Excellent discussion on highly relevant topic. Donald has [rovided an excellent framework that is useful in avoiding the optical illusion of "high P/E" is perceived as overvalued (or consequently low P/E perceived as under valuation!). In the past, I have fallen for the proverbial "erosion of margin of safety" argument and missed a few multi baggers. I think it's a great framework for evaluating it from 2-3 year investment horizon.
I am illustrating my thought process currently (which, obviously, is an evolving process based on feedback loop and hence may change!)here if it makes any sense. Now considering that you are a long term Investor and consider yourself a part-owner of the business, the decision to sell/buy should be a culmination/optimization of three different perspectives i.e. 100% private owner's perspective (business), an investor's perspective (Return) and capital allocation thresholds (Risk). Hence three key question that one would ask before making a decision to sell or not to sell should be
1) If I had 100% ownership of business, Is the current price attractive enough to sell it off to a private buyer?
2) Can I say I be reasonably confident to generate 100% return in 3 years or 1000% return in 10 years?
3) Is the current capital allocation within the threshold/limit set for a single business?
If the answer is 1) No 2) Yes 3) Yes then, it is a hold or else it is a sell
Even though, this may look a very simplistic framework, I think it covers majority of factors relevant for decision making
Question 1: A private owner will have a longer term perspective and ignore whether from 1-2 year perspective, it looks overvalued or not. So for Mr. Engineer, in his reasonable opinion thinks that 1000 crore sales is just the beginning and Astral, for next 8-10 years, can grow at consistently 25% without much difficulty and attain top line equivalent to 6-7 times current size! So, more likely than not, he would not be willing to sell not withstanding the trailing P/E is 50!
Question 2: However, Mr. Engineer's assessment of excellent growth opportunity for the business may be necessary but sufficient condition for investor to stay invested! It has to past the test of "hurdle rate returns" which in my case 25%. So, I will evaluate whether it can double in 3 years or grow 10 times in 10 years. My judgement of fair value of Astral type business is anywhere between 2-3 times sales. Currently the market cap is around 3800 crore (3.6 times sales). It has to double from here to 7600 crores to meet with 25% CAGR return criteria. Now considering very favourable market conditions, the business will trade in the upper range, say 2.75 times sales. So, in FY 2017,in order to reach Mcap of 7600 crores, it should have achieved sales of 2800 crores, which is 2.6 * FY 14 sales. Hence, Astral has to grow CAGR 38-40% from here on. Is it possible with sufficient tailwinds? May be. Can I accept 38% CAGR as baseline? May be not. So for short term, the odds are stacked against an investor who has return expectation is 25% CAGR.
Now let's look at the long term perspective say 10 year period. What is the expected top line growth CAGR for Astral? Let's take base case of 25% (which in my opinion is quite aggressive as such). Thus, topline will be 9X in 10 years. However, as happens in most cases, the reversion to mean is likely to happen eventually! So, Mcap/Sales multiple of 2.5 shall be a reasonable estimate of fair value. If we apply this numbers, market cap is likely to be 25,000 crores in a "open sky" scenario. This means, 6.5 fold return from here on. Is it sufficient? It depends on whom you ask. But doesn't meet my return criteria. So I will be inclined to sell.
Now, people may argue that margins may improve due to higher value added product etc. However, from what I could gather from management was that it is a volume game and not a margin game. They were forthright in saying that margin are likely to remain in 14-15% range going forward as well (an they have better visibility of product mix and margin profiles for the new products).
Question:3: This question relates to individual's risk bearing capacity. This is one mechanism which can protect investors from negative black swan events and hence is a must! It has to be adhered to as strictly as one adheres to strict stop losses in technical calls. So, irrespective of answer to the above two questions, if the allocation to a particular business goes beyond 25% of my portfolio, I will trim the exposure to bring it to 25%. This ensures for me peace of mind and protection against any negative black swan event in particular business/industry. The threshold number may be different from different people, nonetheless, it is a "must have" before constructing a portfolio!
Now having illustrated this, I would like to point out to one caveat. One can stick to this framework in its current form, if there are enough opportunities to deploy money in alternative investments in which the investor has same conviction level and investment can generate the expected return (25% CAGR) over medium/long term investment horizon. However, in case of absence of such opportunities, I personally would bring the bar lower for returns from existing investments ( I would be happy to stay invested with Astral/Cera giving 20% CAGR as compared to hurdle rate of 25%) rather than bear the risk of reinvestment!
The only time when it makes sense to sell and remain partially/fully in cash when the overall market is overvalued (as suggested by Donald, if it is 1 or two SD away from mean)