That is an incomplete approach. If the sector is in a bull run or has very high valuation then you are committing the same mistake twice. First assuming an optimistic estimate of earnings and then applying a high PE. Don’t believe me ? …well several IT companies sold for a PE of 100 in 2000 and real estate and capital goods companies sell for similar high valuations. Average PE for IT companies is now below 20 and mid caps in IT sometimes sell for less than 10 times.
This brings me to some interesting observations which you can derieve from this table below
Is that likely ? well it can happen …but don’t bet on that. Industries which have high growths and high ROC tend to attract a lot of competiton which drives the returns down. That’s a given rule of economics.
As a result I am wary of companies having a high PE. To justify an investment, the company has do better than the implied value (which you can get from the table above).
Final point – I have put comments on the right of the table with color schemes. Red means stay away for me !
Hi Rohit, I have one question on the P/E vs CAP table. What is the probability column? Does it indicate the probability of able to estimate value correctly? Thank you, Rajani
the probability column is a subjective probability column. you can read it with the color code in the main matrix. so a green color with probability of 0.9 means that a company with a PE of 14 has a high probability of achieving the growth of 12% and maintain a CAP of 3 yrsOn the other hand red and low probability means that a company with a PE of 40 has an expectation of 18% growth and CAP fo 18 years built into the price. That would be a tough hurdle to cross and very few companies would do that.hope this helps
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