Since most investors fail to evaluate a company before buying it, they usually have no preconceived idea of what they can earn over time.

That is a fatal mistake.

You should be able to estimate the annualized rate of return you expect from every investment and be able to quantify how you derived that figure.

If your criteria for investing are vague or ill-defined, you are more likely to make mistakes about selling.

Are you looking for a 50% price increase in one year. If so, what factors can cause that to occur, and how likely are those factors to occur?

Are you looking for 15% a year for 10 years? If so, calculate what the stock must trade for in 10 years and determine the earnings that will be needed to support the price.

Then ask yourself whether those earnings can be attained.

Let me explain with two examples.

Before that, please note that all valuation calculations come only after you understand a business well, and also that it is a business that will sustain itself over the long term. You cannot just use any model on any business, just because the former is easy to perform.

Let us first consider the stock of Nestle India. (Disclosure: I do not own the stock)

Nestle is currently trading at Rs 17000. Its 2019 (year-ended December 2019) earnings per share (EPS) stood at Rs 204. The price-to-earnings or P/E thus comes to 83 times.

Now, let us assume you expect to earn a 15% annual return from Nestle (excluding dividends) over the next 10 years. This means, Nestle’s stock should trade at around Rs 69000 by June 2030.

Assume the maximum P/E you want to sell Nestle’s stock in June 2030 is 25 times. So, the EPS Nestle would earn in the year ended December 2029 would be “P divided by P/E,” or 69000 divided by 25, which equals to Rs 2750.

From EPS of Rs 204 in 2019 to Rs 2750 in 2029 means an annual growth of 30%.

Now, you ask this question – Can Nestle attain 30% annual EPS growth over the next 10 years? As a reference, Nestle’s last 10 years’ annual EPS growth has been 9%.

Anyways, as a second example, let us consider a stock that is not trading at such a high P/E as Nestle. Let us take Eicher Motors. (Disclosure: I do not own the stock)

Like Nestle, Eicher Motors is also trading at Rs 17000. Its last twelve months earnings (four quarters ended December 2019) earnings per share (EPS) stood at Rs 757. The P/E thus comes to 22 times.

Now, let us assume you expect to earn a 15% annual return from Eicher (excluding dividends) over the next 10 years. This means, Eicher’s stock should trade at around Rs 69000 by June 2030.

Assume the maximum P/E you want to sell Eicher’s stock in June 2030 is also 25 times. So, the EPS Eicher would earn in the four quarters ended December 2029 would be “P divided by P/E,” or 69000 divided by 25, which equals to Rs 2750.

Till now, we are almost on the same track with same numbers as Nestle’s. But here is where it diverges.

From Eicher’s EPS of Rs 757 now to Rs 2750 ten years later means an annual growth of 14%.

Now, you again ask this question – Can Eicher attain 14% annual EPS growth over the next 10 years? As a reference, Eicher’s last 10 years’ annual EPS growth has been 35%.

One point you must also consider before coming to the belief that Eicher is trading at cheap P/E valuation, given that the company requires to grow its EPS at just 14% annually over the next 10 years when it has already done 35% annually over the past 10, is that EPS, like trees, doesn’t grow to the sky. Something that has grown rapidly in the past ten years, often largely owing to low base, would not compulsorily grow at rapid rates in the future too. In fact, the law of averages and a high earnings base should pull down Eicher’s EPS growth to a lower level.

But the fact is that even if the annual EPS growth over the next 10 years were to be 14%, Eicher’s stock should give you 15% annual return (excluding any dividends), also if the stock trades at 25 times P/E then (which is appropriate for a high-quality business, though you may use your own number).

But wait, what if you expect not 15% but 25% annually from Eicher’s stock to take the risk of investing in it today? In that case, here is how the calculations will change –

The company would now have to grow its EPS at 24% annually to hand over a 25% annual stock price return to you. Now, this looks doubtful, at least much more than a 14% expected number.

You see, in investing, price and return are closely linked. The lower the price you pay, the greater your potential return. The lesser (though enough) you expect from a business, the less harder the business needs to work to get you what you expect.

It is that simple.

Also Read:

• P/E Valuation Excel Sheet
• My Email Exchange with Prof. Sanjay Bakshi on Valuations

That’s about it from me for today.

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Stay safe.

With respect,
— Vishal

https://www.safalniveshak.com/simple-pe-valuation-model/