilisation (or seasonal demand in case of say hotel rooms) also impact the share prices especially in the short run. Tremendous logic prevails in equity share and equity market pricing. Of course international interest rates being so low will also reduce ‘r’ dramatically and we can build up a bubble pretty fast.

Be ready for both the voting machine and the weighing machines…..

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1. ##### neal

again a gem of a article.

read it.. re-read it again and gain till you understand each and every word…

2. ##### subra

Neal…i write and only you read. LOL…serious stuff nobody reads..’if i do a post on why Rico Auto is a great buy’ I will have a 1000 hits in an hour. Financial porn sells. LOL

3. ##### Aby

Subra, I read it too 🙂 Very good article. I never thought that such small change in return expectation or risk could result in such large change in market price of a stock. I still am re reading to completely understand it. Later I may need to check each share in my small portfolio and readjust my expectation about how much it can fall without triggering any action from me (buy/sell). Now, if market drops the price of a stock due to short term reasons, it would present a good opportunity to buy, if I can understand whether the reason is indeed short term.
Again… brilliant.