How Can a High P/E Multiple Stock Be Cheap - Simple Concept Paper on Valuation Math

We as investors are always confronted with making decisions, which involve judging the price paid versus the value received for securities in consideration. Valuation of securities is a complete subject in itself and needs a practitioner to delve into numerous technical aspects of finance. Even after understanding the technicalities of the subject, one realises that it is not a complete science, but a blend of art and science, as it involves forecasting the future. Because of these reasons, most investors rely on short-cut multiples like Price / Earnings (P/E), Price/ Sales, EV / EBIDTA (EV- Enterprise Value, EBIDTA – Earnings Before Depreciation, Interest and Tax), Price/Book Value, Dividend Yield, etc.

Amongst the valuation ratios, the most popular one is the P/E multiple. It is computed by dividing the current market price by earnings per share. Various companies, industries, indices, country benchmarks have different P/E multiples.

Some sections of the market believe that low P/E multiple companies are cheap and vice-versa. There is a superficial but logical merit to this argument. Suppose you buy a Company A at 10x P/E multiple. It means you are expecting to get your money back in 10 years. For example, assume you pay Rs.100 for a company with Rs.10 earnings per share, which makes the company trade at 10x P/E multiple. If the company keeps earning Rs.10 per share every year for the next 10 years, you will get your money back in that time period. Similarly, if you are paying a P/E multiple of 40x to buy shares of Company B, you are expecting to get your money back in 40 years. Thus, a company with lower P/E multiple appears cheap versus the one with a higher multiple.

Let’s now delve a bit deeper in this argument.

First some key conceptual notes needed to build up our understanding on this subject:

• Equity shares are considered as securities with a perpetual life.
• It is assumed companies will retain some portion of the earnings and reinvest it to generate growth. This is called retained earnings. The remaining part of profits are paid out as dividend to shareholders.
• Growth = (Return on Equity) * (retained earnings)
• Fair Value of a growing annuity to perpetuity = Annuity / {(Cost of Equity) – (Growth)}

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Using the above concepts, we shall analyze the companies in the example and derive the Implied P/E multiple for each company.

Let’s now consider the following examples:

Company A has a current EPS (Earnings Per Share) of Rs.100. It generates a Return on Equity of 20% and its management retains 25% of profits and pays out the remaining 75% or Rs.75 as dividend to shareholders.

The shareholders desire a cost of equity of 10% from their investment.

Now the growth for the company A = (25%) *(20%) = 5%

Fair Value of company A = (Rs.75) / (10% - 5%) = Rs.1500.

Since the EPS of Company A is Rs.100, Fair P/E multiple for the company = Rs.1500 / Rs.100 = 15x

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Similarly, we derive the Fair P/E multiple for Company B as 30x and Company C as 11x.

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Now, looking at the above Fair P/E multiples, we should not conclude that company A (Fair P/E of 15x) is available at a cheaper valuation than Company B (Fair P/E of 30x) and expensive valuation compared to Company C (Fair P/E of 11x).

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Company B deserves to trade at high multiples due to its higher expected growth (8%), while Company C deserves to trade at lower P/E multiples due its lower expected growth (2%)

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If company A’s stock trades at say 18x P/E multiple, then its stock can be called expensive.

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If company B’s stock trades at a P/E multiple of 28x, then its stock can be called cheap. Thus, an apparently high P/E multiple company’s stock can also be “cheap”.

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Conclusion:

Investors should not judge valuation of companies just by looking at absolute traded P/E Multiples. Based on financial theory, Fair P/E multiples are driven by four factors: 1) Expected earnings growth, 2) Expected Return on Equity, 3) Riskiness of Business and 4) Expected Risk Free Interest Rates.

A stock is considered cheap if its trading at a P/E multiple which is below its Fair P/E and vice-versa.