April 6, 2018

Should we pay High P/E for Established & Proven Companies, Which P/E Ratio should be used, Can we predict future Market Cap? (Q&A)


www.drvijaymalik.com has a section dedicated to answering queries from readers: “Ask Your Queries”. Over time, many readers have asked their queries related to many aspects of stock analysis and sought clarifications about investing. We have responded to these queries as replies to their comments.

“Q&A” series is an attempt to share the queries & their responses, which have featured on “Ask Your Queries” section, with all the readers. The primary aim of this new feature is to share the knowledge with other readers of the website, who might have similar queries.

The current article in this series provides responses related to the following queries:
  • Should we pay high P/E for stocks with proven competitive advantage/moat?
  • Which P/E ratio should we use?
  • Can we predict the future market cap of a company?


Should we pay high p/e for established companies like HDFC, Kotak, Asian Paints, Which P/E ratio to use, Predict Market Cap




Should we pay high P/E for stocks with proven competitive advantage/moat?



Dr. Malik,

I hope you are well.

I have questions regarding valuation of a stock over the long term.  I would like to use Asian Paints as an example. I am not invested; I am just trying to understand the dynamics of a long-term moat stock.

As you have taught, buying at the right price is critical to higher profits, in essence, a low PE/low PB.


I am left confused by the case of Asian Paints. Over the last 10 years, Asian Paints has gone from a PE of 24 to the currently exorbitantly high 63 PE. What I find astounding is that the chart of Asian Paints PE is a steady rise over the last 17 years, giving us a CAGR of nearly 11% for 17 years.

What I am surprised to find is that even if an investor picked up Asian Paints at a PE of 30, he or she would have still produced decent profits over the years.

Lynch says that the PE number should be about the growth rate of a stock, meaning Asian Paints must produce a growth of 60%, which to my mind does not seem plausible. However, this argument would have held strong when the stock was at PEs of 30 and 40.

Therefore, I have to ask, how this is possible. A relentless growth in the PE for a company with never a reversion to the mean. What PE would be considered ludicrous for this stock? I would have thought 40 PE was too much, then 45, then 50, and now 63. It would seem that I am wrong in all of my assumptions.

How does a market justify, over 17 years, this growth in the PE, even for a moat company? I know that Buffett has said that in the long term, the Market is a weighing machine, but in this case, it does not seem to be the case.

I would welcome your thoughts, and if I have made mistakes in any of my calculations, my apologies in advance.

With Thanks,


Author’s Response:


Hi,

Thanks for writing to us.

We believe that when we pay a high P/E to enter into a stock (e.g. a P/E of more than 25), then a lot of things have to work in favour of the company for it to make good returns for the investor. We do not know of any precise method to justify or to determine why a stock should command a P/E of 30 or 45 or 60. One thing that we know is that it’s not the actual slowdown of growth but even a perception of the impending slowdown of growth can reduce the P/E multiple of such companies and in turn, can reduce the return of the investor when compared to the EPS growth over the holding period.

We have highlighted such issues in the following article: Hidden Risk of Investing in High P/E Stocks

So when we see the margin of safety in such investments, then we understand that the probability of negative surprises leading to reduced returns is higher when the initial purchase price is high than the case when the initial purchase price is lower.

Nevertheless, there is never only one way to look at markets and investments and Peaceful Investing is only one way to invest in markets. Many investors have made significant returns by investing in well known, high growth companies at high prices. However, as discussed in the above article, we do not believe that we are able to find out what all factors can affect the future of business performance/investor perception/sentiment about such companies and therefore, we tend to stay away from them.

This is not to say that everyone should follow our approach. In fact, there is a book "Common Stocks Uncommon Profits" by Phil Fisher, which focuses solely on such growth stocks. I have read this book and realized that I am better off sticking to finding growth at lower prices so that the odds are more in our favour.

In summary, we believe that the odds (margin of safety) are more in favour of the investor when the initial purchase price is low. However, does that mean that high P/E stocks will always lose money for investors over a selected period? No. The market is too uncertain to make such predictions.


In addition, as we routinely say, there would always be stocks outside one's portfolio, which would make huge returns for other investors. Investors should be ok watching such stocks from the sidelines if they do not fit into their investing approach. The idea is to find an approach, which an investor feel comfortable and find companies, which meet that approach.


Hope it answers your query.

All the best for your investing journey!

Regards,

Dr. Vijay Malik


Which P/E ratio should we use?



While looking at the P/E ratio of a particular stock, should we be looking at the average P/E over a period or current P/E?

Please advise.


Author’s Response:


Hi,

Thanks for writing to us!

It is an investor’s choice to use the parameters that she prefers and finds suitable to her investing approach. Different investors use P/E ratios based on different set of earnings like last FY or last 12 months or an average of last 3 or 5 years etc.

We normally use the lower of the: 
  1. P/E based on average of EPS of last 3 years and
  2. P/E based on last 12 months (if the company does not have any subsidiary or the consolidated quarterly financial results are available) or last financial years' earnings (when the company has a subsidiary/associate but it does not provide quarterly consolidated financial results).


We would not be able to comment on the criteria used by other investors.

All the best for your investing journey!

Regards,

Dr Vijay Malik


Can we predict the future market cap of a company?



Dr. Malik,

How can we analyse if the current market cap of a company as on date is x? Will it grow to 5x? E.g. - Godrej Agrovet is ₹12,400 cr approx. today. Can it be ₹50,000 crore in 5 years’ time?


Author’s Response:


Hi,

Thanks for writing to us!

We do not know any method to predict the future market cap of any company. We can only find out whether a company is fundamentally sound by following the below mentioned steps and then hope that the market will increase its market cap in future:


We do not believe that it can be said with certainty that the market cap will increase for sure in future for any stock. It may or it may not. Even if it increases in future, then there is no certainty with the pace at which it may increase in future.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik


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DISCLAIMER


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