In practice, the actual price earnings ratio may differ from the price earnings ratio established by you. This discrepancy may be caused mainly by two factors: (1) the assessment of the market (about growth and risk, growth in particular) may differ from your assessment, and (2) there may be certain imperfections in the market (artificial support provided by the management, negligible floating stocks etc) which may persist over time.
When the discrepancy arises due to these factors, you should examine the following:
1. The average price earnings ratio of the share in the last 3 to 5 years; and
2. The average price earnings ratio of the industry to which the share belongs.
The above evidence provides useful clues to certain factors that you may have overlooked but the market considers them relevant. Based on this information, you may modify your initial assessment. For example, if your initial assessment suggests that a reasonable price earnings ratio for a certain share is 8.33 but you find that the 5 year average price earnings ratio for the share has been 15.0 and the current average price earnings ratio for the industry to which this share belongs is 12.0 you may revise your assessment upwards to reflect these pieces of information. The adjustment will have to be necessarily judgmental in nature.
Assess Market Psychology: Shares prices are influenced by fundamental factors as well as psychological factors. If drawn a graphical figure show how these factors influence price behavior. AA1 represents the intrinsic value line which reflects fundamental factors. The assumption made here is that the intrinsic value rises gradually over time as the underlying fundamental factors like book value per share, earnings per share, and dividend per share. The actual price tends to gyrate around the intrinsic value line mainly under the influence of psychological forces. For example, when a wave of euphoria and greed sweeps the market, the price may rise to P1, far above the intrinsic value line. On the other hand, if fear and panic envelop the market, the price may fall to P2far below the intrinsic value line.
To judge the mood of the investors consult the price chart and other indicators. While they are not infallible guides, they do provide help in judging, at least broadly, whether the share is technically strong (indicative of investor bullishness) or technically weak (suggestive of investor bearishness). In addition, technical analysis may be profitability used in assessing roughly the resistance level and support level.
Apart from technical analysis, which may provide ambiguous signals or delayed indications, you should use your experience, intuition, insight, and judgment to feel the pulse of the market. Ask the questions: Will the stock catch the fancy of the investors? Is the stock likely to generate contagious dreams and induce investors to build castles in the air?
Combine Fundamental and Technical Analysis: As stock process are governed by fundamental factors as well as psychological influences, practical wisdom suggests that fundamental analysis must be used in conjunction with technical analysis. The indications of fundamental and technical analyses may be combined as follows in a decision matrix:
Technical — Weak
Analysis – Strong
It is instructive here to recall three rules prescribed by Burton Malkiel in his fascinating book A Random Walk Down Wall Street:
1. Buy only companies that are expected to have above average earnings growth for five or more years.
2. Never pay more for a stock than its firm foundation value.
3. Look for stocks whose stories of anticipated growth are the kind on which investors can build castles in the air.