The following note is from upcoming annual letter to subscribers. I will be publishing the rest of the letter on the blog soon
When I look at companies which are priced a lofty multiples, I try to break it down to the first principle of investing – The value of an asset is the sum of its discounted cash flow over its lifetime.
A company with a high multiple, is not necessarily expensive if the company can grow its free cash flow for a long period of time. This means the market ‘assumes’ that such a company has a sustainable competitive advantage and a large opportunity space. Please note use of the word ‘assume’. The market is not some all knowing entity which can see the future. It is just the aggregation of the combined wisdom (or madness) of its participants.
The market on average and over time gets the valuations right, but not always.
As I look at several companies in the small cap and midcap space now, I am left wondering if investors really understand the implications behind the valuations. A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price, the actual growth will have to be much higher and longer.
How many companies are able to deliver such growth rates for so long? Let’s look at some numbers from the past
In the last 10 years, we had around 233 companies in the sub 3000 cr market cap space, deliver a growth of 25% or higher. That’s around 6.2 % of the small/ mid cap universe. As the market cap/ size increases, the percentage of companies which can deliver this kind of performance only shrinks.
How many companies in the above space currently sport a PE of 50 higher ? around 22% or roughly 830. So 3 out of 4 companies in this group of ‘favored’ high PE companies are going to disappoint investors in the coming years in terms of growth
In other words, if you could buy all these ‘favored’ companies (greater than a PE of 50), you have a more than a 50% chance that you will lose money. Why would you take such a bet?
All investors in aggregate are taking this bet assuming individually, that their ‘chosen’ companies will not be the ones to disappoint. Ofcourse every individual thinks he or she is smarter, more handsome or than the crowd (also called illusory superiority).
The odds are against everyone being right. So it makes sense to be cautious and do your homework well enough. Some of these companies could turn out to be the bitcoins of our market: assets with promise but without cash flow. In such cases, the end result is likely to be unpleasant.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.
Hi Rohit,Can you please explain this little more? “A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price”Regards
“A company selling at a PE of 50 will need to deliver a growth of 25% for 10 years to justify the price. In order to make any returns for an investor buying at this price”Would it be useful to check the past data and see all the companies that were at 50 PE at any time, how many of them really grew at 25% for next 10 years?My guess is “extremely few”.
Hi phanido a reverse dcf. assume terminal valuation around 10-12 times earnings and plug in the starting earnings and see how many years of cash flow and growth is needed to justify the pe.not a scientific number, but gives a rough estimate of the embedded expectations. you can play with the numbers, but giving a very high terminal value is not a good ideargdsrohit
I don't know whats wrong with people. The moment they notice some trend they tend to flow with it, same goes for bitcoin trading. Most of the Indian share market traders have turned their back towards bitcoin investment when it was near to INR 800K.And now,it has fallen drastically at 400K approx which is equivalent to half of the buying price. Why we are so desperate to be in a flow ? They could have opted for share market tips for safe side investing.Why don't they stay where they are before analyzing and estimating the risk and other factor ?