Don’t rely solely on P/E ratios
However, relative valuation metrics cannot be focused in isolation. One has to look at the price of the stock vs the value one can derive from it in future. The current fair value of any asset is the expected present value of its future cashflows discounted at the fair expected rate of return.
In case of the equity market, an investor is purchasing on higher-than-anticipated growth and return on equity. They believe that the stock is undervalued, and it will perform with higher than perceived growth (cost of equity). If the market expectation about a company is that it will grow perpetually at 6%, and investors feels it will perform better than that, then the investors can make money out of it.
However, the recent rise in valuations are more due to a declining interest rate cycle rather than greater growth rates. An investor buying in 2021 is paying for 12% long-term growth, compared to the same 12% in 2019. Only the cost of equity (defined as the yield on a 10-year government bond + equity risk premium) has decreased, causing the multiple to rise while the ROE expectations have remained constant.
As a result, relying solely on the optical P/E multiples to conclude that markets today are more expensive than pre-covid levels would be incorrect.
So, is it still worth investing?
Markets are not as pricey as they appear, but the risks have grown. Investors may be adept at spotting companies with a promising future in terms of development and return on investment (ROI), but this alone may not guarantee the greatest results in the future. Further, when interest rates (discounting factor) start to rise, future returns may be significantly lower than anticipated as multiples fall.
As value is just a matter of perception, it will always be better to join at the dip and stay aboard rather than waiting for the crash. Just make sure you’re in it for a long-time frame and not going running anytime soon.
Pick stocks based on the new future rather than blue label of the past
Go for companies which are showing potential sales growth and valuation-wise are still comfortably placed.
Seek for sparks such as potential mergers and acquisitions candidates, promoters increasing their stake, and growing top-line numbers as good starting points to identifying future outperformers.
But don’t go a long way, make sure safety is not comprised on high potential gainers, even if it means missing out on a few strong outperformers. As smart investing is not necessarily about catching the top gainers; it’s about having no top losers.
How to choose?
In the current scenario, one of the good approaches to investing in equities would be using favourable Price Earnings Growth (PEG) ratio. This ratio is calculated by dividing the current PE ratio by the EPS growth over the previous 12 months. Stocks with a PEG ratio of 1 or less are considered as undervalued. For example, a corporation with a PE of 25 and a 25% EPS growth rate will have a PEG of 1.
In addition to looking at the PEG ratio, you should also consider if the current growth pattern will continue in the coming quarters. This will result in a forward PEG ratio calculation, which is a more meaningful metric than the trailing PEG ratio. Forward PEG will be appealing if forward growth is expected to be strong.
Just a tip, qualitative factors like management commentary can be used to predict the future growth by discounting their over-optimism.
(The writer is a Chartered Wealth Manager and Economist.)