Why are Investors Paying 2x More for Relaxo than HUL? 

Hello everyone, Rahul Shah here trying to make investing accessible and profitable for the average investor.

The stock market of the past few years has seen the emergence of a lot of multibaggers. There have been stocks that have gone up 5x, 10x and even 20x in some cases in recent years.

One of the most popular out of these has of course been the footwear brand, Relaxo Footwears ltd.

There won't be many people who wouldn't have either used the company's value for money footwear or at least heard about it.

Over the years, the company's products have also been endorsed by celebrities such as Salman Khan, Akshay Kumar, and Katrina Kaif.

This has given the brand a lot of visibility and played an important role in its growth.

Speaking of growth, the growth in the company's share price over the last couple of decades is nothing less than extraordinary.

You'd be surprised to know that the stock has been a massive 1,100 bagger over the last 20 years. Yes, that's right. Not a 100-bagger or a 200-bagger but a massive 1,100 bagger.

This extraordinary performance has come on the back of an 18x growth in topline and a 55x growth in bottomline during the same period. Let me repeat that. The company has grown its topline by 18x and its bottomline by a significant 55x over the last two decades.

I am sure you are wondering if the bottomline has grown by 55x, then how come the stock has given 1,100x returns during the same time period.

After all, if profits grow by 55x, shouldn't the stock price also grow by the same magnitude? Shouldn't the share price also go up by 55x?

Well, no.

The reason the share price has gone up by 1,100x and not 55x is because investors have been willing to pay a significant premium per rupee of the profits earned by the company 20 years ago versus currently.

You see, 20 years ago, investors were willing to pay only Rs 5 per rupee of profits earned by the company. However, now, investors are willing to pay, hold your breath, Rs 114 per rupee of profits earned by the company. Yes, that's correct.

From willing to pay Rs 5 per rupee of profits earned by the company, the investors are now willing to pay Rs 114 per rupee of profits. That's a jump of almost 20x and is a big reason why the share price of Relaxo footwear has gone up by 1,100x and not 55x over the last 20 years.

In stock market parlance, this is also known as PE expansion or price to earnings multiple expansion.

The stock was trading at a PE of 5x back in 2003 and currently trades at a steep PE of 114x. The PE multiple of the stock has expanded by almost 20x and has played a big role in multiplying investor wealth by more than 1,000x.

So, to sum up, the massive 1,100-fold jump in the company's share price was made possible, both by investors willing to pay a huge premium per rupee of the company's profits as well as the 18x and 55x growth in topline and bottomline respectively.

Now, as impressive as the last 20 years and even the 10 years were, I don't think the next 10 are going to be anywhere close.

In fact, let us bring it down to a more manageable 3-5 years. I believe that at current price, there is a strong chance that the stock may fail to give good returns over the next 3-5 years.

There are a couple of reasons behind this belief. The first one has to do with the exorbitant valuations the stock is currently trading at.

As I write this, the stock trades at a PE multiple of more than 100x. Contrast this with the PE multiples it was trading at both 10 or 20 years ago.

20 years ago, the stock was trading at a PE in the range of 5x-6x as we just discussed. This was an extremely attractive valuation, which left a lot of room for the PE multiple to expand in the future. And expand it did. The stock's PE multiple has expanded from a low PE of 5-6x to the more than 100x today.

In fact, even 10 years ago, the stock was trading at a very reasonable PE ratio of 13-14x. The current PE of more than 100x leaves very little scope for further expansion and this can restrict future returns in a big way in my view.

Also, to put things in proper perspective, it should be noted that Relaxo footwear's current PE ratio is almost twice as expensive as commanded by Hindustan Unilever Ltd or HUL as it is popularly known as.

HUL, the FMCG giant, is currently trading at a PE ratio of nearly 60x. Relaxo on the other hand trades at more than 110x.

I know some of you would get furious with Relaxo's comparison with HUL.

You'll complain that the comparison is unfair as HUL is a large blue chip for whom stability matters more than high growth.

Relaxo on the other hand is a smaller, nimbler player that has grown much faster than HUL in the past and is likely to do so in the near future as well.

Well, allow me to burst this bubble, starting with growth first.

Hindustan Unilever Ltd has managed to grow its topline by 10% CAGR and bottomline by 14.6% CAGR for the 5 year period between FY17 and FY22.

And look at Relaxo. There is hardly any outperformance. In fact, its bottomline growth during the same period has been a shade lower than that of Hindustan Unilever Ltd. Even on the topline front, the growth is almost identical.

Therefore, despite commanding a PE multiple of 114x, Relaxo hasn't managed to outperform HUL on the growth front. This means that there is a strong possibility that if Relaxo does not grow at a much higher rate in the future, its PE ratio can come down to as low as that of HUL.

In other words, if it fails to meet high growth expectations, Relaxo can fall by another 40%-50% due to the contraction in PE multiple.

Worth highlighting that the stock is already down 34% from its 52-week high and can correct even more if it continues to disappoint on the growth front.

Ok. So growth is just one of the factors. What about business quality? Can the high PE multiple given to Relaxo be justified on the grounds that Relaxo is a better-quality business than HUL?

Well, theoretically yes. A better-quality business does deserve a higher PE multiple than a poor quality one.

And one of the ways to judge the quality of a business is the return on the capital employed by the business or more commonly known as the ROCE of the business.

Return on capital employed is the profits that a company is able to generate on the total amount of capital employed by the business.

Think of it as an interest that you earn on your fixed deposits in a bank. A bank that pays you an interest of 20% on your fixed deposits will certainly be preferable over the one that pays only 10%.

Likewise, a company that consistently generates an ROCE of 20% would be preferred over the one that generates an ROCE of only 10%.

A high ROCE business is a good quality one because when a business generates higher profits per rupee of capital invested in the business, it can use these profits to reinvest back into the business and also pay dividends to shareholders.

Therefore, the higher the ROCE of a business, the more it can reinvest in the business and also pay more dividends to shareholders.

So, with this basic definition in mind, let us see how the historical return on capital employed of Relaxo compares with that of HUL.

As you can see, HUL is miles ahead of Relaxo even on the return on capital employed front. At an average ROCE of a massive 102%, HUL generates 4x greater return on capital employed than Relaxo whose average ROCE stood at 25.8%.

Here, I would like to point out that if we assume the future growth rates of both the companies to remain the same, then HUL deserves a PE multiple that should be 4x more than Relaxo based on its average ROCE.

Yes, you heard that right. Assuming growth to be the same, HUL should trade at a PE multiple that should be 4x greater than that of Relaxo.

Instead, we have a situation where Relaxo trades at a PE multiple that's twice that of HUL.

This goes to show that even on the business quality front, Relaxo's high PE multiple aren't justified especially when you compare them with HUL's business quality.

Thus, it is quite evident that both on the growth front as well as form the point of view of business quality, Relaxo seems to be trading at a pretty expensive valuations.

In fact, forget HUL, let us compare Relaxo's valuations with its own historical valuations.

You will find that even here, Relaxo is on shaky ground as its current PE multiple of 114x is greater than its 5-year average PE multiple and 10-year average PE multiple of 79x and 53x respectively.

Now, don't get me wrong. I don't think that Relaxo is a bad business. I think it is a fantastic business with a great management team at the helm.

However, for every business, there is a certain valuation beyond which the risk of earning poor returns is on the higher side. And I believe that for Relaxo, we seem to be well past that point.

For not only is the stock significantly expensive than one of the best bluechips in the business i.e. HUL, it is also significantly expensive than its own historical valuation multiples.

In view of this, I think investing in Relaxo at the current valuations is fraught with risks and the risk-reward equation is not in favour of the investor at the current price point.

I may consider it an attractive buy once its PE ratio goes below its 10-year average of around 53x and even then, there are no guarantees that I would call it a strong buy at those levels.

Let me know what you think. I would sincerely appreciate your comments and your likes on this video.

Until next time, good bye and happy investing.