Price Earnings (P/E) multiple is derived by dividing the market capitalisation (Mcap) by annual Profit after Tax (PAT). P/E changes every time price or PAT changes and provides investors with an insight into how the market values a stock. The problem is that a P/E of 12 may not be cheap and P/E of 60 may not be expensive. P/E is also unique to each sector and company, and reflects its economic environment. In this article, we present an alternative approach to decoding the P/E.
P/E is majorly dependent on a company’s expected PAT growth and Return on Equity (ROE). If a company with ROE of 15 percent is expected to grow its PAT at 20 percent and has a P/E of less than 25-30 times, it should generally be a good investment. Higher growth will obviously warrant higher P/E and vice versa.
Given that P/E is unique to each company, it is very useful to observe P/E as a trend across time periods to learn how markets have valued the same company in different growth environments. The table shows computed annual Mcap, PAT, and P/E (readily available at www.equitylevers.com) for the last eight years for three FMCG companies each with 15 percent-plus ROE.
Based on the current trend, ADF looks most attractive. We can see that its PAT growth has been consistent (15-20 percent pa) and its Mcap has moved mostly in tandem—its PE is in its historic range. Bajaj’s P/E may look attractive at just 16. However, its PAT has shown no growth over the past several years and consequently, its Mcap and P/E have gradually declined. Lastly, we can see that Godrej’s PAT has been flat over three years even while its PE and Mcap are at an all-time high, indicative of high valuation.
However, if each of the companies were to start growing 15-20 percent over the next few years, Bajaj Consumer will be most attractive and will give the best investor returns, followed by ADF Foods and then Godrej Consumer. This is because there is more valuation space in Bajaj and followed by ADF.
Observing valuation trends across time periods is a powerful way to find big winners. Interested readers may watch my in-depth talk last week (available on YouTube) on this subject at the World Investor Week 2021.
Badri Narayanan
badri@equitylevers.com
Equity investor and Founder, Equitylevers Finance Lab