Fear of the High P/E
Most often, we avoid buying quality stocks as we are scared of the high P/Es and end up regretting. Stalwarts like Sanjay Bakshi and Basant Maheshwari have made it abundantly clear that there is no harm in paying up for quality.
One way to get out of the fear of high P/E is look at PEG ratio, as Peter Lynch suggests. However, PEG typically understates the value of a stock. For companies with strong economic moats, a high P/E might very well be justified and in many cases, is likely to be understating the value. Sanjay Bakshi explains it beautifully in this insightful note , especially the section where he takes us on a time machine back to 2005 to get a “perfect foresight” to help us in the valuation of Asian Paints.
Can we take this time machine into the future to helps us get “sufficient foresight” to assess whether to buy a high P/E stock or not?
@ 50 P/E – to buy or not to buy
In the last week of June 2014, Page Industries broke out after a short pause (moving within 5700-6700 range for about 2 months) in its long upward journey. It presented me a huge dilemma – despite its strong fundamentals, is Page a good buy at a P/E of 50 (based on trailing 12 months EPS)? I did not buy.
Now, it trades at 15k, after peaking at 17k levels. Interestingly, I came to know later that Basant Maheshwari had added more of Page about 6k levels (Probably, it was he who caused the momentum burst).
So, how can one get the conviction to buy a stock at such an apparently high P/E? For that, we need to get a sense of what is the upside potential from the current levels. We can spend hours in building a detailed DCF model to calculate the target price. The key issue here is identifying how long should be the explicit forecast period and how to estimate the terminal price, which typically accounts for over two-thirds of the total company value estimate.
To start with, we can forecast how the company’s EPS can grow in the future and use a target P/E to arrive at a target price for the stock. One of the key assumptions behind this is that the company can sustain the ROE it generated in the recent past. I have discussed below how we can get “reasonable confidence” that the company can sustain ROE at the recent levels and how can pick a target P/E multiple.
- Calculate potential EPS growth rate as sustainable growth rate (g)
- 3-year average ROE x (1-payout ratio)
- Forecast EPS of the company 3 years further down
- Current EPS compounded for 3 years at g %
- Calculate target price based on EPS estimate and target P/E multiple
The idea of this exercise is to get a “reasonably right” price range and help us face our fear of high P/E. In order to gain conviction, we need to look at how realistically can the EPS growth be sustained and also what target P/E multiple should be used.
Dissecting The Sustainable Growth Rate
We can do a DuPont analysis of ROE to understand how the key driving factors are trending. By understanding how profit margins, asset turnover and leverage have contributed to growth in the past, we should be able to assess how sustainable the current ROE levels would be. A look at the chart below shows that Page has been able to increase its ROE by using the right levers and we can be reasonably sure that the high levels are likely to sustain for a longer period.
- Profit margins: Increasing / stable profit margins over 3-5 years bode well. Is the competition in the industry intensive? How does the firm’s margins compare with the industry?
- Asset turnover: Higher the asset turns, the better it is
- Equity multiplier: Higher ratio indicates higher leverage, which should be avoided
Picking The “Correct” P/E
A useful way to think about P/E is in terms of payback period. How long does it take to recover each rupee I pay for a rupee of EPS? Not surprisingly, high growth companies give you back the money quickly than slow growers.
In the example below, I have used cumulative EPS to calculate the time required to recover for a stock with EPS growing at 10% and another one with 30% growth. Assuming I pay Rs.15 for each stock, it takes about 9-10 years for me to recover full price paid for the slow grower, while it is about 6-7 years for the fast grower. If I bought the stocks at Rs.32, the fast grower would pay it all back in 9 years, whereas the slower one will take about 15 years.
In the previous calculation for finding the target price for Page, I have used the 8 year average P/E. Page has witnessed a P/E expansion over the previous eight years, reflecting improving fundamentals. If we take the 3 year average P/E of 31x, we get a price target of 12,565. Going back to Peter Lynch, if we were to value Page using a fair PEG of 1, we would use P/E of 38 (based on 3 year average EPS growth) in the above calculation, resulting in a target price of 15,400 (using a 3rd year EPS estimate of Rs.405).
Assuming Page makes another breakout, now above 16k levels, would I buy?
I might. As Basant Maheshwari put it eloquently – you cannot buy today’s stock at yesterday’s price.
An important point to remember is that investors generally tend to underestimate the competitive advantage period (CAP) of a company, the time over which the company generates returns above its cost of capital. If we were to assume Page will sustain such high ROEs for 5 years and extend the above target price calculation to 5 year horizon, we would arrive a target of 25,400 (based on 5 year averages – ROE of 63%, payout of 41%, P/E of 38 and FY2014 EPS of Rs.137). This implies a 69% upside from current levels.
Will Page be able to sustain such stunning high growth beyond 3-5 years? That will require much more detailed analysis. Prima facie, it seems it might.
I am not registered with SEBI under SEBI (Research Analysts) Regulations, 2014. As per the clarifications provided by SEBI: “Any person who makes recommendation or offers an opinion concerning securities or public offers only through public media is not required to obtain registration as research analyst under RA Regulations”.
This article is not a recommendation and for educational purposes only. No holdings in Page Industries.