August 13, 2016

3 Principles to Decide the Investable P/E Ratio of a Stock for Value Investors

Deciding about the valuation level of any company at which an investor buys its stock is one of the key aspects of stock analysis. It is said that even a very good company if bought at an overvalued price, might not prove to be a good investment. Therefore, every investor while analysing stocks for investment keeps on continuously asking herself, whether the current price presents an attractive valuation opportunity or whether she might get stuck in an overvalued stock if she buys the stock at current prices.

There are many parameters, which are used by different investors to assess the valuation levels of any stock at a given price. A few of these parameters are listed below:
  • Price to Earnings ratio (P/E ratio)
  • P/E to Growth ratio (PEG ratio)
  • Earnings Yield (EY)
  • Price to Book value ratio (P/B ratio)
  • Price to Sales ratio (P/S ratio)
  • Dividend Yield (DY)
  • EV/EBITDA

An investor should read the following article to understand the above mentioned valuation parameters in further detail: How to do Valuation Analysis of a Company

Every investor has her own favourite valuation ratios, which she determines based on her own experience and preferences. I prefer using the price to earnings ratio (P/E ratio) as the valuation level for determining the attractiveness of a given stock price of any company.

P/E ratio is the most widely used parameter to analyse whether the stock of any company is overvalued or undervalued at any point of time. It is calculated by dividing the current market price (CMP) of a stock by profit/earnings per share (EPS). It represents the price an investor pays to buy ₹1 of earnings of a company.

To illustrate, if the P/E is 10, it means that to get ₹1 of earnings in one year from a company, the investor is paying ₹10. Similarly, if P/E is 20, it means that to get ₹1 of earnings in one year from the company, the investor is paying ₹20. If we compare P/E ratio of 10 and 20, in the above example, it would become evident that at P/E of 20, the investor is paying more money to get the same value of ₹1 in earnings than when P/E is 10.

Investors interpret P/E ratio and its derivatives in multiple ways to decide about valuation level of a stock: 
  • Comparing P/E ratio of the stock with the industry in which the company operates: Industry P/E ratio is the average of P/E ratios of all the companies of the specific industry listed on the stock exchange. If P/E ratio of the stock is higher than the industry P/E ratio, it is assumed to be overvalued and vice versa.

  • Comparing current P/E ratio with historical P/E ratio of the stock: if P/E ratio is lower than average P/E ratio of last 10 years, then stock is deemed undervalued and vice versa.
  • Comparing P/E ratio with earnings (EPS) growth rate (PEG ratio) and
  • Comparing P/E ratio in form of Earnings Yield (EY) with yield on other asset classes like government securities (G-Sec), Treasury Bills etc.

However, despite presence of such multiple ways of interpreting P/E ratio investors still find themselves unsure about the right P/E level that they should pay for any stock. The fact that the price of the stock is influenced by a multitude of factors like external factors (interest rates etc.) and internal factors (competitive advantage etc.), further increases the uncertainty about the right price to be paid for the stock of any company.

The current article is an attempt to help the reader tread on a guiding path to determine the right price i.e. P/E ratio to be paid for a stock. The article attempts to determine a few of the factors that influence the P/E ratio of the stock and tries to bring a some objectivity to the approach of determining the right P/E ratio that the investor might be willing to pay for the stock.

The article would focus on the key criteria that an investor should look at while deciding about the P/E ratio (premium or discount) that she may pay for any company. These criteria would help her in deciding about the maximum P/E that she may pay for a company, which she has initially bought at very attractive levels but the stock has now increased in price and P/E ratio. This would also help her in deciding her strategy for accumulating stocks which are already existing in her portfolio.

Among all the multitude of factors that influence the potential purchase price (P/E ratio) of any stock, we believe that there are three primary factors:
  1. Prevailing interest rate in the economy
  2. Competitive advantage (moat) enjoyed by the company
  3. Circle of competence of the investor

(Out of the three factors mentioned above, the first two factors draw a lot from the article on assessment of margin of safety of a stock. Therefore, it is advisable that, in case the reader has not read the following article earlier, then she should read it in detail before continuing further:


Let’s now delve deeper into each of these factors to assess how they influence the potential purchase price of any stock for the investor:

1.    Prevailing Interest Rate in the Economy


The prevailing interest rate in the economy influence the stock prices as well as the underlying business of the companies in a significant manner.

Investor always compare expected returns from stocks with the alternatives available to them. One of the key alternative asset class available to all the investors is debt funds, whose return depends a lot on the prevailing interest rates. As interest rates fall, the returns from debt funds decline and they lose their attractiveness to investors. As a result, a lot of investors shift their money to stock markets and are ok to accept comparative lower returns from stock markets until the time such returns are sufficient to beat the yields on debt funds. It results in investors willing to pay higher prices to same stocks, which they otherwise would not have paid.

On the contrary, if interest rates are high, then investors have debt funds as a readily available alternate asset class giving them good returns. In such a scenario, attractive by the perceived certainty of returns from debt funds, a lot of investors withdraw funds from equity markets as they are unwilling to take the risk associated with stocks and as a result, they are unwilling to hold the stocks at higher prices. It results in the stock prices, in general, getting depressed at the times of high interest rates.

Moreover, low interest rates lead to easier and cheaper availability of credit/loans to companies and in turn help them grow and post good results/profits. This leads to a lot of investors buying stocks and taking their prices high in low interest rate situations. The reverse happens when interest rates are high. Profits of companies decline and the investors push the stock prices lower.

In an attempt to bring an objectivity to this influence of interest rates of the economy, the article delves on the concept of margin of safety put forward by Benjamin Graham in his book: The Intelligent Investor.


The discussion below uses Earnings Yield as a factor to determine the margin of safety and the resultant P/E ratio that an investor should target for any stock.

Earnings Yield (EY) is calculated as inverse of Price to Earnings (P/E) ratio i.e. E/P ratio. It is calculated by dividing the earnings per share (EPS) with the current market price (CMP).

EY provides an idea about the earning/returns that a stock would produce for every ₹1 invested by the buyer in it.

Benjamin Graham advised comparing the EY with Treasury Yield (USA). Similar yield to compare in India is the ongoing yield on Government Securities (G-Sec). The higher the difference between EY and G-Sec/Treasury Yield, the safer is the stock investment.

To illustrate, suppose an investor buys a stock of company ABC Ltd at ₹100. If EPS of ABC Ltd is ₹10 then its P/E ratio would be 10 (100/10) and its EY would be 1/10 or 10%. As current G-Sec yield is about 7.50-8.00%, ABC Ltd is a good investment as per Graham’s criteria.

Suppose, after the investor buys the stock of ABC Ltd., its price falls to ₹50, then the P/E ratio would become 5 and the EY would become 1/5 i.e. 20%. EY of 20% would attract more and more investors to shift money from bonds markets and use it to buy stocks of ABC Ltd. as it provides an opportunity to invest money at a yield of 20% against G-Sec yield of 8%. This new demand for stocks of ABC Ltd. would increase its stock price and limit the downfall.

The higher the difference between EY and G-Sec/Treasury yield at the time of purchase of the stock, the higher is the cushion in times of adversity i.e. higher Margin of Safety. Therefore, the stocks with higher earnings yield (EY) i.e. the ones with low P/E ratio, would provide a higher cushion to the investor during tough times.

Therefore, one benchmark that an investor might keep to determine the maximum P/E ratio to pay for the purchasing the stock of any company can be derived from Government Securities (G-Sec Yield) or the Treasury Yield.
  • If the 10 years G-Sec yield is 10%, then the investor may decide about the maximum P/E ratio to be paid for a stock as 10 (i.e. 1/10%)
  • If the 10 years G-Sec yield declines to 8%, then the investor may be comfortable at paying a P/E ratio of 12.5 (1/8%) for the stocks.
  • If the 10 years G-Sec yield rises to 12.5%, then the investors should pay only a P/E ratio of 8 to the stock (1/12.5%)

The article on assessing margin of safety uses the above concept to determine the margin of safety inherent in the purchase price of the stock.



2.    Competitive Advantage (Moat) enjoyed by the Company


Competitive advantage of any company, aka moat, helps it to protect its business, its market, and its margins from competition. As a result, the company is able to generate higher sales growth, sustained/improving profitability margins, significant free cash flows etc. for its shareholders.

The article on assessing margin of safety uses two concepts to determine the margin of safety in the business of a company. These two concepts are:
  1. Self-Sustainable Growth Rate (SSGR)
  2. Free Cash Flows (FCF)

The current article utilizes these two concepts to determine whether the company has a competitive advantage and deserves to be paid any premium in terms of a higher P/E ratio over and above the P/E ratio arrived by using 10 year G-Sec yields discussed above.

2. A) Self-Sustainable Growth Rate (SSGR)


Self-Sustainable Growth Rate (SSGR) is a measure of the growth potential inherent in the business model of a company, which it can achieve using resources generated through its current profits without relying on external sources of funds like debt or equity dilution.

Self-Sustainable Growth Rate (SSGR) utilizes the features of a company’s business model like net profit margin (NPM), dividend pay-out ratio (DPR), depreciation (Dep) and net fixed asset turnover (NFAT) to arrive at the sales growth rate that the company can achieve without leveraging itself.

The formula for calculating SSGR is:

SSGR = [(1-Dep) + NFAT*NPM*(1-DPR)] – 1

(I advise that the readers should read the following article dedicated to SSGR, in case they have not read it already, before proceeding further in order to fully understand the concept and implications of SSGR:


It can be inferred from the above formula, the companies with higher profitability (NPM), operating efficiency (high NFAT) and lower dividend pay-outs (DPR) would have higher self-sustainable growth rate (SSGR).

An investor should compare the SSGR of the company with its current sales growth to see if there is any margin of safety in the business of model of the company:

1) If the SSGR is higher than current sales growth rate:


It means that the company’s business features (NPM, NFAT & DPR) allow it to grow its sales at a higher rate than the current growth rate. In case of economic downturn, the company can safely:
  • reduce its profitability to generate higher demand
  • reduce dividends to conserve funds to make additional investments and
  • invest in fixed assets to improve its plant & machinery/technology (leading to lower NFAT) 

in an attempt to maintain its current sales growth rate.

All the above steps would provide funds from business activities and the company would not have to rely on external sources like debt or equity dilution to get funds to maintain its current growth rate. Therefore, the company with higher SSGR can increase their sales growth rate in normal times and maintain current sales growth rate during tough times without leveraging their balance sheet by taking on debt.

This ability to sustain the growth rate in times of stress without impacting the returns to shareholders makes such companies eligible to be paid a premium while purchasing their stocks. An investors may choose to pay a premium over the P/E ratio arrived at after considering ongoing 10 years G-Sec yield, to purchase these companies that have SSGR above sales growth rate.

Let us see the examples of companies, which have SSGR higher than their 10 years sales growth rate:

VST Tiller Tractors Limited:

”How


VST Tiller Tractors Limited has an SSGR of more than 45%, whereas it is growing its sales at an annual rate of 15%-17%. SSGR data indicates that the company can grow at a rate much higher than its current sales growth without requiring outside capital in terms of debt/equity dilution. No wonder that the company has shown very healthy growth without raising any debt.

Tide Water Oil Co. (India) Limited:

”How


Tide Water Oil Co. (India) Limited has an SSGR of more than 55%, whereas it is growing its sales at an annual rate of 12%-15%. SSGR data indicates that the company can grow at a rate much higher than its current sales growth without requiring outside capital in terms of debt/equity dilution. No wonder that Tide Water Oil Co. (India) Limited has shown very healthy growth without raising any debt.

We can see that the companies like VST Tiller Tractors Limited and Tide Water Oil Co. (India) Limited, which have SSGR higher than their 10 years sales growth are able to sustain their growth without leveraging their balance sheets. In case of economic downturn, these companies can decide to reduce profitability to generate higher demand, reduce dividends to conserve funds to make additional investments and invest in fixed assets to improve its plant & machinery/technology to maintain their current sales growth rate.

In case of such companies, an investor may choose to pay a premium (higher P/E ratio) over and above the P/E ratio arrived at after considering ongoing 10 years G-Sec yield.

The premium that an investor might decide to pay for such companies is a personal preference. However, while making investments, I keep a rough guideline of a premium of incremental P/E ratio of 1 for every 10% cushion of SSGR over the 10 years sales growth.

(Please note that this is a very rough guideline for calculating the amount of premium in terms of P/E ratio of which is yet to be established by any statistical estimates).

2) If the SSGR is lower than current sales growth rate:


The investor would notice that such companies are already growing more than their business potential. Such companies usually rely on raising debt or diluting their equity to generate funds needed for investments to generate the sales growth.

These companies usually grow at a sales growth rate which is much higher than their business potential (SSGR). The result is that these companies have to consistently raise debt/dilute equity to raise funds for investments to generate the growth, as their operational business is not able to generate required amount of funds.

Let us see the examples of companies, which have SSGR lower than their 10 years sales growth rate:

Pratibha Industries Limited:

”How


Pratibha Industries Limited has been growing its sales at a growth rate of about 28%-38% over last 10 years, however, its business model indicates that in the current situation it is not able to sustain any growth beyond 5% from inherent sources in the business as its SSGR is almost 1%-5%. Pratibha Industries Limited has to raise almost entire amount of funds to support its growth from additional sources like debt.

It is not surprising that Pratibha Industries Limited has witnessed its debt increase from ₹50 cr. in FY2006 to ₹2,283 cr. in FY2015.

Jai Prakash Power Ventures Limited:

”How


Jai Prakash Power Ventures Limited has been growing its sales at a growth rate of about 35%-45% over last 10 years, however, its business model indicates that in the current situation it is not able to sustain any growth from inherent sources in the business as its SSGR is almost 0%. Jai Prakash Power Ventures Limited has to raise almost entire amount of funds to support its growth from additional sources like debt.

It is not surprising that Jai Prakash Power Ventures Limited has witnessed its debt increase from ₹1,081 cr. in FY2006 to ₹22,901 cr. in FY2015 and recently has to resort to selling its assets to repay its lenders.

An investor would notice that the companies that grow at a rate higher than what their business model can fund have to face stress going ahead when the debt burden increases to unsustainable levels.

An investor might feel that she may invest in such companies by buying them at a discount to the P/E ratio arrived at after considering ongoing 10 years G-Sec yield, just as she decided to buy the companies with SSGR higher than sales growth at a premium. However, it is advised that the investor should avoid investing her hard earned money in such companies and try to find out other opportunities where companies are growing within their SSGR.

2. B) Free Cash Flows


As described in the article on margin of safety: 3 Simple Ways to Assess "Margin of Safety": The Cornerstone of Stock Investing , I believe that free cash flow (FCF) is the ultimate measure of investibility of any company.

It is calculated as the surplus cash with the company after meeting its capital expenditure requirements.

FCF = CFO – Capex

Where,
  • CFO = cash flow from operations
  • Capex = capital expenditure including maintenance capex and capital work in progress (CWIP) 

Capex for any year can be calculated as the difference between gross fixed assets (GFA) & CWIP at start of the year and end of the year. It can also be calculated by deducting net fixed assets & CWIP at start of the year from the net fixed assets & CWIP at end of the year and adding back the depreciation for the year.

Capex:
(GFA + CWIP) at the end of the year – (GFA + CWIP) at the start of the year

OR

(NFA + CWIP) at the end of the year – (NFA + CWIP) at the start of the year + Depreciation for the year

Free cash flow (FCF) is the most essential feature of any business as it amounts to the surplus/discretionary cash that the business/company is able to generate for its shareholdersFCF is the equivalent of savings for a household.

If we as households are not able to manage our expenses within our means of income, i.e. are not able to save anything, then our financial health is going to suffer a lot in future. We would have to borrow from relative/banks etc. to meet our requirements. The debt, which we raise to fund our expenses, needs to be paid at predefined intervals irrespective of the fact whether we are able to save in future/have our job intact or not. The debt pressure increases the bankruptcy risk and leads to stress in our lives.

The scenario is exactly the same for companies as well.

If a company does not have positive free cash flow, it means that it is spending beyond its means. Such a company would have to raise funds from additional sources like debt or equity dilution to meet its requirements. These funds, if raised from debt, would decrease profitability by interest expense and increase bankruptcy risk and if raised from equity, would lead to dilution of stake of existing shareholders.

In both the cases, the situation of companies continuously raising debt/equity to meet their cash flow requirements becomes less attractive for investors as compared to the companies that are able to meet their funds requirements from their cash flow from operations.

It might be argued that the investments done today by the company would lead to revenue & profits in the future and would generate wealth for the shareholders.

This argument is a valid argument just like an educational loan for an individual. An education funded by loan is an investment, which has the potential of increasing the skills set, earnings ability and future wealth of a person and therefore is considered a good investment.

Similarly, for companies the investments in plants & machinery and technology is like educational loan, which increases future earnings potential. Therefore, we should worry about a situation where a company is not able to generate positive FCF for a few year. Such companies might be taking education loans to generate future wealth. However, if a company is not able to generate positive FCF over long periods of time (I assess them over last 10 years), then the company resembles a continuous cash guzzling machine.

It resembles an individual who is continuously garnering degrees after degrees costing millions of rupees/dollar, without ever putting those skills to commercial use. Or those degrees might be fake and cash has already gone down the drain! In both the cases, the investment done is not of much use.

I, as a shareholder, expect the companies I own, to be cash generating machines. Their business should be source of cash for me and not the other way round. Therefore, positive free cash flow generation by a company over last 10 years, is one of the key criteria for stock selection for me.

Once an investor has identified a company with positive cash flow, then she should further analyse what proportion of cash flow from operations (CFO) over last 10 years, it has used in capital expenditure (capex) and what proportion is available as free cash flow (FCF%).

Free Cash Flow% (FCF%) and Margin of Safety:


I find that the companies, which have achieved their sales growth in the past by using minimum amount of CFO as capex have significantly higher margin of safety over the companies which have used almost all CFO. Needless to say, the companies, which have their capex much higher than their entire CFO over last 10 years (i.e. negative FCF), have very low/negative margin of safety.

An illustration:

Let’s take an example of two similar sized companies (A & B) growing their sales at a similar rate (say 15%) in the past. Let’s assume that both the companies A & B, generated same amount of CFO over last 10 years (say ₹100 cr).

Let’s assume that on analysing the capex done by these companies in last 10 years, we find company A has achieved the sales growth (15%) by doing a capex of ₹50 cr (50% of CFO), thereby, generating a FCF of ₹50 cr. On the contrary, we find that the company B has achieved the same sales growth (15%) by doing a capex of ₹100 cr (100% of CFO), thereby, generating NIL FCF.

When the tough times strike the economy in future, the profitability of companies would decline, customers would delay the payment of cash, suppliers would ask for immediate cash and the credit from all sources would become costly.

In such a situation, company A, whose business model permitted it to achieve the sales growth by using only 50% of CFO in the past, would be able to bear the impact of reducing cash inflows as customers cancel their orders, squeeze profit margins and delay the payments. Theoretically, company A can tolerate its profitability and cash collections (CFO) declining by 50%, before signs of stress start becoming visible on its business operations & planned investments.

On the other hand, company B, which was already investing 100% of its CFO to generate its sales, would find even the slightest decline in its cash flow (CFO), impacting its operations. Declining orders, reduced profitability and delayed payments from customers would make it difficult for company B to make payments to its suppliers and do planned investments. Company B would have to rely on additional debt/equity raising to fund its cash requirements.

If there is another company C, which was already using more than 100% of its CFO in capex, thereby having negative free cash flow (FCF). Such a company would already be sagging down under lot of debt burden. In tough economic situation described above, company C would find difficult to continue its business operations as usual as sources of cash dry up. The additional debt, which was essential to sustain its business model, would become further costly.

Companies like C are prime candidates for bankruptcy in tough times as they find it difficult to service exiting debt, make payments to suppliers. Such companies, usually being capex heavy and operating at low profit margins, find it difficult to garner additional business by reducing their profitability as it would push them into losses. Such companies rarely have any margin of safety built in their business model.

Free Cash Flow% (FCF%) and P/E Ratio


Let’s see the examples of some of the companies from the perspective of FCF and try to determine if they deserve any premium in terms of P/E ratio over and above the P/E ratio arrived at after considering ongoing 10 years G-Sec yield.

1. Companies with Positive Free Cash Flow (FCF):


Atul Auto Limited:

”How


Over last 10 years (FY2006-15), Atul Auto Limited has generated cash flow from operations (CFO) of ₹168 cr. whereas it needed to invest only ₹88 cr. in its business and thereby leaving ₹80 cr. (48%) in hand of the company as discretionary cash to reward its shareholders. No wonder, the company could provide dividends to the tune of ₹35 cr. over last 10 years despite remaining virtually debt free.

The investor may read an analysis of Atul Auto Limited in the following article: Analysis: Atul Auto Limited

TTK Prestige Limited:

”How


Over last 10 years (FY2006-15), TTK Prestige Limited has generated cash flow from operations (CFO) of ₹663 cr. whereas it needed to invest only ₹385 cr. in its business and thereby leaving ₹278 cr. (42%) in hand of the company as discretionary cash to reward its shareholders. No wonder, the company could provide dividends to the tune of ₹156 cr. over last 10 years despite remaining virtually debt free.

We can see that the companies like Atul Auto Limited and TTK Prestige Limited, which have generated positive free cash flows (FCF) are able to sustain their growth without leveraging their balance sheets. During tough times, such companies can reduce prices of its products, offer higher credit period to its customers, pay suppliers promptly to attract and retain quality suppliers without impacting its balance sheet.

These companies would not need to raise debt for such crisis strategies; only a slight reduction in the dividend pay-outs to the shareholders would provide enough of money to fund the emergency measures.

In case of such companies, an investor may choose to pay a premium (higher P/E ratio) over and above the P/E ratio arrived at after considering ongoing 10 years G-Sec yield.

The premium that an investor might decide to pay for such companies is a personal preference. I believe that any investible company must have positive FCF to the tune of 25%-30% of its CFO while using the balance 70%-75% of CFO to fund a respectable sales growth. Therefore, while making investments, I keep a rough guideline of a premium of incremental P/E ratio of 1 for every 10% cushion of FCF% above minimum 25-30% for companies that have been growing their sales above 15% per annum for last 10 years.

(Please note that this is a very rough guideline for calculating the amount of premium in terms of P/E ratio of which is yet to be established by any statistical estimates).

2. Companies with Negative Free Cash Flow (FCF)


Now, let’s see some cases where companies have grown beyond their means (CFO) and have done more capex than its inherent business strength permitted.

Bhushan Steel Limited:

”How


Over last 10 years (FY2006-15), Bhushan Steel Limited has generated cash flow from operations of ₹10,312 cr. However, its business required it to invest ₹41,255 cr in the company, thereby eliminating any chance of free cash flow. The company, on the contrary, had to raise debt to fund its capital expenditure requirements. Total debt of the company increased from ₹2,036 cr. in FY2006 to ₹39,079 cr. in FY2015.

If an investor analyses deeply, then she would notice that the entire dividend of ₹97 cr., paid by the company over last 10 years has been funded by debt.

National Fertilizers Limited:

”How


Over last 10 years (FY2006-15), National Fertilizers Limited has generated negative cash flow from operations of ₹ (1,766) cr. However, its business required it to invest ₹4,395 cr in the company, thereby further deepening the negative cash flow position. The company, on the contrary, had to raise debt to fund its capital expenditure requirements. Total debt of the company increased from ₹227 cr. in FY2006 to ₹7,645 cr. in FY2015.

The investor would notice that the entire dividend of ₹295 cr., paid by the company over last 10 years has been funded by debt.

If the economic scenario deteriorates further, then companies like Bhushan Steel Limited and National Fertilizers Limited would have to meet its cash requirements by raising further debt or equity. In case its lenders or shareholders, do not provide this capital, then the company would face difficult time to tide over the crisis and may resort to sell assets to repay lenders or face bankruptcy.

Looking at the above situation, it is clear that companies like Bhushan Steel Limited and National Fertilizers Limited do not have a significant margin of safety built into its business model.

An investor might feel that she may invest in such companies by buying them at a discount to the P/E ratio arrived at after considering ongoing 10 years G-Sec yield, just as she decided to buy the companies with positive free cash flow (FCF) at a premium. However, it is advised that the investor should avoid investing her hard earned money in such companies and try to find out other opportunities where companies are growing while maintaining a positive FCF.

The investor should note that positive FCF should be a necessity before considering any company for investment and the fact that higher the FCF as proportion of CFO, the higher the margin of safety.

3) Circle of Competence of the Investor


An investor should prefer to invest in the companies, which are in her circle of competence i.e. the companies where the investor understands the products, the markets, the management, the industry etc.

The investor should continuously try to expand her circle of competence by reading more and more about companies and industries. It is one of the key requirements from a stock investor.


Investors usually have a lot of knowledge about companies that are:
  • from the industry in which the investor works
  • already part of investor’s portfolio where the investor had selected the company after doing significant research

It is a known fact that the investors can take informed decisions about the companies that are within their circle of competence and thus have a key advantage over other investors while deciding about investments in these companies. This advantage is also a form of Margin of Safety.

I believe that in case the investor is not finding good opportunities in the markets at very attractive prices, then she can pay a little premium to purchase stocks of companies in her circle of competence.

To illustrate, assuming an investor has a criteria of purchasing companies at a P/E ratio of 10 or lower but is not able to find any new company to add to the portfolio, which is priced at a P/E ratio of 10 or below, then she may think of buying additional quantities of stocks already existing in her portfolio at a little premium say P/E of 11. This is with the assumption that the investor has selected the stocks in her portfolio by doing sufficient research and has been monitoring the stocks on a continuous basis and is well aware about the management, business, products and markets of the companies in her portfolio.


With this, we come to an end of the current article, which focused on the key criteria that an investor should look at while deciding about the P/E ratio that she may pay for any company. These criteria would help her in deciding about the maximum P/E that she may pay for a company, which she has initially bought at very attractive levels but the stock has now increased in price and P/E ratio. This might help the investor in deciding her strategy for accumulating stocks which are already existing in her portfolio.

To summarize, the investor may use the following approach in determining the P/E ratio while buying a stock:
  1. Prevailing Interest Rate in the Economy: 
    • The investor should use the 10 year government securities (G-Sec) yield/treasury yield to arrive at a benchmark P/E ratio at which she may decide to pay a premium or a discount depending on the other parameters about the company. Lower interest rates/yield scenarios would lead to higher P/E ratios and vice versa.
  2. Competitive Advantage (Moat) enjoyed by the Company:
    1. Self-Sustainable Growth Rate (SSGR): If the company has an SSGR, which is higher than the last 10 years annual sales growth rate, then the investors may decide to pay a premium over the P/E ratio arrived at after considering ongoing 10 years G-Sec yield, for buying the stocks of the company. 
      • The investor should avoid companies, which have SSGR much lower than the 10 years annual sales growth rate and as a result are growing beyond their business potential by continuously raising debt.
    2. Free Cash Flow% (FCF/CFO): An investor may decide to pay a premium over the P/E ratio arrived at after considering ongoing 10 years G-Sec yield, for buying the stocks of the companies which generate high free cash flow as a proportion to their cash flow from operations (FCF/CFO).
      • The investor should avoid companies, which have negative free cash flows and are funding their growth/normal business operations by raising debt. 
  3. Circle of Competence of the Investor:
    • In case the investor is not able to find any new stock, which is within her comfortable P/E ratio range, then she may decide to pay a little premium to invest in stocks, which are within her circle of competence. These stocks may be from the existing portfolio of the investor, which she has selected after doing sufficient research or may be from the industry that the investor knows thoroughly about.


In the current article, I have shared the learning that I have had in my investing journey related to the finding attractive investment opportunities at attractive prices while maintaining a healthy margin of safety, which I believe that could be useful to other investors.

It’s your turn now.

Share your experiences and let the other readers and the author know about the ways you assess the purchase price of any stock while making an investing decision. It would be a pleasure to read your experience and investing strategy.

It would be great to have your feedback about the current article and the website.

P.S:

  1. The analysis of the companies used in illustrations above has been done by using my customized stock analysis excel template which has the features like SSGR, Free Cash Flows% (FCF/CFO) already built in. The excel template is now compatible with screener.in. This customized excel template is now available for download as a premium feature. For further details and download: Click Here
  2. To know about the stocks in my portfolio, their relative composition, cost price, details of the last 10 transaction as well as to get updates about any future buy/sell transaction in my portfolio, you may subscribe to the premium service:  Follow My Portfolio with Latest Buy/Sell Transactions Updates (Premium Service)
  3. You may read “Selecting Top Stocks to Buy - A Step by Step Process of Finding Multibagger Stocks” to select fundamentally good stocks for investment.
  4. I have used the financial data provided by screener.in while conducting analysis for this article.



DISCLAIMER


The views and opinions expressed or implied herein are my own and do not reflect those of my employer, who shall not be liable for any action that may result as a consequence of my views and opinions.

Registration Status with SEBI:


I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013

Details of Financial Interest in the Subject Company:



Currently, I do not own stocks of any of the companies discussed above.