3 Points to Consider in High PE Stocks

If you're serious about making money from stock markets, and have been curious about how investing works, you are likely to have come across some financial metrics.

Some of the most tracked ones are return on capital employed (ROCE) and return on equity (ROE). They reflect how much profits a business can generate on the capital invested in it.

Experienced investors rely more on these metrics as compared to some of the widely followed ones like profit margins.

Why? That's because while high margins might signal efficiency, a company's ability to generate strong returns on its capital can hint at something deeper: a competitive edge, an economic moat.

But there's a twist-returns alone isn't the full story.

The Trap of High Return, Low Growth

Some companies generate strong returns year after year-but with nowhere productive to reinvest their earnings.

Think of mature industries like lubricants, where market demand is stable, but growth opportunities are few and far between.

These companies often have a "legacy moat"-a solid base, loyal customers, and reliable profitability but they lack room to grow. They tend to return most of their profits to shareholders as dividends, instead of reinvesting for future expansion.

The Reinvestment Edge

Now imagine a company that not only earns strong returns on capital but also has places to put that capital to work again-at high rates. This is what's often called reinvestment moat.

Companies with this rare combination-high ROCE and sustainable growth prospects-can compound investor wealth over time. They're not just making profits; they're multiplying them.

These are the companies that not just look good today but have the potential to look better tomorrow.

Investor Chuck Akre, known for spotting long-term winners early, explains this with his famous "three-legged stool" approach:

According to Mr Akre, a company must be evaluated on three important aspects:

• Business model
• Management quality
• Reinvestment prospects

Here's Mr Akre explaining in his own words:

• The first leg has to do with the quality of the business enterprise, and we're looking for businesses that earn high returns on the owner's capital. We spend a lot of time trying to focus on what's causing that better-than-average result, return on capital, to occur, and is it getting better or worse.
  
  The second leg of the stool goes to the issue of the people who manage the business. And not only are they terrific managers, but are they honest and do they have high integrity? Do they see that what's happening at the company level is happening identically at the per share level?
  
  And then lastly, the third leg is the issue of reinvestment. We call it sometimes the glue that holds these together. That is, is there an opportunity that exists because of the skill of the manager, the nature of the business to reinvest what we presume is excess cash. To reinvest that in a way to continue to earn these above-average rates of return.

When all three legs are sturdy, it could be a company that has the potential to compound capital for years.

The Math Behind Compounding

Let's say a business grows its earnings at 25% annually. In 20 years, that means earnings can multiply nearly 87 times. Even if the stock looks expensive today based on PE ratio, sustained reinvestment at high returns can still lead to strong long-term outcomes.

Or as Charlie Munger once put it...

"If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result."

Consider these companies that look like they are heading there. Here are examples to explore and understand the metrics better. This is not investment advice or stock recommendations.

Shilchar Technologies manufactures power and distribution transformers and exports to global markets. With a ROCE of 23.6% and FY26 growth guidance of 20-25%, it has tailwinds from rising electricity demand and green energy initiatives. Its current PE is 37, and PEG is 0.6.

Advait Energy Transitions is focused on power transmission and renewable energy solutions the company has an unexecuted order book of Rs 8 bn (including L1 orders). It reported FY25 revenue of Rs 4 bn. It trades at a PE of 51 and a PEG of 1.1.

These companies are benefiting from structural trends, though like any business, they face risks-including regulatory shifts and rising competition.

As you explore investing, it's useful to look beyond headlines or stock tips. Understanding how a company earns its returns-and what it does with them-can help you think more like an investor, not a speculator.

Happy investing.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)