This argument about high PE and low PE stocks creeps into valuations discussions very often.
We often see many businesses quoting at seemingly high multiples forever and stay away from them while it is also true that many businesses always seem to be quoting at low multiples making them attractive. Businesses also get re-rated suddenly and their PE just shoots up and vica versa.
From a shareholder value perspective a company has only two jobs to do - First - increase the gap between Return on Equity and Cost of Equity & second - keep finding reinvestment opportunities for a long period of time. If the marketplace believes that it can do both successfully - the market rewards it by assigning it a high multiple. There are few companies that continue to do that and we know their names by heart by now.
Following is the chart of the long term exit PE multiples at various ROE’s and Reinvestment rates. The vertical axis is the exit PE & the horizontal axis is the ROE. The bars represent reinvestment rates.
If your ROE is equal to your cost of equity (15%) over a long period of time - the exit multiple is 6.67 no matter how much the company reinvests. The PAT growth for companies which invest 100% of their profits is 15% under such business economics - a good growth rate by any means - but you cannot give more than a 6.67 exit multiple. Many very good companies in growing sectors with plenty of reinvestment opportunities are in this situation and seem to trade at ok multiples for this reason.
However, when the business increases this gap ( ROE & COE ) , the exit multiple improves rapidly. In fact if the marketplace believes that the company can keep reinvesting all its profits at higher & higher ROE’s, the valuations become irrational and the exit multiple at 25% ROE & 100% profits reinvested can reach crazy levels. In the long run, no company can keep on doing that but in the short run many can. These 50%-60-70%% falls that we see from the peak are when the marketplace realizes that its not possible and the multiples drop rapidly.
If the reinvestment opportunities go down or the ROE’s drop , multiples come down with a vengeance. Its rational for them to do that. Whats irrational is investors extrapolating good times to infinity and believing in them
This often happens when great companies come down a notch and become good. Its still a good company no doubt - but its no longer awesome. The difference between awesome and good is thin but its a graveyard.
A company that generates a 20% ROE and is able to reinvest 50% of its profits a good company but deserves an exit multiple of ~9. A great company which generates an ROE of 25% and is able to reinvest 100% of its profits for a very very long time deserves an exit multiple of ~49. The difference in multiples is huge.
Over time, I think one should look at incremental ROE’s improvements and reinvestment rates to spot companies where the market has not rerated it a lot. The opposite is also true and if incremental ROEs drop ( like they always do ) and companies run out of reinvesting opportunities - one should not blame the marketplace for acting they way it does.
What i do quickly sometimes to get a rough gauge of valuations is multiply the exit multiple by 2 under my normalized ROE and reinvestment assumptions. Examples
Colgate : ROE - 50% , reinvestment : 30% thus exit multiple is 21 so steady state PE is 42
Mahanagar Gas - ROE- 20% , reinvestment : 50%, thus exit of 9 so steady state multiple of 18
Dmart - ROE : 25%, reinvestment : 100%, thus exit of 49 and a steady state multiple of 98
Avanti : ROE : 18%, reinvestment : 80%, thus exit of 9.59 and steady state at 20
Page : ROE : 40%, reinvestment : 50%, thus exit of 35 and steady state of 70
REC : ROE : 15%, reinvestment : 70%, thus exit of 6.67 and steady state of 13