Don’t Just Rely on the P/E Ratio
However, relative Evaluation Metrics cannot be centered in isolation. One has to look at the price of the stock versus the value it will get from it in the future. The present fair value of an asset is the expected present value of its future cash flows discounted at the appropriate expected rate of return.
In the case of equity market, an investor is buying on higher than expected growth and return on equity. They believe the stock is undervalued, and it will perform with a higher than perceived growth (cost of equity). If the market expectation of a company is that it will grow consistently at 6%, and investors think it will outperform, investors can make money from it.
However, the recent hike in valuations is more due to the fall. Rate of interest cycles rather than higher growth rates. An investor buying in 2021 is paying for 12% long-term growth compared to 12% in 2019. Only the cost of equity (defined as return on 10-year government bonds + equity risk premium) has come down, due to which ROE expectations have remained stable, while increasing manifold.
Consequently, to rely solely on optical P/E multiples to conclude that markets today are more expensive than at pre-Covid levels would be wrong.
So, is it still worth investing in?
The markets are not as expensive as they seem, but the risks are heightened. Investors can be adept at finding companies with a promising future in terms of growth and return on investment (ROI), but this alone cannot guarantee the greatest results in the future. Also, when interest rates (the discount factor) begin to rise, future returns may be much lower than expected as the multiplier declines.
Since price is only a matter of perception, it is always better to join the plunge and stay aboard rather than wait for an accident. Just make sure you’re in it for the long run and aren’t going to run out anytime soon.
Choose stocks based on the new future instead of the blue label of the past
Go for companies that are showing potential sales growth and are still comfortable with valuations.
Look for sparks like growing top-line numbers as good starting points for identifying potential merger and acquisition candidates, promoters increasing their stake, and future outperformers.
But don’t go a long way, be sure not to include protection on high potential gainers, even if it means missing out on some strong outperformers. As smart investing is not necessarily about catching the top gainers; It’s not about a top loser.
How to choose?
In the current scenario, a good way to invest in equities would be to use the favorable price-earnings growth (PEG) ratio. This ratio is calculated by dividing the current PE ratio by the EPS growth over the past 12 months. a . stock with peg ratio A depreciation of 1 or less is considered. For example, a corporation with a PE of 25 and an EPS growth rate of 25% would have a PEG of 1.
Apart from looking at the PEG ratio, you should also consider whether the current growth pattern will continue in the coming quarters. This will result in a further PEG ratio calculation, which is a more meaningful metric than the previous PEG ratio. Forward PEG will be attractive if forward growth is expected to be strong.
Just a tip, qualitative factors such as management commentary can be used to predict future growth by discounting their over-optimism.
(The author is a chartered wealth manager and economist.)