FE Report (October 27, 2010)
An unprecedented event took place the other day in Bangladesh; the chiefs of the Dhaka Stock Exchange (DSE) and the Chittagong Stock Exchange (CSE) held a joint press conference to warn investors about the over-valuation of equities in the Bangladesh. The bourse chiefs stated that the current valuation of stocks in the Bangladesh capital market is irrational and cannot be justified by the expected earnings of the companies concerned. As a student of Finance, I was dumbfounded by the event because I know of no such event ever taking place in any country of the world since stocks and bonds began to trade publicly almost 300 years ago. One of the reasons why the bourse chiefs took this unprecedented step was probably to warn and protect uninformed small investors from a disaster that is imminent. History tells us that whenever the stock market crashes, it is the small and uninformed investor who is hurt the most. People have even committed suicide after they lost their wealth in the stock market.
The Securities and Exchange Commission (SEC) is the regulatory body that is responsible for the enforcement of laws and regulations so that investors can trade with confidence and not become victims of any malpractice or fraud. The SEC is responsible to ensure that listed companies make full disclosure of information that may affect the stock price. It is also the task of the SEC to ensure that company insiders do not use privileged information to benefit in the stock market at the expense of the uninformed investors. If there is any indication of irregularities or price manipulation, the SEC is the authorized body to stop the irregularity and initiate appropriate legal and administrative action. The news conference of the bourse chiefs therefore raises the question as to why the SEC hasn't made any public statement on this matter as yet. Do the bourse chiefs know something that the SEC is not willing to admit or is it that they simply don't know? After all, it is the members of the stock exchange who are on the trading floor. These traders observe and know many things that are not reported in the financial press.
We should remember that in the stock market crash of the mid-nineties, the SEC was unable to detect on time the price manipulation by certain rogue traders. Furthermore, the SEC was unable to successfully prosecute the perpetrators of the crash. Are we on the verge of another crash that the SEC will be unable to detect and control in a timely manner? After all, the caution was not sounded by an immature journalist who does not understand the complexities of the capital market. It was sounded by the two chiefs of the two stock markets in Bangladesh.
In mature markets, many analysts follow the market as well as individual companies. It is not uncommon for several analysts to give conflicting opinions about the same stock or the future of the market. Market participants have access to these opinions and they base their trading decisions on all the information available to them. Analysts whose predictions are borne out by the price movements are stars and those who make wrong predictions usually don't last too long and they eventually find their livelihood elsewhere. What is interesting is that none of the analysts' reports on the local market that I have come across mention anything along the lines that bourse chiefs stated in their press briefing. Why is that? Are the analysts' missing something or are they not revealing the truth because revealing the truth may jeopardize their livelihood?
Valuation of stocks is more of an art than science. Different analysts use different models to value stocks. Professors William Sharpe and Harry Markowitz won the Nobel Prize in Economics in the eighties for their seminal work on the valuation of stocks. Their work gave us the discounted cash flow model for the valuation of stocks. Briefly, their work showed that the value of a stock is simply the present value of future cash flows (dividends) discounted at a rate that is consistent with the riskiness of the stock. The challenge is to determine the riskiness of the stock based on the volatility of the stock price.
A simpler model is the price earnings ratio (P/E) which is simply the price of the stock divided by the earnings per share. A high P/E ratio signifies that the market values the earnings of the company favourably and is willing to pay a high price for the ownership of that stock. Low P/E ratios signify poor valuation. Corollary to this would be that if an investor goes by the principle 'buy low sell high', then investors should buy stocks when the P/E ratio is low and sell when the P/E ratio is high.
P/E ratios have been studied extensively by researchers who follow the stock market. Their findings show that historically P/E ratios of the very best companies have hovered around 14-16. This is true for America as much as it is true for European markets or Asian markets.
What is the P/E profile of Bangladeshi stocks? The mid range of P/E of the most actively traded stock is currently hovering around 40 and the P/E of the most favorite ones are in excess of 100. This suggests that these Bangladesh companies have better earnings prospect than the very best companies of the world. Can this be true?
Finally, did the market participants pay any heed to the caution sounded by the bourse chiefs? It doesn't seem so. Immediately after the press conference, the market had a 4.0% drop the next day following the press conference and thereafter the market has been on the rise thereafter. It seems the warning of the bourse chiefs has fallen on deaf years.
E-mail : qayyum.khan@bd.bureauveritas.com
The Securities and Exchange Commission (SEC) is the regulatory body that is responsible for the enforcement of laws and regulations so that investors can trade with confidence and not become victims of any malpractice or fraud. The SEC is responsible to ensure that listed companies make full disclosure of information that may affect the stock price. It is also the task of the SEC to ensure that company insiders do not use privileged information to benefit in the stock market at the expense of the uninformed investors. If there is any indication of irregularities or price manipulation, the SEC is the authorized body to stop the irregularity and initiate appropriate legal and administrative action. The news conference of the bourse chiefs therefore raises the question as to why the SEC hasn't made any public statement on this matter as yet. Do the bourse chiefs know something that the SEC is not willing to admit or is it that they simply don't know? After all, it is the members of the stock exchange who are on the trading floor. These traders observe and know many things that are not reported in the financial press.
We should remember that in the stock market crash of the mid-nineties, the SEC was unable to detect on time the price manipulation by certain rogue traders. Furthermore, the SEC was unable to successfully prosecute the perpetrators of the crash. Are we on the verge of another crash that the SEC will be unable to detect and control in a timely manner? After all, the caution was not sounded by an immature journalist who does not understand the complexities of the capital market. It was sounded by the two chiefs of the two stock markets in Bangladesh.
In mature markets, many analysts follow the market as well as individual companies. It is not uncommon for several analysts to give conflicting opinions about the same stock or the future of the market. Market participants have access to these opinions and they base their trading decisions on all the information available to them. Analysts whose predictions are borne out by the price movements are stars and those who make wrong predictions usually don't last too long and they eventually find their livelihood elsewhere. What is interesting is that none of the analysts' reports on the local market that I have come across mention anything along the lines that bourse chiefs stated in their press briefing. Why is that? Are the analysts' missing something or are they not revealing the truth because revealing the truth may jeopardize their livelihood?
Valuation of stocks is more of an art than science. Different analysts use different models to value stocks. Professors William Sharpe and Harry Markowitz won the Nobel Prize in Economics in the eighties for their seminal work on the valuation of stocks. Their work gave us the discounted cash flow model for the valuation of stocks. Briefly, their work showed that the value of a stock is simply the present value of future cash flows (dividends) discounted at a rate that is consistent with the riskiness of the stock. The challenge is to determine the riskiness of the stock based on the volatility of the stock price.
A simpler model is the price earnings ratio (P/E) which is simply the price of the stock divided by the earnings per share. A high P/E ratio signifies that the market values the earnings of the company favourably and is willing to pay a high price for the ownership of that stock. Low P/E ratios signify poor valuation. Corollary to this would be that if an investor goes by the principle 'buy low sell high', then investors should buy stocks when the P/E ratio is low and sell when the P/E ratio is high.
P/E ratios have been studied extensively by researchers who follow the stock market. Their findings show that historically P/E ratios of the very best companies have hovered around 14-16. This is true for America as much as it is true for European markets or Asian markets.
What is the P/E profile of Bangladeshi stocks? The mid range of P/E of the most actively traded stock is currently hovering around 40 and the P/E of the most favorite ones are in excess of 100. This suggests that these Bangladesh companies have better earnings prospect than the very best companies of the world. Can this be true?
Finally, did the market participants pay any heed to the caution sounded by the bourse chiefs? It doesn't seem so. Immediately after the press conference, the market had a 4.0% drop the next day following the press conference and thereafter the market has been on the rise thereafter. It seems the warning of the bourse chiefs has fallen on deaf years.
E-mail : qayyum.khan@bd.bureauveritas.com
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