Pe report: identification of multibaggers with expansion and contraction of the PE

The price/earnings ratio is one of the most popular and widely used indicators by investors when investing. The formula for the PE ratio is PE = price/earnings.

Now let’s ask the most fundamental question. Why invest in stocks? The simple answer is – we invest in stocks because we expect stock prices to rise in the future and provide better returns than fixed deposits and other asset classes.

Now let’s get to some tough questions. Do you remember the PE of the title when you first bought it? Do you remember the trend of the EP of the same title over the past two years?

I’m sure these questions have put you in a sticky situation! However, let’s now replace PE with price in the above two questions. Now, this could be a piece of cake for you to answer.

You can find out the price at which you first bought the stock as well as the trend of the stock price over the past two years.

So what does this tell us about the mindset of most investors?

Well, most of the investors only focus on the price and the price trend, but they tend to neglect the PE trend and the profit trend over the lifetime of an investment. But it is very important to understand the reason for price fluctuations. Stock prices tend to rise due to an increase in private equity or an increase in earnings, or both.

Likewise, prices tend to fall due to a decline in income.

This is where the concept of PE expansion and PE contraction comes into play.

What is the PE extension?
Let’s take a hypothetical example. A stock, say ABC, is trading at Rs 100 for an EPS of Rs 10 and a PE of 10. The stock price can skyrocket to Rs 1000 if the EPS of the stock increases by almost 32%. over four years and rises to Rs 30 driven by explosive growth and the PE ratio also rises to 33.33 times.

A more than threefold increase in PE is called PE expansion, which is the result of the belief and credibility shown by the company’s stock market against the backdrop of a high growth perception that the company is expected to generate profits at an accelerated rate for an extended period of time.

Below is a graphical representation of

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From the graphical representation above, we can see how the PE expansion worked. In 2012, the stock’s PE was 33.2 and EPS was Rs 10.57, and when the stock peaked in 2020, its PE was 106.3 and EPS was 23.72 Rs.

What is the contraction of the EP?
When a company generates above-average growth for an extended period, it reaches a stage where its own size becomes unsustainable as it experiences problems due to market saturation, increased competition, product obsolescence or any other reason that threatens to cause a trend reversal. the fundamentals that underpin the company’s growth.

More often than not, the market acts on anticipation because the decline in the share price precedes the decline in the growth rate of the company. Thus, a company could begin to see a decline in its stock price even if earnings growth continues uninterrupted for the next two quarters.

Now let’s go back to our example of the action named ABC. The company has seen explosive growth and the shares are trading at Rs 1000 at a PE of 33.33x for EPS of 30 and growth of 33.33% YoY.

In this case, if the market senses that instead of growing 33.33%, the company will now only grow 25%, then the PE could fall 33.33 to 18 times.

The reason for this sharp decline in the PE could be attributed to market sentiment, which outweighs the actual upside or downside of growth in both the optimistic and pessimistic scenarios.

So despite a 20% increase in EPS to Rs 36, a PE of 18 would drive the stock down to Rs 648, which would result in a drop of almost 35% from the high of Rs 1000.

So, although EPS has increased, the sharp correction in the share price is due to the contraction in the PE, which is the result of market sentiment turning sour as the company’s growth trajectory faces obstacles and that it is no longer able to sustain the higher rate of growth.

Returning to the example of Asian Paints, we can see from the graphical representation below that despite EPS rising to Rs 32.12, PE contracted to 80.3.

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Here it is important to note that investors are always trying to search for an answer to the critical question: How to identify a multibagger?

The answer to this question is simple: a perfect recipe for a multibagger is strong earnings growth complemented by rapid expansion in private equity. But the crucial question is: when does PE begin to develop?

Usually, the PE starts to develop from the moment a company starts to show above average growth and to witness a structural change and with each earnings announcement the PE ratio of the stock keeps on increasing. increase. This is a multibagger in the making.

(The author is Director, Choice Equity Broking)

Sallie R. Loera