What does Re-Rating of Stock mean?
Re-Rating of a stock indicates that Investors are willing to pay more or less for the stock. Re-Rating, is the opposite of Mean Reversion (in which the P/E multiple returns to its average value) and the P/E expands or decreases along with the EPS. The Re-Rating of a stock is mostly correlated to the investors’ sentiment and companies future prospects. Below is a simple example of Re-Rating:
PP water balls is a company which is the only player in the water balls industry with a stock price of 100 Rs and Annual EPS of 50 Rs. Thus its P/E ratio is currently 2x. Now let’s say a big shot on Dalal Street Mr. Prasad writes a report on how the water balls industry is poised for exponential growth. This creates a strong positive sentiment among investors and in turn PP water balls gets a higher P/E multiple, let’s say 5x. So now, the stock price will be 5 * 50 Rs = 250 Rs. Now, if the EPS doubles and rises to 100 Rs, its price will not double, but will increase by 5 times and become 5 * 100 Rs = 500 Rs.
If you’ll want to know more about PP water balls check out this video - PP Waterballs IPO - Jaspal Bhatti - BN Sharma - Most Popular Comedy Video - Best Punjabi Comedian - YouTube
Of course, this example was imaginary and now we will go through a real life examples of Re-Ratings:
As you can see, Praj Re-Rated from a P/E multiple of around 15x to around 85x in a year! This resulted in the Stock generating a lot of alpha in that period. The reason for this Re-Rating the potential rise in demand on Ethanol (You can read more about the Ethanol Story in the Praj Industries ValuePickr thread here).
Here you can see that Pix Transmission’s P/E multiple went from around 5x to 20x. The expansion was accompanied by accelerated Earnings growth. You can read more about Pix Transmission in its Valuepickr thread here.
~FYI its just a coincidence that both the names of the examples companies given started with “P”
How to identify Re-Rating candidates?
Here are some factors that I have identified and found that can lead to a Re-Rating (Disclaimer - all of these are not my own findings):
- Potential growth in Revenue
- Change in prospects of a company
- ROCE Expansion (Especially when it expands past the WACC)
- OPM Expansion/Operating Leverage
- ROE Expansion
- Accelerating Earnings growth
- Identifying a stock before it Re-Rates is not an easy task to say the least. What is for sure though is that stocks trading at high P/E multiples like 50x have an extremely low chance of Re-Rating while compared to stocks trading at lower multiples.
- In the Long term, P/E Re-Ratings don’t really matter - what matters more is Sales and Profit growth. However, the Multiple plays an important role in the performance of a stock in the Short to Medium term. This can be see in the chart taken from a Morgan Stanely Research Report below:
I will add stocks which are Re-Rating candidates in my opinion and other factors that lead to Re-Ratings as I discover them. I will appreciate if you’ll do the same.