Is Your Stock 'Priced for Perfection'? - The 5 Minute WrapUp by Equitymaster
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Is Your Stock 'Priced for Perfection'?

Feb 2, 2016
In this issue:
» RBI Keeps Key Rates Unchanged
» The Rupee Fall Could Hit These Firms Hard!
» ...and more!
0.00
Devanshu Sampat, Research analyst

A stock's valuation is broadly a function of three aspects:

  1. The quality of earnings
  2. The surety of those earnings
  3. The riskiness of the business

When business quality is perceived to be high, a fast-growing business will garners high valuations.

Here's a table that might put things into perspective.

Price-to-Earnings Ratio: Risk-Reward Table
ROE/g 2% 4% 6% 8% 10% 12% 14%
10% 6.2 5.5 4.4 2.9 0.0 (6.7) (40.0)
20% 6.9 7.3 7.8 8.6 10.0 13.3 30.0
30% 7.2 7.9 8.9 10.5 13.3 20.0 53.3
40% 7.3 8.2 9.4 11.4 15.0 23.3 65.0
50% 7.4 8.4 9.8 12.0 16.0 25.3 72.0
60% 7.4 8.5 10.0 12.4 16.7 26.7 76.7
70% 7.5 8.6 10.2 12.7 17.1 27.6 80.0
80% 7.5 8.6 10.3 12.9 17.5 28.3 82.5

Data Source: Equitymaster Research; K assumed at 15%; ROE=return on equity, g=growth

The table depicts the justified price-to-earnings multiple formula, which is:

PE Ratio = (RoE - g)/ (RoE * (k -g))

The required rate of return, or 'k' here, is assumed to be 15%. As you can see, the justified multiple for a stock rises at a much faster rate when earnings growth is improving than when RoEs are improving.

In short, growth plays a big role in valuations.

But the market tends to get carried away with prospects. And in the process, stocks can get expensive...to the point that they are 'priced for perfection' - a situation that arises when a stock price is so high that gains depend on a very favorable environment, with strong corporate profits being a key expectation. In other words, at such valuations, a small slip up by a company can send the stock tumbling.

Subscribers wrote into us over the past week...

The choppy markets of late have had an impact on many of our recommendations. Some have gained. Some have been flat. Some have been hit hard.

Many India Letter subscribers have written in over the past week. Some praised the service's staggered buying approach, saying it allows them to increase their exposure during market declines. Others have written to us complaining about the sharp corrections to a few of our recommendations.

We'd like to address these matters here, starting with the latter...

Subscribers wrote to us saying they have suffered substantial losses on a particular stock, as much as 30%. One subscriber told us that he'd invested heavily in the company... It turns out that the average price he bought at was considerably higher than the price we recommended.

We review our India Letter recommendations every month. We originally recommended a 'partial buy' for the stock in question in September 2014 and gave a 'Do not buy more at current levels' view by mid-April 2015.

Allow us to reiterate...

The India Letter is different from our other services. The aim here is to buy stocks that will benefit from the Indian Megatrend, i.e. companies and sectors with strong tailwinds. And a key difference is our staggered buying approach.

The relative valuation system we use allows us to gauge the attractiveness of a stock viz-a-viz a benchmark - the Sensex in this case. The more attractive the stock is on this metric, the higher our suggested exposure. If a stock does not seem to provide enough margin of safety, we suggest investors wait for a correction before biting into it.

This simple investing process of the service is the reason we sometimes give partial buy recommendations.

But we make it a point of reminding subscribers to mitigate risk by limiting their exposure to 3-5% for a particular stock in their portfolio. While no method is perfect, we believe the pros of this approach far outweigh the cons.

What is your investment approach for stocks that seem to be 'priced for perfection'? Let us know your comments or share your views in the Equitymaster Club.


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2:35 Chart of the day

The falling Rupee made headlines recently. The Indian currency is very close to its all-time low against the US dollar. A level of 70 seems inevitable now. There is no uproar about this because India's current account situation is stable and forex reserves are at all-time highs. In addition, the crash in commodity prices has provided much needed comfort. The fall has also brought some relief to the struggling export sector. However, there is another risk of the falling currency that tends to go unnoticed.

Today's chart shows some firms that have a lot of US$ denominated debt. They could face tough times due to the depreciation of the Rupee. Companies with foreign currency loans have seen a jump in interest payments due to the fall in the Rupee. As per an article in the Mint, fourteen companies from India's top 10 corporate groups have very high levels of debt and nine of these have more than 30% of debt in foreign currencies. A look at the long-term price charts provides a sobering reminder why investors should stay away from such stocks.

Foreign Currency Loans are a Worry

3.50

The RBI announced its first bi-monthly Monetary Policy of 2016 today. As expected, the central bank kept all key interest rates unchanged. In its monetary policy statement, the RBI said the Indian economy was doing along well. However, it said it would take into consideration steps taken in the Union Budget that would boost growth while keeping inflation in check.

The RBI has increased its inflation target for Jan 2017 to 5% (subject to upwards risks) from 4.8% earlier. This was largely due to the Pay Commission recommendations. It appears to us that governor Rajan is concerned that the government will loosen its purse to boost growth. Finance Minister Arun Jaitley has said that the fiscal deficit target (3.9% of GDP in FY16) will be met.

However, economists have begun calling upon the government recently to consider revising its deficit targets and using more borrowing to boost growth. Governor Rajan has already warned against this. In this debate about the fiscal deficit we favour the RBI's views.

4.40

After opening the day in the green, the Indian stock markets witnessed choppy trading and were trading above the dotted line at the time of writing. The BSE-Sensex was trading higher by about 63 points (up 0.3%), while the NSE Nifty is trading up by 10 points up (0.1%). Sectoral indices were trading on a mixed note with stocks from the software and capital goods sectors leading the gains. Pharma and energy stocks are, however, trading in the red.

4.50 Today's investing Mantra

"It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst) and Tanushree Banerjee (Research Analyst).

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4 Responses to "Is Your Stock 'Priced for Perfection'?"

Aditya

Feb 25, 2016

A few questions - 1. How did you derive the formula? 2. The ROE and g is current or expected? 3. How can ROE of 10% and g of 12% = negative growth!

Like 

Prakash

Feb 10, 2016

The Price-to-Earnings Ratio: Risk-Reward Table is explained in a following article.

Like (1)

Prakash

Feb 10, 2016

Please explain the Price-to-Earnings Ratio: Risk-Reward Table.

Like (1)

mukesh

Feb 2, 2016

Incomprehensible.
Pl. quote reference and show derivation from first principles.
Doesn't even look like PEG which was popular (and failed) in 2007-2008

Like (1)
  
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