This is How Much You Should Pay for Quality Stocks

I wish you a very Happy and Prosperous New Year!

2021 was a good year for investors.

In my previous editorial, I shared the names of some stocks. These big winners were not famous before the covid rally.

While reflecting further over it, a lot of names like Kilpest, Bombay Oxygen Investments Ltd, and Ruchi Soya come to my mind. These too rose from nothingness to great heights. But could never sustain the gains.

For 2022, if you could separate sustainable growth stocks from story stocks, half the battle is won.

The other half of the battle is ensuring enough a margin of safety.

A few days ago, Tanushree wrote about the stocks with PE multiple of over 100 times, and their potential fate.

It's indeed time to be exercise caution and not get stuck in growth traps, which I believe quite a few stocks in this category are.

But the caution has to be balanced well with action.

You see, on a positive note, there are many businesses which have stepped on growth accelerators in our post-covid world.

The business fundamentals, management quality, and tailwinds have come together to create a recipe for lasting gains for some companies.

And conventional value investors, who just look at price to book value multiple, or historical performances, and balk at anything above a PE ratio of 20, are taking a huge risk of missing out in this market.

The only value investing I believe in is GARP (growth at reasonable price).

I believe it's okay to pay up, without overpaying when the business has high probability of delivering on growth, profit and returns front.

While this sounds good in theory, its practical implementation is tricky.

How and where do we draw the line between a reasonably priced and overpriced stock?

I came across an illustration years ago, that might have the answer. I was highly impressed by the analysis. I found it to be a good way to assess how much you should pay for a growth stock.

The numbers I'll use here are different for simplicity and to drive the message home.

Let's begin with two stocks with same earnings per share of Rs 20. I have named them growth stocks and value stock.

The growth stock does not pay dividend but reinvests all profits back in the business. It is able to generate 25% return on the reinvested earnings. Further, it's available at a PE ratio of 30, priced at Rs 600.

The value stock, on the other hand, reinvests 50% of net profit back into the business. The remaining 50% is paid as dividend. At a price of Rs 200, it's available at a PE ratio of 10, and a dividend yield of 5%. It's can generate a 10% return on reinvested earnings.

Growth Stock v/s Value Stock

		Growth Stock	Value Stock
a	Current EPS (Rs )	20	20
b	Stock Price (Rs )	780	200
c	PE Multiple (b/a)	30X	10X
d	Dividend Payout	0%	50%
e	Reinvestment Ratio (1-d)	100%	50%
	Dividend Yield	0	5.0%
	Returns on reinvestment	25%	10%

If I ask you to consider a period of 10 years, which stock would you choose?

Make your choice and read on...

Let's assume both can maintain their earnings power, stick to their dividend policies and reinvestment returns, and both will be valued at a PE ratio of 15 after 10 years. This is what the future will look like.

Growth Stock v/s Value Stock After 10 Years

		Growth Stock	Value Stock
a	Current EPS (Rs )	20	20
b	Stock Price (Rs )	780	200
c	PE Multiple (b/a)	30X	10X
d	Dividend Payout	0%	50%
e	Reinvestment Ratio (1-d)	100%	50%
	Dividend Yield	0	5.0%
	Returns on reinvestment	25%	10%
After 10 Years...		Growth Stock	Value Stock
	Returns on reinvestment	25%	10%
f	Total Dividends over 10 years	0	126
g	10th year earning	186	33
h	10th year PE multiple	15x	15x
i	Stock Price (Rs) : g*h	2794	489
j	Internal Rate of return	13.6%	13.50%
k	Multiple on original investment	3.6	3.1

Look at the row 'g'.

The earnings per share (EPS) after 10 years is Rs 186 for growth stock. For value stock, the earnings per share (EPS) is Rs 33.

Why are the future earnings is so different when they both began at the same level?

You see, for growth stock, every rupee of profit was reinvested back in the business at a handsome return of 25%. These earnings also compounded.

On the other hand, the value stock returned half the earnings as dividend and reinvested the remaining 50% at much lower rate of 10%. Over the years, due to compounding, a big earnings gap was created.

Now, an investor earns a total dividend of Rs 126 on dividend stock, and zero on growth stock over 10 years of holding period.

After 10 years, the internal rate of return (IRR) is 13.5% for dividend stock. This is much better than fixed deposit returns.

However, it pales in comparison to 16.6% IRR of growth stock. The difference of 3.1% in IRR may not seem big on an annual basis. But add to it the impact of compounding, and the difference becomes glaring.

For instance, if you begin with an amount of Rs 1 lakh in each stock, the difference between 16.6% IRR and 13.5% IRR for 10 years is Rs 1.1 lakh. This is higher than the initial investment in the stock.

Growth stock, which was initially priced at 30 PE, and offered no dividends, would become almost a 5-bagger in 10 years.

The value stock, with a PE of just 10 and a 50% constant dividend payout ratio, would only triple over 10 years.

But it gets even more interesting from here...

You see, up to a PE ratio of 39 for growth stock, and a PE ratio of 10 for value stock, an investor would be better off with growth stock.

To be specific, if you had entered at a 39 PE for growth stock, you would have earned 13.6% IRR, compared to 13.5% for dividend stock.

That's what Charlie Munger meant when he said, 'A great business at a fair price is superior to a fair business at a great price.'

However, above a PE ratio of 40 for growth stock, the value stock outperforms.

The Bottomline

It's okay to pay up for growth and quality. But 'buy at any price' (BAAP) investing does not make sense.

Now the example I just shared was hypothetical.

In real life, growth assumptions could go for a toss. The future is uncertain.

A growth company using acquisitions to expand may end up making a value destructive acquisition. Or its expansion plans may get shelved or delayed.

And who knows? It might even become a victim of disruption.

Well, there is another rule that could come to your rescue. A way that allows you to make optimum bets. And that is the discipline of asset allocation.

We recommend this broad asset allocation at Equitymaster.

This could indeed vary depending on your horizon, return expectation, and risk appetite.

But the underlying message remains the same: Never put all your eggs in one basket and do not invest more in a single stock than what you can afford to lose.

Further, equities should be one part of the overall investment portfolio, after one has kept aside some cash.

We saw its importance during covid. This cash will take care of your liquidity needs.

It will also come handy during market declines when there will be many opportunities to buy fundamentally strong stocks at cheap valuations.

I believe if you take care of margin of safety and asset allocation, you have a good chance of winning big, without losing too much.

I hope 2022 turns out to be a year that you win big in the stock market.

Stay tuned for many exciting investing opportunities.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure