P/E multiples are consistently used by all investors alike to determine the profitability of a company and how expensive or cheap the stock is relatively.
However, there are many fallacies regarding the understanding of the P/E multiple, the most common one being: A higher or lower P/E necessarily means a stock is expensive or cheap.
For example, let us say we have stock A and stock B (from the same industry) with P/Es of 15x and 40x. Most would likely conclude that Stock B is overvalued and would go on to buy more and more of A. Only if it were so simple!!!
In fact, B could be cheaper than A with a P/E even 4 times that of A. Let us explore with an example:
Consider 2 companies from the same industry: A & B
Let us assume that they have similar earnings and earnings growth rates. However, the companies have different ROCE and P/Es as shown below:
- Here, RoCE of B is 4 times that of A.
- This means, to earn Rs 10, A would have to employ Rs 100, while B would have to employ only Rs 25.
- This would further imply that B would have more Free cash Flow (FCF) available to shareholders as it is employing lesser capital. In fact, B would have 4 times that of the Free Cash Flow generated by A.
- Now, P/E is directly proportional to FCF as Free cash flow is a measure of the fair value of a company.
- This means, P/E of stock B would also be 4 times that of A (15*4 = 60x), justifying its higher value.
In this instance, at a prevailing P/E of 40x, B is in fact undervalued relative to its fair P/E value of 60x.
Note: Here we assume that the P/E of A is trading at its fair value.
Shown below is the effect of RoCE on the P/E of a company at a fixed earnings growth.
For a fixed earnings growth, the expected P/E of a company increases as its RoCE increases, making the stock more undervalued. For example, P/E increases from 15x to 60x (4 times) as RoCE increases from 10% to 40%.
Therefore, we can conclude that:
- Capital efficiency plays one of the most important roles in determining the future profitability.
- Improved capital efficiency is also associated with increased RoA and reduction in working capital cycles thereby freeing up more cash flows over time.
- These measures should be looked at closely while determining whether a higher P/E can be justified and can give a fairer picture of your investments.
Hence, we cannot undermine the impact RoCE (coupled with earnings growth) has on P/E and thereby a company’s valuation.