Why it makes sense to invest in high P/E stocks?

Vikas SinghaniaTrade Smart OnlinePrice to earnings or P/E Ratio is the most commonly used valuation tool by investors to judge a company's valuation. Investors have been traditionally advised to buy low P/E stocks as compared to higher ones. At times the strategy works but mostly it does not. In fact historically high P/E stocks have given better returns than lower PE ones. Before looking at the details let’s first try to understand what P/E represents. P/E multiple is a function of the share price of the company and the profit it generates on a per share basis. In other words if say a company is trading at a share price of Rs 100 and its earning per share (EPS) is Rs 5 than the PE is 20. Suppose an investor intends to buyout the entire company and de-list it. Further assume that the company is in a rock steady business which will earn Rs 5 for perpetuity. In such a case the buyer would be able to recover his money in 20 years. Thus he will be getting a yield of 5 per cent every year for his investment. Clearly, a bad deal if the risk free investment in a government bond is yielding 7 per cent. However, if say the company is expected to grow its profit by 30 per cent in the next five years, then the company will generate an EPS of Rs 6.5 in the second year, Rs 8.45 in the third and around Rs 11in the fourth year of take over. PE based on forward earning is 15.3, 11.8 and 9.1. As profits of the company increases forward PEs contract. The current P/E of 20 in such a case does not look too expensive as the company is in a fast growth trajectory. Using the same value of P/E for all companies or all sectors is unwise. A sector with a high growth rate will deserve a higher PE while a matured sector will always get a lower PE. The current valuations of diagnostics companies which trade at high P/Es of nearly 60 are the case in the point. Analysts predict that these companies have a clear road ahead and will grow at over 30 per cent for the next few years as the sector is fragmented. IT companies in their heydays were all trading at an average of 40 P/E since the sector was a sunrise one.  But growth or perception of growth is not the only factor that affects P/E. Liquidity or non-promoter free float is also partly responsible for higher discounting, especially in case of companies with high quality management.Quality of management is an important factor in market. A better managed company enjoys higher valuation. Another factor is the nature of business. Sectors which have a high entry barrier and where the companies have a higher pricing power are favoured by investors. Companies dealing in commodities normally get lower discounting while companies having a brand generally are valued higher. Multinational companies despite a low growth rate are all trading at high P/Es as most of the stocks are generally held by their parent company. Also, these companies have good dividend pay-out. Asian Paints which has a good quality management and high brand recall traded between a P/E of 28 and 66 since 2010. An investor who looks only at P/E would consider even the lower band of 28 as high. Among all the factors that determine high P/E, growth is the most important for determining the PE that the company or the sector will get. Since 2010 the software sector has been facing pressure from a slowing American and European economy on account of Lehman crisis followed by the Euro crisis. During this period share price of Infosys has increased by nearly doubled but its PE has nearly halved from 32 to 17. Investors would jump over to other companies or sectors with a higher growth rate.Rather than looking at P/E based on historic data it would be better if one looks at PEs based on forward numbers which capture growth. The problem here is that in a bull market analysts keep on projecting numbers four or five years. By using growth numbers in distant future, they try to justify the current stock price. This is the first sign of a bubble building up. As for companies with low PE, it is better to always check for other financial data points before picking up the stock. In most of the cases a stock is trading at a low P/E for a reason.