As the clamour for a healthy correction in high-flying midcap and smallcap stocks, many of which have doubled in just a few months, is rising, ETMarkets turned the pages of history to find out whether high PE (price-to-earnings) stocks actually fail to deliver.

Out of the 45 stocks (with a market capitalisation of over Rs 500 crore) which had TTM PE multiples of over 100 a year ago, only 20 of them have given negative returns in the last one year. In fact, three of them – Zen Technologies, PTC Industries and Premier Explosives – have gone on to deliver multibagger returns and remain in the high PE zone even today.

The list of high PE outperformers also include Olectra Greentech, RateGain Travel Technologies, Westlife Foodworld, Indian Hotels and Gensol Engineering.

Expensive remains expensive
If PE, which tells you how many years it will take for the company’s earnings to cover its current price, is treated as the top valuation criteria, Dalal Street is full of stories about stocks that have managed to remain expensive for ages by delivering both earnings growth as well as share price performance. This holds true not just for bluechip Nifty stocks but also for their much smaller peers.

Tata Group’s retail arm Trent, which owns Westside and Zudio, for example, commanded a PE of 143 a year ago. Despite an impressive share price gain of 47% in the last one year, the stock’s PE has actually increased to 150, shows ACE Equity data.

Should you buy or avoid high PE stocks?
Data indicates that investors should not get scared away by high PE stocks as what looks expensive today may look expensive tomorrow as well.

Religare Broking’s fundamental analyst Nirvi Ashar agrees saying that companies with decent growth and margins, low debt and leadership brands are usually the ones to trade at expensive PE levels. “So, a high PE shouldn’t be a reason to shy away or lower PE doesn’t mean the stock is attractive. Different sectors and stocks trade at different PE valuations which are ideally not comparable but the focus should be on that particular sector,” she told ETMarkets.

While PE is the most simple and commonly used valuation parameter on the Street to decide if the stock is overvalued or undervalued, the valuation metric should not be looked at in isolation but along with other parameters like growth.

Giving the example of FMCG stocks, Dr. VK Vijayakumar, Chief Investment Strategist at Geojit Financial Services, says the pack always had and continues to have high PE because of its good track record of consistent growth. “If the growth prospects are good, high PE is justified. Conversely, low PE for a stock doesn’t justify buying, if the growth prospects are poor,” he explains, adding that a very high PE for a stock without good credentials is a red flag.

Many retail investors often get value trapped in a low-PE stock, forgetting that if something is cheap it is for a reason. Therefore, unwritten rules like ‘the lower the PE the better it is’ and ‘higher PE is expensive’ may not always give the complete picture.

“Rather, investors should value the stock by comparing companies within the same sector and focus on its qualitative and quantitative aspects before assigning the right multiple,” Religare’s Ashar says.

High PE vs low PE
The debate over high PE vs low PE stocks is an old one on Dalal Street. Masters of the game like Saurabh Mukherjea have long argued that a stock with a PE of 100 can be undervalued as the valuation metric ignores two critical elements – reinvestment required to grow the business and the longevity of cash flows from the business.

Instead of PE, Mukherjea looks at the free cash flow generation of a company before making buy or sell decisions.

On the other side of the debate is veteran money manager Sunil Singhania. When asked by a TV channel recently to comment on stocks with PE multiples above 100, he retorted saying it is always better to cry without investing than cry after investing.

“Ultimately growth has to justify what multiple you are paying. So if a company is growing at 30-40%, maybe you can justify a 40-50 PE multiple but if a company is growing at like 10%, you cannot justify such high PE multiples because then the PE multiples will have to be that high all its life,” argues Singhania.

The fun part of the debate is that investors on both sides of the argument can make money provided they have good stock-picking skills, patience to hold and a bit of luck.

(Data inputs: Ritesh Presswala)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)


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