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.
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
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:
Can you please share the Morgan Stanely Research report?
What I find interesting is the less relevance of PE in longer duration. The whole premise of Value Investing is based on this principle of valuation. Not that I am proponent of Value Investing myself but just an observation.
@valorem I wish I was as good as you and other fellow members in explaining fundamentals, but my concept of investing is very simple and I prefer simple investing strategy while watching QoQ numbers and keeping close watch on sales and margins. Factors above mentioned are genuine and ideal ones for re-rating.
Definitely I have been lucky to get on of script which I want to contribute here: Sree Rayalaseema Hi-stength
Vp thread might justify whether its re-rating candidate or not .
Disc: Invested and biased
@valorem :- First of all, the work done by you, considering your age is IMPRESSIVE…. The way you probe cos. and sm of the investor threads is inspiring. Keep up the Good Work!!!
Coming to the above list, the only consideration for low PE cases is that are these the sustainable earnings. Some cos. got COVID and ensuing shortage earnings bump, sm hv been damaged for considerable time and hence the low PE is justified.
On the other hand consider adding those high PE stocks whr the earnings are suppressed currently.
Bcoz the thread’s name is Re-rating, why not consider the Earnings re-rating as well, apart frm multiple re-rating.
Disclosure :- No investment in any of the above stocks, bt considering sm of them
@shardhr - thanks for showing interest in the thread and your kind words!
About the list I shared above, I did not mean that all of them have a Re-Rating potential. Maybe none of them do! However, like you said, the stocks which have growing earnings/improving fundamentals have a chance of getting a multiple rerating, especially as they are trading near/below their historical multiples.
When a P/E is high and earnings improve, majority of the time the P/E decreases and price does not increase a lot. That eliminates the whole reason we are hunting Re-Rating candidates!
I’ll make my point clear with the help of an e.g - check out Deepak Nitrite’s PE in 2018-19 period. It was always 50+ and got de-rated from there still the stock became 8-10X from that point. So much sustainable earnings growth was coming that PE re-rating\de-rating didnt matter much.
The whole point was just to invert ur initial point and look for ideas frm that angle. Of course, as you mentioned - not all from the low PE list were re-rating candidates, similarly not all from high PE list will be de-rating candidates.