Since most investors fail to evaluate a company before buying it, they usually have no preconceived idea of what they can earn over time.
That is a fatal mistake.
You should be able to estimate the annualized rate of return you expect from every investment and be able to quantify how you derived that figure.
If your criteria for investing are vague or ill-defined, you are more likely to make mistakes about selling.
Are you looking for a 50% price increase in one year. If so, what factors can cause that to occur, and how likely are those factors to occur?
Are you looking for 15% a year for 10 years? If so, calculate what the stock must trade for in 10 years and determine the earnings that will be needed to support the price.
Then ask yourself whether those earnings can be attained.
Let me explain with two examples.
Before that, please note that all valuation calculations come only after you understand a business well, and also that it is a business that will sustain itself over the long term. You cannot just use any model on any business, just because the former is easy to perform.
Let us first consider the stock of Nestle India. (Disclosure: I do not own the stock)
Nestle is currently trading at Rs 17000. Its 2019 (year-ended December 2019) earnings per share (EPS) stood at Rs 204. The price-to-earnings or P/E thus comes to 83 times.
Now, let us assume you expect to earn a 15% annual return from Nestle (excluding dividends) over the next 10 years. This means, Nestle’s stock should trade at around Rs 69000 by June 2030.
Assume the maximum P/E you want to sell Nestle’s stock in June 2030 is 25 times. So, the EPS Nestle would earn in the year ended December 2029 would be “P divided by P/E,” or 69000 divided by 25, which equals to Rs 2750.
From EPS of Rs 204 in 2019 to Rs 2750 in 2029 means an annual growth of 30%.
Now, you ask this question –
Can Nestle attain 30% annual EPS growth over the next 10 years?
As a reference, Nestle’s last 10 years’ annual EPS growth has been 9%.
Anyways, as a second example, let us consider a stock that is not trading at such a high P/E as Nestle. Let us take Eicher Motors. (Disclosure: I do not own the stock)
Like Nestle, Eicher Motors is also trading at Rs 17000. Its last twelve months earnings (four quarters ended December 2019) earnings per share (EPS) stood at Rs 757. The P/E thus comes to 22 times.
Now, let us assume you expect to earn a 15% annual return from Eicher (excluding dividends) over the next 10 years. This means, Eicher’s stock should trade at around Rs 69000 by June 2030.
Assume the maximum P/E you want to sell Eicher’s stock in June 2030 is also 25 times. So, the EPS Eicher would earn in the four quarters ended December 2029 would be “P divided by P/E,” or 69000 divided by 25, which equals to Rs 2750.
Till now, we are almost on the same track with same numbers as Nestle’s. But here is where it diverges.
From Eicher’s EPS of Rs 757 now to Rs 2750 ten years later means an annual growth of 14%.
Now, you again ask this question –
Can Eicher attain 14% annual EPS growth over the next 10 years?
As a reference, Eicher’s last 10 years’ annual EPS growth has been 35%.
One point you must also consider before coming to the belief that Eicher is trading at cheap P/E valuation, given that the company requires to grow its EPS at just 14% annually over the next 10 years when it has already done 35% annually over the past 10, is that EPS, like trees, doesn’t grow to the sky. Something that has grown rapidly in the past ten years, often largely owing to low base, would not compulsorily grow at rapid rates in the future too. In fact, the law of averages and a high earnings base should pull down Eicher’s EPS growth to a lower level.
But the fact is that even if the annual EPS growth over the next 10 years were to be 14%, Eicher’s stock should give you 15% annual return (excluding any dividends), also if the stock trades at 25 times P/E then (which is appropriate for a high-quality business, though you may use your own number).
But wait, what if you expect not 15% but 25% annually from Eicher’s stock to take the risk of investing in it today? In that case, here is how the calculations will change –
The company would now have to grow its EPS at 24% annually to hand over a 25% annual stock price return to you. Now, this looks doubtful, at least much more than a 14% expected number.
You see, in investing, price and return are closely linked. The lower the price you pay, the greater your potential return. The lesser (though enough) you expect from a business, the less harder the business needs to work to get you what you expect.
It is that simple.
That’s about it from me for today.
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Umesh T says
Very informative article. Only few think like this way about the relationship of price and return. Thank you bro for writing this
With smiles and respect
Manikandan Manoharan says
Sir, Very good explanation on how to use the P/E ratio. I think E/P is also a good tool to value the business
Mohan Lal Tejwani says
Very good article 👍. You selected good example also. I appreciate your your skills. Thank you so much for sharing.
With regards 😊
very useful article on valuation and in fact all ur email messages and articles are very useful
keep up the good work and very helpful
I have a query regarding the above article.
How can I decide what p/e to exit after 10 years? What are the criteria to decide what level of p/e to exit?
Sachin Rane says
Thanks for another insightful article as always.
I did not get this – “Assume the maximum P/E you want to sell Nestle’s stock in June 2030 is 25 times”.
Nestle being FMCG, will have high P/E. Even now it has 83 P/E.
Can you please elaborate, what am I missing?
Akshay Gautam says
Quite an explanation !
I also think that the explanation given by Peter Lynch in once upon wall street !
the post has two point which are vital…
1) Growth rate
2) future PE
even if the PE of FMCG are rated on higher side after 10 years say Nestle is at 50 PE in 2030
But if it grows at the past 10 years rate of 9% for next 10 years
EPS would be at 485 form present value 204
so stock price would be (485*204) = 24,250 rs
which is just 1.4 time the present value
Now the point if our expectation is Nestle would grow @15% or @25% EPS for next 10 years what could be the triggers , which it had not done in last 10 years
read it so stock price would be (485*25) = 24,250 rs
read it so stock price would be (485*50) = 24,250 rs
If a company does not have high earnings growth in future, then such high PE will not sustain and it would reduce to a more reasonable level which is 25-30 in Nestle’s case. One should not assume that Nestle will still trade at 80-90 PE in 2030 if the earnings does not grow substantially. By assuming a low PE in future we have margin of safety in our valuations.
MANIKANDAN MANOHARAN says
You are absolutely Right . I learned from Prof. Sanjay Bakshi sir’s bullet proof Investing lecture that it is better to treat the growth as speculative factor in valuation . By doing this we need not to worry about the growth projections , why because by buying the business at lower PE in relation to the earning power gives the downside protection. So if the growth happens then we can more money but if the expected growth did not happen then we will not lose much.
Aditya Goyal says
I have the same question. How to assume the PE for a stock, because it can differ industry wise? Whether we should check industry average?
Good article which is not focused on the intangible gyan but real nitty-gritty tangible knowledge.
Please keep sharing such practical things in your future articles too !
Sushil Jose says
Very useful article for long term investors . Examples are so relevant .
Thanks a lot for continuously sharing such insightful articles
So simple , yet so powerful …
well explained as all wise
Any particular reason for choosing exit P/E of 25x? Also, why should both Nestle and Eicher Motors command the same exit multiple 10 years down the line?
Akshay Gautam says
If you’re looking for growth stocks in the long run, I think the P/E should be lesser than 27 !
You can also read the book by Peter Lynch ! Once upon wall street
Rahul Chauhan says
Very interesting perspective, specially for ppl, who do not understand lengthy financial calculations.
Do keep up the good work
Mangesh Limaye says
An important learning for me and in very short time. Thank you sir.
Ravi Krishna Yendru says
Very good one Sir.
The Implied from your sheet if we compare with the EPS Growths in the past 10, 5, 3 years then we will have a perspective if the business’s current valuation is justified.
Anselm DSOUZA says
You have touched on a very interesting point….are high PE multiples for companies like Asian Paints, Nestle,justified.
Prof Bakshi has written an article where he shows that buying at High multiples Quality companies like Asian Paints etc which give consistent increasing cash flows is absolutely profitable in the long run….would like your comments.
Saurabh of Marcellus espouses the same view…
Manikandan Manoharan says
High Multiples of quality companies are justified only if the current reported earning is less than actual normalized earnings or still a long runway for growth is available. In a growing companies which enjoys the high PE ration , things like Marketing expense , R& D expense , Depreciation etc are shown as expense and the cash flow is hidden. If we are smart enough to look through that hidden cash flow then we can find the actual PE which may be lower than the market PE. In such cases I think high PE is justifiable . But some times we may pay too much for the quality and try to convince ourselves for the premium .
Thanks for another good article !! I understand these valuation models are important when we want to invest lump sum amounts in a specific company but how much importance do these valuation methods have when one wants to select few healthy companies and invest in them regularly ( monthly or quarterly basis) ? I believe Dollar cost averaging neutralizes the PE ratio . Would love to know your thoughts on this ?