Terry Smith, a well-renowned investor, in his book ‘Investing for the Growth’, has written following about High PE stocks:
“The level of valuation which may represent good value at which to buy shares in a high-quality company may surprise you.”
The following chart shows the “justified” PEs (price-to-earnings ratios) of a group of stocks of the sort we invest in.
What does that mean? It looks at the period 1973 to 2019 when the MSCI World Index produced an annual return of 6.2% and works out what PE an investor could have paid at the outset for those stocks and still returned 7% p.a. over the period, so beating the index
You could have paid 281 times earnings for L’Oréal in 1973 and beaten the index return. Or a PE of 126 for Colgate. Or buy high PE stocks like Coca-Cola at 63.
Clearly, this approach would not fit the mutation of value investing in which the rating must simply below.
Yet it is hard to argue with the fact that these stocks would have been good value even on some eye-watering valuation metrics.”
We have tried to apply a similar method to the Indian Stock Market.
Below is the chart of High PE Stocks from India.
The data suggest that investors can pay high PE to get a respectable return of 15%.
But the catch in the above is that he should stay invested for a long period of time.
But is it that simple?.
Is Paying for High PE Stocks Justified?
Well, not necessarily
As we can see from the above chart, we need to pay lower PE to get a 15% return over the last 10 years.
Why is there much difference in justifiable PE?
Well, returns from the stock are determined by earning growth.
As we can see, high PE can only be justified when companies delivered high earning growth over a long period of time.
Key takeaways from the above
- It is okay to pay high for high PE stocks if an investor believes in the long-term fundamentals of the company.
- High PE is justified for the companies that are growing or in a sector where there is a long runway for growth
- Investors may get a lower return in the short to medium term if they pay high PE.
- The investor has little margin of error when he pays a high price. It means that a slight change in the fundamental of the business could wipe out the whole of his capital.