The controversy over whether one should buy high P/E – high quality stocks or low P/E – low quality stocks is as old as the hills.
While investors like Porinju Veliyath are firmly in favour of buying low P/E – low quality stocks on the basis that such stocks are “value picks”, others like Basant Maheshwari and Prof Sanjay Bakshi are staunch believers in the philosophy that that buying high P/E – high quality stocks is the only way to profit from stocks in the long run.
To this debate, Bharat Shah has now added a new perspective by explaining that the P/E ratio is an entirely wrong method to evaluate stocks. He has made his contempt for the P/E ratio more than clear:
“Price to earnings ratio is a rubbish way of computing value. But unfortunately that is the most prevalent method. Price to earnings is in fact a derivative of value, but people infer value from P/E. I mean, nothing can be more stupid than this. People will have all kind of rational P/E based on current or next year’s earnings. A P/E of 10 or 15 is good because on the past ten years the average P/E is more or so! I do not know how relevant that can be. The value of a business is intrinsic to the business. Price and opinion on it is external to that. The biggest fallacy of P/E is that it is one year’s earnings compared with today’s price whereas the value of a business comes from the future.”
So, what should investors look for when evaluating whether a stock is a worthwhile investment or not? Bharat Shah provides the answers with his customary clarity of thinking:
(1) Look for the size of the opportunity. Don’t look at the size of the fish but at the size of the pond:
Size of opportunity is the mother lode. It is about how big something can be in the future compared to what it is now. Every business can be converted into a tangible template based on the size of opportunity. You need to ask: What is there today? What are the gaps? How practical is the assumption that the gap will be covered? This understanding is the size of opportunity. It is about the size of the pond not about the size of the fish. In a large pond, both, large and small fish are welcome. But if the size of the pond is small, even a large fish will not create value.
Example of size of the pond – the shaving market in India:
Of the 120 crore people in India, half of them are males, so need to shave. Of the 60 crore people, if we exclude the very young and the very old, there are 45 crore potential customers. Out of the 45 crore, based on the affordability you can determine how many will be your customers. Based on their habits; whether they shave daily or four times a week, you can assume an average of 2.5 times a week. If the shaving solution costs Rs. 2 per shave, the weekly potential opportunity is some Rs. 220-240 crore. And multiplied by 52 weeks, you get Rs. 11,000-12,000 crore. You may not have the best razor in town but launching a shaving foam or aftershave or deodorant will expand the size of the pond.
(2) Pay attention to the quality (integrity) of management and their attitude towards capital allocation:
Apart from the size of opportunity, the quality of management is important. It can be assessed in terms of integrity and the ability to convert the future into a rewarding outcome. Management must be wise enough to allocate capital to deserving opportunities and return excessive capital to shareholders.
Examples of poor capital allocation:
(i) When you are unsure about the payoff but still allocate capital you are flirting with uncertainty;
(ii) If a management is unsure of the size of opportunity it will allocate capital randomly;
(iii) Frantic activity (diversification) could destroy value. No management has the capability of managing more than one or at the most two businesses. Trying to do too many things indicates a lack of confidence and an inability to comprehend the opportunity;
(3) High RoE indicates that capital allocation is proper and that the quality of growth is high – low RoE indicates value destruction:
Growth in itself is not enough; it is the quality of growth that creates value. Quality can be derived from the return on capital employed. If the return on capital is higher than the cost of capital being deployed in the business, it will add economic value. The equation is simple, economic value creation is the function of capital efficiency and the cost of capital. The difference between the two is the net value added. The total value add over the period of time discounted to the present is the net present value.
For these numbers to be attractive it has to grow, otherwise it will become like a bond. So if you are generating a return on capital lower than your cost of capital, even if your business is growing nominally, it is actually destroying value and the market price will reflect that eventually.
(4) Valuation is not only about numbers but requires valuing intangible factors:
You have to understand the business and character of the business, which are all intangible. Converting those intangibles into a tangible number is more of a mechanical process. More importantly, this must be looked at in the framework of the size of opportunity, calibre of the management, for what period of economic life you can reasonably forecast, whether the growth is accelerating or decelerating, whether it will be consistent or volatile? What will be the character of the growth in terms of producing return on capital, whether it will be rising or it will be falling? How long can it sustain? All these are judgments you need to ponder a lot. Once you are able to answer in some form of numbers, they need to fit into the valuation model. The model itself has to have robust mathematical and intellectual investment understanding to compute it right.
(5) Discounted Cash Flow (DCF) is the proper method of valuation:
Discounted Cash Flow (DCF) is what you do. Time value of money is critical. How can a rupee today and a rupee three years down the line be equal? Valuation is based on free cash flows. It is the incremental real cash generated over the estimated economic life of a business discounted back to the present. The total of different NPVs is the value.
(6) The Q as to the period for which the stock will be held should be determined by the character of the business and its valuations:
Whether you are going to hold the stock for ten years or twenty years is based on the character of the business. But whether you will prolong that journey or not will be decided by the excess of price over the value of the business. Character of the business is important but how much you are paying for it is equally important.
(7) So, investors should look at the size of opportunity, quality of management and its “economic” value when evaluating a stock:
In a nutshell, size of opportunity plus management gives me growth, growth plus quality of growth creates economic value and buying economic value at a discount creates an investment return higher than the economic value itself.