We will see examples of such companies later in this article. Such re-rating happens typically in growth companies where earnings are forecasted to grow steadily for extended period of time. This huge difference in returns offered by a high growth stock versus a risk-free investment forces investors to shift to such stocks, settling for even lower returns than the initial potential – say for 8X or 4X returns. On the other hand, a risk free return) instrument takes 12 years to just double your money. In other words, it should theoretically deliver 16X returns in 12 years if bought at a PE Ratio of 25 or PEG Ratio of 1. But how does it cause price earnings (PE) multiple to go up – that is, how does PE re-rating happen? Let us theoretically try to understand this:Ī company growing its earnings (PAT) at 25%, is doubling its earnings every three years. PE re-rating: Growth leads to returns yes. So, looking at businesses based on based on capital efficiency (RoCE) than margins can lead you one step closer to identifying multi-bagger stocks. (lower investments in fixed assets and low working capital needs). On the other hand, many low margin businesses from sectors such as retail, consumer durables or consumer electronics/electricals generate similar/ superior RoCE to high margin businesses, despite thin margins of 5-15%, due to low capital intensity. ![]() Here margins MUST compensate for capital intensity to generate decent RoCE. have high capital intensity (high investments in both fixed assets as well as working capital). This is not really the case at all times! Here’s why looking at margins alone can be deceptive at times.Ĭertain high margin businesses in sectors like engineering & capital goods, pharmaceuticals & chemicals, auto ancillaries, textiles, etc. In other words, they believe that high margin means high quality of return or high RoCE. Some investors look at quality of growth from the perspective of high margins. In the Indian context, sectors such as IT services and consumer goods, where companies typically grow their profits with high capital efficiency for extended period, can be classified under the category of ‘quality growth’. In simple terms, unless RoE is above the cost of capital for a business, the business is not going to generate any shareholder returns. RoE gives primary indication of whether a business is worth investing at all. ROE measures the return on your equity capital. In those companies, RoE will improve only with debt reduction as the initial debt capital results in profit growth that helps generate sufficient cash flows to repay the debt. RoCE is a better indication of capital efficiency and future potential of a business in cyclical sectors or capital-intensive sectors. If a company has a high debt component at high interest rate, then it can have a high RoCE that may not finally translate into high RoE. Even here, the debt capital should have come at attractive interest rate. RoCE = Earnings before interest and taxes/ total capital employed (equity + debt)Ī high RoCE should eventually translate to high RoE if the debt capital is put to good use. It gives a primary indication of the capital efficiency of a business. The ratio is used to measure how much returns a business is generating on the total capital employed. What is Return on Capital Employed (RoCE)? It rewards the quality of growth – meaning the ability of a company to steadily grow its profits for an extended period with great capital efficiency (RoCE). Quality of growth: The market does not reward just growth. ![]() ![]() Anyone buying such a company’s stock at around a PEG ratio of 1 is theoretically getting a great price to invest since he or she will theoretically be at least doubling their wealth in 3 or 5 years (in the above examples). A company growing profit at 15% every year is doubling its profits every 5 years while one growing at 25% is doubling profits every 3 years. Now, let us understand how a stock is termed attractive in relation to its growth. So if a company’s price earnings ratio is say 18 and its earnings is expected to grow at say 18% every year for the next 3 years, its PEG is 1. This is called the PEG ratio.Īs a formula, this is a stock’s price-to-earnings (P/E) ratio divided by the growth rate of its earnings for a specified time period. Growth, when seen with the price that the market places for a stock’s earnings (price to earnings ratio)– tells you whether you are buying a stock at the right price. Growth here refers to growth in net earnings (profit after tax). It is a prerequisite for a stock to deliver returns. Growth: Growth is the one factor that makes stocks attractive over other asset classes. #1 Growth, quality of growth and re-rating We will first discuss the importance of each of these factors and then go through few illustrations to understand how these factors play out.
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