Yesterday night, I was speaking with a very respected friend, elder and we discussed about investments & businesses. We started talking about strategy and then he revealed that he was invested in two stocks. I definitely endorsed his strategy, since I, myself am invested in a single business and am enjoying the benefits of that greatly. We started talking about his picks and then I realized that both of his stocks were pretty richly valued in terms of PE. I, then suggested, him to move to a stock which was equally good & of high quality but quoting at undervalued prices. Later, I realized that this was worth writing an article.
The idea is very simple here. We all know that maximum money is made during PE expansion in stocks. And a stock which is already in high PEs or in rich PE valuations will be able to grow by the business growth rate only or profits growth rate. We all know its very difficult to maintain a business growth rate of more than 30%. So, going forward in a high PE valuation, one can only get a business growth rate. Also, its accepted that around a point of time, every business has the tendency to reach the top side of the bell-shaped curve after that it'll stagnate & may deteriorate. So, my argument is that once your investments reach high or rich PE valuations, its time to look for equally good businesses with low PEs to enjoy their PE expansion and exit the former at an appropriate point of time & get invested in the later.
While injvesting in a "business" (stock), Why not look for Return on Equity (RoE) which is actually moment of truth, instead of PE. PE tend to vary with price while RoE is market price independent. If business can keep increasing RoE, will it not lead to PE expension automatically?
ReplyDeleteRoE or RoCE(I think RoCE is much better than RoE) is indicative of business efficiency. Its a parameter by which a business evaluates itself which has an impact on its profitability finally. PE valuation criterion is indicative of the business valuation in market. PE valuation is about how much market is willing to pay for the business. Of course, RoE/RoCE has a foretelling on business's valuation and affects PE valuation.
DeleteIn the above discussion, I'm taking into consideration the fact that the concerned business has excellent ratios and works on a negative Cash Conversion Cycle. I'm talking about the ideal business model above and then talking about PE valuation. In India, a PE valuation of 30+ is generally considered rich. Post that, valuation growth will coincide with business growth/revenue growth/profit growth. And in worsened market conditions, that valuation can infact drop too, since its quoting at a higher valuation. My suggestion is that when a business get richly valued, one should start looking for undervalued targets provided the business quality is at par or better since, its an accepted fact that big money is made during PE expansion and it is what value or growth-oriented investors strive for.
Its all about buying cheap and selling at higher prices. This is what investment is all about.
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