A Simple Technique for Finding Big Money-Spinners in this Market

Oct 5, 2020

Rahul Shah, Editor, Profit Hunter

Back in Feb-March 2014, Page Industries was trading at a price to earnings multiple of around 50x.

Now, a decent multiple to give for a no-growth company is around 8x in my view.

Yes, a company that's not growing but maintaining its current rate of earnings can be given a price to earnings multiple of around 8x-9x.

However, Page Industries was being rewarded with a multiple that was 6.3x higher than a no-growth company.

Clearly, investors had huge growth expectations from the company.

How huge exactly?

Well, Ben Graham was of the view that for a high growth company, future growth rate is accounted for twice in the price that investors pay for the company.

The first time in the expected future earnings and the second time in the PE multiplier awarded to the company.

Thus, if you have to figure out the expected growth rate of the company in the rough ballpark, you should take the square root of the extra 6.3x multiple for Page Industries.

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This gives us a number of around 2.5x.

And this is nothing but the growth in earnings that investors were expecting from Page Industries over the next few years.

So, was Page Industries able to meet investor expectations? Did it manage to grow its earnings by 2.5x over the next 5-7 years?

Well, it certainly did.

For the year ending March 2019, Page Industries recorded earnings that were almost 3x higher than five years earlier.

This means that the company was able to live up to investor expectations of a minimum 2.5x earnings growth.

Little wonder the stock price is also up 4x during the same period.

I believe that 50x is too high a multiple to give to any stock, no matter how promising the future prospects.

However, kudos to Page Industries and the management that the stock has been able to earn handsome returns even from such high multiples.

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Now, at around the same time I was analysing Page Industries, I came across another stock. This one went by the name of Navin Fluorine Limited.

The stock was trading at a price to earnings multiple of around 10x. Using the same formula as Page Industries, investors were willing to pay a multiple of around 1.25x for growth squared.

And if you take the square root of this, you end up with 1.1x.

In other words, investors were expecting a growth of just 10% in earnings over the next 5-7 years.

Given the company's past track record, it was well within company's reach.

Well, the company performed way beyond expectations over the next five years. It multiplied its earnings by a whopping 5x-6x.

This led to the stock price going up a whopping 1,300% during the same period.

The stock turned out to be a 14-bagger, way better than the 4-bagger that was Page Industries.

The takeaways from this case study are simple.

Using a simple back of the envelope calculation like we used here, one can figure out the expected growth rate in earnings that the share price is reflecting currently.

In the case of Page Industries, the market was expecting the company to grow its earnings by almost 3x over the next few years.

And in the case of Navin Fluorine, the markets were expecting the earnings to remain almost flat.

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The second takeaway is that if I have to buy 20-30 stocks in the stock market, I will prefer buying stocks with the characteristics of Navin Fluorine than Page Industries.

The reason is not hard to find. Stocks like Page Industries already have high expectations built into their share price.

Therefore, if these expectations are met, the upside could at best be 3x-4x over the next 5-7 years.

However, the downside could be catastrophic in case of the expectations not being met.

The stock price suffers a double whammy. Not only do the earnings don't grow as expected but the PE multiple also takes a huge hit.

Stocks like Navin Fluorine on the other hand can end up giving a huge surprise on the upside if they manage to log in strong earnings growth.

And the downside is limited as the market wasn't expecting a high earnings growth in the first place.

With the stock able to grow its earnings by a whopping 6x between 2014 and 2019, there was a whopping 14x upside in the stock price.

When I recommended the stock to my subscribers back in February 2014, they earned an impressive 170% returns in one year flat.

However, I did not pursue the stock further as my mandate was to make a quick 50%-100% from a stock and then switch to another undervalued name.

However, there's no reason why I slightly diligent investor wouldn't have earned the full 1,300% that it delivered over the next few years.

In fact, with the method I just highlighted, he can unearth many more such money-spinning stocks in his investing career.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

PS: This Friday, our smallcaps editor, Richa Agarwal, will reveal her top 3 stocks to profit from the rebound in smallcaps. Get the details here...

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1 Responses to "A Simple Technique for Finding Big Money-Spinners in this Market"

SANKARAN VENKATARAMAN

Oct 20, 2020

Instead of this formula involving squareroot etc. why don't we adopt simpler timetested tool PEG to be less than 1. Earlier EM used to give PEG also in their stock recommendations .

SANKARAN VENKATARAMAN

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