One of the most popular earnings multiples used is price to earnings. What is the ideal P/E ratio for a particular stock? This question has bewildered many to date. Value investors may not like anything which is trading at high or even double-digit multiples. They would always want to buy the cigar butt.
How much should we pay up for a particular stock? Return on a particular stock is a function of earnings growth and the P/E multiple which the market is ready to assign to the stock. Valuation that the market is ready to assign for a particular stock would depend upon various factors. The most important ones are: expected earnings growth and quality of earnings.
When buying any investment one of the fundamental question one should ask is what P/E multiple would the market be ready to pay for the company at the end of my investment horizon or going forward. If the market expects the company’s earnings growth to slow it might de-rate the stock and there might be a severe P/E contraction.
A business may be a great franchise but it’s the valuation which decides if it’s a good stock.
Let’s take the example of Gillette India. Gillette is an outstanding franchise globally. Warren Buffett is a great fan of Gillette. With a growing young population with aspirations and growing income level coupled with a huge population and low penetration levels, India provides Gillette with ample opportunities to grow.
On March 31, 2003, Gillette was trading at a P/E multiple of 135. Now 135 is a insanely high number.
Fast forward to a decade later on March 31, 2013, the stock is trading at a P/E of 86. Now even 86 is a high number, but the stock had seen an insane P/E contraction of 48 times.
For the period between 2003 and 2013, the earnings grew at a compounded average of 28% and even after a severe P/E contraction, the stock was an eight bagger. While the earnings grew at a compounded growth rate of 28%, the market cap grew at 22% CAGR. The differential is reflected in the P/E contraction.
Even at a P/E of 86, markets expects Gillette India’s earnings to grow at a very healthy pace. Given the moat that the business enjoys and the opportunities that the Indian market provides, they may materialize and it may be a good stock to own even at such high earnings multiples.
Let’s look at another example. My first look at this company was Prof Bakshi’s who is an authority on value investing and keeps a blog. I still consider it one of the best reads.
The company we are talking about is VST Industries. VST Industries operates in the cigarette market where there are barriers to entry in the form of government regulations. It operates on the lower end of the market with the Charms Brand. The company enjoys moat around its business. It was reflected in its working capital cycle. It's because its brand used to take cash up front from its dealers whereas it used to get credit from its suppliers, which resulted in negative working capital. As a result of this and high asset turnover it does not need significant capex to grow.
From 2003 to 2013 while the sales grew from 331.3 Cr to 663.7 Cr the volume of cigarettes in fact declined from 8,885 to 8,062 million units. Thus all the growth in sales has come from price increase. Profits grew from 37.3 Cr to 126.2 Cr at a compounded CAGR of 13%. This investment was a 17 bagger. The stock as of March 2013 traded at a P/E ratio of 18. While VST industries represents a sustainable durable moat its sales and profit growth are being delivered by price increases and not volume growth.
At a P/E ratio of 4, the stock was a very good investment, but at 17 it may not be the same. With limited or no volume growth there is serious possibility of the stock being de-rated by the market, and then it may trade at a low valuation. A very good franchise which was a good stock to own at a P/E of 4 may certainly be a risky bet at an earnings multiple of 18.
Let’s look at another example Infosys. Infosys (INFY, Financial) on March 31, 2000, was trading at a P/E ratio of 219. Now we are talking about the tech bubble. But Infosys did represent an opportunity. It was about the entire offshore model developed by Indian Tech Companies. Infosys was leading the charge. Its earnings grew at a compounded growth rate of 31.47% from 267 Cr in 2000 to 9365 Cr in 2013. It grew 35 times. Not many companies have delivered that sort of growth for more than a decade. Even at such stellar profit growth, if someone had invested in 2000 he would have earned around only 8.25% compounded annually. As of March 31, 2013, the company was trading at a multiple of 17.63. The market does not perceive that the company will continue its impressive growth.
Peter Lynch who by far is one of the most successful money managers gave the world an interesting way to judge what earnings multiple is appropriate for a stock. He said it should equal the sustainable earnings growth that the company can achieve. Anything less than that is ideally cheap. What came out of it is what is known in the investing world as the PEG Ratio. The PEG ratio is the P/E divided by the sustainable earnings growth rate. Anything above 1 is considered expensive while below 1 is considered cheap. It may not again be the most appropriate way to look at a stock. Coupled with the earnings growth rate the investment horizon also matters because the power of compounding also plays a role. Gillette is a live example. We are replete with such examples from very high quality companies in India like Nestle, etc.
It’s difficult to answer what exactly is the right P/E by looking at a formula. It is aptly said Investing is more art than science. It’s the art of understanding business dynamics and moat. At what rates will the company keep growing and till what period. If we can reasonably draw a conclusion to the same we are much nearer to taking an appropriate call. If a company which is trading at high multiples and is may not see earnings growth due to increased volume growth then there is a serious possibility of P/E contraction.
Professor Bakshi who is an authority on value investing in India in his article in Outlook Business had shared his thoughts about paying up for quality in Indian Context. In his subsequent post he has emphasized the importance of paying up for quality.
In India we have a few very high quality companies which may appear expensive but have a lot of steam left to grow and may continue to grow and trade at high P/E multiples.
How much should we pay up for a particular stock? Return on a particular stock is a function of earnings growth and the P/E multiple which the market is ready to assign to the stock. Valuation that the market is ready to assign for a particular stock would depend upon various factors. The most important ones are: expected earnings growth and quality of earnings.
When buying any investment one of the fundamental question one should ask is what P/E multiple would the market be ready to pay for the company at the end of my investment horizon or going forward. If the market expects the company’s earnings growth to slow it might de-rate the stock and there might be a severe P/E contraction.
A business may be a great franchise but it’s the valuation which decides if it’s a good stock.
Let’s take the example of Gillette India. Gillette is an outstanding franchise globally. Warren Buffett is a great fan of Gillette. With a growing young population with aspirations and growing income level coupled with a huge population and low penetration levels, India provides Gillette with ample opportunities to grow.
On March 31, 2003, Gillette was trading at a P/E multiple of 135. Now 135 is a insanely high number.
Fast forward to a decade later on March 31, 2013, the stock is trading at a P/E of 86. Now even 86 is a high number, but the stock had seen an insane P/E contraction of 48 times.
For the period between 2003 and 2013, the earnings grew at a compounded average of 28% and even after a severe P/E contraction, the stock was an eight bagger. While the earnings grew at a compounded growth rate of 28%, the market cap grew at 22% CAGR. The differential is reflected in the P/E contraction.
Even at a P/E of 86, markets expects Gillette India’s earnings to grow at a very healthy pace. Given the moat that the business enjoys and the opportunities that the Indian market provides, they may materialize and it may be a good stock to own even at such high earnings multiples.
Let’s look at another example. My first look at this company was Prof Bakshi’s who is an authority on value investing and keeps a blog. I still consider it one of the best reads.
The company we are talking about is VST Industries. VST Industries operates in the cigarette market where there are barriers to entry in the form of government regulations. It operates on the lower end of the market with the Charms Brand. The company enjoys moat around its business. It was reflected in its working capital cycle. It's because its brand used to take cash up front from its dealers whereas it used to get credit from its suppliers, which resulted in negative working capital. As a result of this and high asset turnover it does not need significant capex to grow.
From 2003 to 2013 while the sales grew from 331.3 Cr to 663.7 Cr the volume of cigarettes in fact declined from 8,885 to 8,062 million units. Thus all the growth in sales has come from price increase. Profits grew from 37.3 Cr to 126.2 Cr at a compounded CAGR of 13%. This investment was a 17 bagger. The stock as of March 2013 traded at a P/E ratio of 18. While VST industries represents a sustainable durable moat its sales and profit growth are being delivered by price increases and not volume growth.
At a P/E ratio of 4, the stock was a very good investment, but at 17 it may not be the same. With limited or no volume growth there is serious possibility of the stock being de-rated by the market, and then it may trade at a low valuation. A very good franchise which was a good stock to own at a P/E of 4 may certainly be a risky bet at an earnings multiple of 18.
Let’s look at another example Infosys. Infosys (INFY, Financial) on March 31, 2000, was trading at a P/E ratio of 219. Now we are talking about the tech bubble. But Infosys did represent an opportunity. It was about the entire offshore model developed by Indian Tech Companies. Infosys was leading the charge. Its earnings grew at a compounded growth rate of 31.47% from 267 Cr in 2000 to 9365 Cr in 2013. It grew 35 times. Not many companies have delivered that sort of growth for more than a decade. Even at such stellar profit growth, if someone had invested in 2000 he would have earned around only 8.25% compounded annually. As of March 31, 2013, the company was trading at a multiple of 17.63. The market does not perceive that the company will continue its impressive growth.
Peter Lynch who by far is one of the most successful money managers gave the world an interesting way to judge what earnings multiple is appropriate for a stock. He said it should equal the sustainable earnings growth that the company can achieve. Anything less than that is ideally cheap. What came out of it is what is known in the investing world as the PEG Ratio. The PEG ratio is the P/E divided by the sustainable earnings growth rate. Anything above 1 is considered expensive while below 1 is considered cheap. It may not again be the most appropriate way to look at a stock. Coupled with the earnings growth rate the investment horizon also matters because the power of compounding also plays a role. Gillette is a live example. We are replete with such examples from very high quality companies in India like Nestle, etc.
It’s difficult to answer what exactly is the right P/E by looking at a formula. It is aptly said Investing is more art than science. It’s the art of understanding business dynamics and moat. At what rates will the company keep growing and till what period. If we can reasonably draw a conclusion to the same we are much nearer to taking an appropriate call. If a company which is trading at high multiples and is may not see earnings growth due to increased volume growth then there is a serious possibility of P/E contraction.
Professor Bakshi who is an authority on value investing in India in his article in Outlook Business had shared his thoughts about paying up for quality in Indian Context. In his subsequent post he has emphasized the importance of paying up for quality.
In India we have a few very high quality companies which may appear expensive but have a lot of steam left to grow and may continue to grow and trade at high P/E multiples.
