Exercise Caution When Investing In Stocks With High P/E

'Sectors like e-commerce, small finance, housing finance, and healthcare are in great favour, and people are paying a PEG ratio of up to 5, which is dangerous.'
'Wealth destruction is inevitable.'

The universe of stocks trading at a 12-month forward price-to-earnings (P/E) multiple of 50x or more has swelled by 2.5x to 104, indicating the growing froth in the market.

In March 2023, the number of stocks with a P/E of 50x and 100x stood at 41 and 3, respectively, which has now grown to 104 and 9, according to an analysis by Kotak Institutional Equities (KIE).

When the market assigns a high P/E to a stock, the company's earnings growth is expected to grow exponentially.

As earnings grow, the P/E normalises. However, a P/E of 50x or 100x is also a sign that the market is pricing in unrealistic expectations.

Equity strategists at KIE said a P/E of 100x is justified if the company's earnings growth compounded at 12 per cent annually for 100 years or at a higher rate to reduce the time frame.

'A 100x P/E company, which may be in the growth phase over the next 40 years, will need to report an earnings compound annual growth rate (CAGR) of 20 per cent over the next 20 years and 9 per cent CAGR over the subsequent 20, according to our simplistic discounted cash flow model,' said KIE strategists, led by Sanjeev Prasad, in a note.

'If the industry's growth phase were to be shortened by 20 years, the required growth rates would be even higher,' the KIE note added.

'Even if we assume a stable market structure and stable profitability, the particular sector would then require becoming 200x in the first scenario and 30x in the second one. Only a few sunrise sectors may pass this small test,' the KIE note pointed out.

The growth in highly valued stocks comes amid a sharp rally in the markets, particularly in the small and midcap space.

The National Stock Exchange Nifty Midcap 100 has gained around 60 per cent in the past year, while the Nifty Smallcap 100 has rallied over 70 per cent.

Market players attributed the explosion in high P/E companies to the current crop of investors who have thronged the market during the post-pandemic bull run.

"A lot of these stocks are in the small and midcap space and are bought by the latest entrants who have only seen a secular bull market and don't have any experience of deep losses in the stock market," said Chokkalingam G, founder of Equinomics Research.

"Many of them are not even bothered about valuations. There is no fundamental justification for the high valuation these stocks are commanding," Chokkalingam added.

Analysts advised investors to exercise caution when investing in stocks with high P/E.

The high P/E stock universe is not restricted to new age companies. After the current bull run, even stocks in traditional sectors -- where growth rates are stable or sub-10 per cent -- command high multiples.

"Investors, if they are taking positions in these companies, at least they should see that the P/E-to-growth (PEG) ratio is not more than 3.

"Sectors like e-commerce, small finance, housing finance, and healthcare are in great favour, and people are paying a PEG ratio of up to 5, which is dangerous. Wealth destruction is inevitable," said Chokkalingam.

Chokkalingam added that it's better to exit a stock if it trades above a PEG ratio of 3 if one is not convinced of consistent high earnings growth.

The PEG ratio also factors in a firm's earnings while determining a stock's value.

Feature Presentation: Aslam Hunani/Rediff.com