Understanding the PE valuations its implications with the help of FMCG sector
It's true that the price-to-earnings ratio, or P/E, is probably the most commonly used valuation metric, but that doesn't mean that it's a good way to gauge an investment in all cases. The long term movement of a stock price is the result of two factors - EPS and PE Ratio. The PE Ratio is that "multiple" which the market is paying for a company based on it's earnings per share. Usually, the market factors in the EPS growth rate and if the expected growth rate is high, then the market is ready to pay a premium to today's earnings. Consider this example:
The EPS grew at 30% p.a. and thus the PE Ratio cooled off. So that is why we have investors and analysts valuing a stock at forward earnings (FY19E earnings, FY20E earnings, etc).
FMCG Sector the living Example Defying the bearish sentiments on the street, the FMCG sector is touching record highs and blue-chips like Hindustan Unilever has given stellar returns on a YoY basis. Most of these stocks are trading at PE levels of 50+ on the back of heightened expectations in the pace of recovery of rural economy, higher GDP growth leading to more spending by Indians, post GST benefits to the organized segment, etc. The below table shows you the premium investors were paying to the premium they are paying now with the premium now stabilizing a bit due to weaker markets:
The above heavy-weight is pulling the FMCG index and the buzz-word around FMCG stocks is back.
Should you invest in FMCG stocks right now?
No. Why? Because the valuations that you will end up paying now will result in very low returns for you over the next few years. Many FMCG names are trading at a premium to their historical valuations and sooner or later the PE will revert back to it's mean. Assume that the earnings of HUL grew by 15% p.a. over the next 5 years and the PE reverts back to the historical mean - What will investors earn?
An Investor would make 11.5% if we assumed the P/E multiple contracted to 55 however if the P/E multiple remained the same the investor would get 15% returns and if the P/E multiple expanded he would get more than 15% Returns
So why are funds and investors Investing in these companies Either they are expecting that the PE ratio will sustain at such high levels for many more years and maybe even expand OR they are expecting a very high growth rate sustaining over the next 5 years. Let's try to reverse calculate.
Assume that an investor wants to earn at least 16.5% p.a over the next 5 years from HUL's stock. He is aware the PE ratio will revert back close to the mean. So this means, if he does buy now he is expecting earnings to grow at a CAGR of ~ 21% p.a. over the next 5 years. It becomes simpler to decide now whether or not you want to invest in HUL's stock? Do you expect Hindustan Unilever's EPS to grow at 21% CAGR over the next 5 years. If yes, then BUY. If No, then do not invest in HUL. Similar is the case with most FMCG stocks. In fact most FMCG stocks have been trading at elevated PE levels since 2014-15 and lately because of the organized sector GST boom they have boomed The price-to-earnings ratio is an oft-used tool for judging a stock's valuation, but it's just one piece of the puzzle.
How can these stocks possibly be good investments?
It's true that the price-to-earnings ratio, or P/E, is probably the most commonly used valuation metric, but that doesn't mean that it's a good way to gauge an investment in all cases. Some solid stocks have P/E ratios that are deceptively high, while other perfectly healthy companies may even have negative P/Es. When it comes to assessing whether such stocks are over- or undervalued, other factors come into play. Three metrics that are particularly useful to look at in these cases are: the revenue growth rate; the PEG ratio, which factors a company's projected earnings growth into the P/E calculation; and the Price to sales ratio or P/S. It's often the case that even if a stock's P/E looks extremely high, one or both of these metrics will make it look cheap.
So Why such a hefty premium ?
On these metrics the valuations looks a bit steep but one has to consider that Hul is 5 times bigger player than any of its counter part. Also it houses one of the largest rural and urban product distribution channel network. With the recent acquisition of GSK consumers, brands like Horlicks have come into its product portfolio with additional distribution channel it could be a good acquisition and expand product base and consumer reach of the company.
Also as the per capita income rises the spending on FMCG products tends to rise. With the population already growing at 7% its a natural advantage for the company. Plus India having 120cr+ population the demand for FMCG products is great and the brand image and recognition of Hul is also very good with it being the leaders in their various product categories. Currently the per capita consumption on FMCG products is 29$ which is 2100 rupees where as in countries like Indonesia its 2x, China 4x and Philippines 5x times that of India there by creating amazing growth opportunity and ability to tap the market. The current valuations are more based on the opportunity and future-positive outlook pricing just like in Netflix and Amazon the market expects it to grow at a constant rate year in year out.
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