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It is priced in: What does that mean
Today’s stock prices are a reflection of tomorrow’s profits. Everyone speaks of how the stock market discounts future events. You may have heard stock market experts on television speak about economic or political developments ‘priced in’ by the market.
But what it means?
Here are some pointers that explain it:
When you purchase a company’s stock, you are buying a portion of the company. Not every share available at the same price. There are a lot of factors that determine the price of a stock. This includes the value of the company, its profits, how it scores over competitors, and so on.
The stock price fluctuates on a daily basis. Whenever there is news that may be detrimental to a company’s profits, the share price falls. Similarly, good news also leads to a subsequent rise in the stock’s price.
This means, investors value the stock in anticipation of a higher future value. You buy stocks today when it is cheaply available if you expect it to do well in the future.
As a result, the stock price takes into account all the factors that will affect a company in the future. This is called ‘pricing in’ or ‘discounting’. It is during this time when the share either falls or rises the most. Once a factor has been priced in or discounted, the share price stabilizes for a while until another factor arises.
The biggest example is when the Federal Reserve, the US central bank, announced plans to cut down its bond purchases from the market as part of its Quantitative Easing programme. Stock markets worldwide crashed, not just for one day, but many days after the statement. However, when the Fed actually cut down the bond purchases by $10 billion, stock markets rarely blinked an eye. This is because, the risks from the Fed’s action were already priced in.
Analysts use the Forward PE or Price-to-Earnings multiple to determine if a stock is correctly valued on the basis of future earnings. This is the amount an investor would shell out for every rupee a company would earn in the near future. Lower the Forward PE, cheaper is the stock valued.
The 30-share Sensex is trading at a PE multiple of 18.54, as of April 3, 2014. However, if one expects a 10% growth in the earnings-per-share of Sensex companies, then the index is trading at a price-to-earning multiple for FY15 of less than 14 times. This means investors are willing to pay 14 times the earnings per share for March 2015 of Sensex companies. If actual profits are higher or lower, stock prices or the Sensex value would adjust accordingly.