PE ratio is elusive and there are many theories around it. We discuss why the PE ratio is an important if not a deterministic factor in investing.
In the book ‘The intelligent investor’, Ben Graham elaborates on the factors that affect the capitalization rate (or PE ratio) of a business. Ben Graham reckons that although future stream of cash flows is the chief determinant of the ‘value’, the valuation multiple is dynamic and affected by below factors.
General long-term prospects (longevity)
Management (Capability and governance)
Financial strength and capital structure (cash generating and moderate debt)
Dividend record (long track record of distributing earnings)
Current dividend rate (payout ratio)
However, the above are characteristics of a mature quality business that is around for a while such as HUL, Nestle, Britannia, etc. There are businesses that are relatively newer and are in the growth stage of their lifecycle. Ben Graham also provides a formula to determine capitalization rate of these growth stocks. The formula ascertains value for growth stocks as below.
Value = Current earnings * (8.5 plus 2 * (expected annual growth rate))
Of Course it’s not helpful to just blindly use the formula to determine the PE multiple of growth stocks but the underlying idea is quite helpful to understand the price earning multiple from growth perspective. Let’s dissect the formula into two parts.
No growth PE - This formula assumes no growth PE as 8.5x as it’s the multiple market assigns to mature companies with no growth. Typically, inverting this multiple will get us the yield generated by AAA rated Corporate bonds. However, this should be adjusted for today’s yield generated by AA rated bonds which is anywhere between 8.5 - 8.7% in India. Hence, no growth multiple can be considered as 11.5x instead of 8.5x.
Growth premium - This formula ascertains premium on growth by multiplying the expected annual growth rate for the next 5-7 years with the factor of two. This factor is subjective and it can be adjusted considering other factors like competitive advantage, management, industry tailwinds, etc.
The problem with price earning ratio is that it’s highly subjective. Two firms in the same industry with same growth also can command different price earning multiple. In the end, intrinsic value of the business depends on its ability to generate free cash flows in the future. Hence, companies that have longer history and good track record in terms of growth, capital allocation and governance will always command higher premium in terms of PE multiple. In other words, market places a great importance on the longevity of the business and a very few businesses can over many decades. Even the businesses which seem durable can be disrupted by market forces and thus buying at any price earnings multiple is a risky proposition. To put things in perspective, there are 65 large cap and 50 mid cap companies in India with PE ratio of more than 50x. Almost half of these companies have PE ratio of more than 70x. There might be truly great companies among these but margin of safety is non existent in case any thing goes wrong. It is true that margin of safety also comes from the quality of business but certainly not at any valuation.