September 24, 2005

Relationship between PE, ROE and Competitive advantage period (CAP)

I have been working on various permutations of ROE and CAP (period for which the company can earn over cost of capital) using the DCF model to see the PE ratios which are thrown up by the model.

Its fairly intuitive that a company with a high CAP and high ROE should have a high PE. But these permutations have thrown a few insights

  • For similar CAP and growth rates a company having an ROE of 20 % should have a PE which is 1.3-1.4 times that of a company with an ROE of 10%. Similar ratios come up for every 10% increase of ROE

  • Companies with moderate ROE ( 10-15 %) need CAP of more than 10 years to justify a PE of 20 or higher

  • Companies with PE of 30 or higher need a CAP of 10 + years with a growth of 15% and ROE of 25% or higher

So any time I see a company with PE of 20 or higher (which is high these days), the first question I ask is – Given the ROE of the company, does the company have substantial duration of CAP ( 10 years or higher ).

A company with a PE of 30 or higher must have a great return on capital, very strong growth and 10 years or higher CAP. A point worth thinking about when looking at such high valuation companies.

This way of think is detailed in the book ‘expectations investing’ by micheal maubossin and is definitely worth a read.


Trading said...

Nice blog. Very informative. It is interesting to see the bullish sentiment these days as expressed by the VIX being so low (volatility guage.) I wonder where the stock prices will be when (if?) the VIX ever gets back into the 40s and 50s. Futures

Rohit said...

appreciate the comment. I agree, the sentiment is fairly bullish. Although i do not look at market volatility, i am getting a similar feel, from looking at various individual stocks. Most are selling at premium multiples and there seems to be no margin of safety. It kind of reminds me of a comment from warren buffett - investors typically look at the market with a rear mirror view. As of now the rear mirror is all bright and sunny, whereas in 2003 it was dark and cloudy with the sensex at 3000 and trailing PE of 11.

ValueArchitects said...

Dont really agree to what you say. Although the "index" is touching all time high, PE is not very expensive. If you acknowledge, the capital mgmt within cos has improved over last 5-6 years.Good growth , coupled with consumerism and cheap credit, should fuel asset-valuations futher. Moreover, someone rightly said, foreigners are more bullish about the india, than indians themselves.

Rohit said...

I have found it difficult to form a firm opinion (maybe its just me) on the index. It is possible to justify the valuation of company within some limits, but have found it difficult to do the same for the index. For one the index composition is changing . so the index in 2003 is different from 2005 (the problem of non stationarity of data).although i agree with the basic premise that indian companies are managing capital much better and the fundamentals are good, my concern is how much to pay for it (i.e what is fair value range for the PE). This is not an small question for me , because i invest in index funds and ETF's.
As i do not have a firm number for the valuation of the index, i prefer to work in a range ( 15-18 PE trailing ). Once the index crosses this range i tend to stop investing and look at reducing my holding after a PE of 20.
All of the above seems mechanical, but it keeps me disciplined and prevents me from becoming too optimistic.
At the same time i agree indians (me included ) are less bullish . but then i think the past bulls runs have had nasty ends (harshad mehta , ketan parekh et al !)

ValueArchitects said...

I wont say that "This would be different this time" - but it would be crime to compare it with HM/KP type markets. You got to take into congizance that today the marketplayers are more bigger/better and more professional in their approach. Few good hedge funds/private equity guys have more information about the books of accounts than most others. And the best part is that the participation of retail guys in the market is lower than earlier periods (again pointing towards professional/mature markets).
Overall I think, we are travelling thru the era what US was in early 80s.