P/E re/derating is a double edged sword
I want to put down my thoughts on some point that I think will effect an investors returns a lot. That is P/E rerating and derating.
Let’s take a stock at 100rs and 20x P/E in Fy23 end with EPS of 5. Let’s assume we expect profit growth of 20% and the P/E to rerate downwards or upwards in FY24. The following scenario may occur
Scenario | EPS | P/E at FY24 | Stock Price in FY24 | Return |
---|---|---|---|---|
same P/E | 60 | 20 | 1200 | 20% |
P/E rerating | 60 | 25 | 1500 | 50% |
P/E derating | 60 | 15 | 900 | -10% |
Slight rerating | 60 | 22 | 1320 | 32% |
Slight derating | 60 | 18 | 1080 | 8% |
What does this tell me:
- Try to be in a scenario of rerating as far as possible
- Even though there doesn’t seem to be much difference in 20 P/E and 25 P/E, the returns are huge if we have a short term view. So, try to take advantage of P/E rerating whenever possible
- One may achieve point 2 by following the trend (technicals) define the exit from a stock rather than exiting once it reaches the P/E you think is fair (there’s not much difference between 20 and 25 P/E as per me). So, hold it and take extra returns
Note:
One may note that the rerating or derating effect is bigger, as I considered a 1 year time frame. But, the difference may not be as big if we consider a view of 4-5 years. But market has lot of cycles, and the rerating and derating can happen in just a few weeks to few months
Example: I’d like to explain one of my current dilemma as an example for this. You may know that MCX is recently gowing through a low earning phase because of high software charges which would normalize from Q4 FY24 onwards. So, I made a calculation of how much return I can expect from MCX by FY25 end. Let’s look at the following scenarios
I consider P/E to be in the range of 35-45x, as this is peers CAMS, CDSL trade at 40,50x P/E and the growth rates are better for MCX
Market cap in FY23 | Profit in FY25 | P/E | Market cap | CAGR return in next 1.5 years |
---|---|---|---|---|
13000 | 425 | 35 | 14875 | 9.4% |
13000 | 425 | 40 | 17000 | 19.6% |
13000 | 425 | 45 | 19125 | 29.4% |
The data says the estimated returns can vary from 9.4% to 29.4% based on what P/E i think is fair. And 9% is very poor return and 29.4% is top notch and the the difference is just P/E change from 35x to 45x
KTA:
- Don’t exit a stock just because it’s reached a P/E that you estimated. After all there is not fair value but there’s a fair band
- Book partial profits or take help of technicals to make exit (for that matter even entry) decisions
- If you have few stocks in P/F you returns may vary highly because of P/E rerating/derating, but if you have 15-25 stock PF, the effect of P/E on the total PF returns may not be significant
Disc: May have postion in the cos discussed
Please feel free to share your experiences of how P/E rerating and derating effected your returns or missed out on high returns as you thought the P/E has reached a fair band
Subscribe To Our Free Newsletter |