I got the following comment from abhishek

Hi Rohit,
Using the same concept, dont u think L&T is a very expensive stock trading at PE of above 70.
To sustain this PE, how much growth it must show in the future?
Does this PE look sustainable?
If no, could u please help us understand this calculation by using L&T as an example?

Following is a very brief unpacking or analysis of the expectations embedded in the stock price. Is the stock undervalued?…that is your call

Caution: I have done a quick analysis and hence there are a lot of assumptions (such as net profit = Free cash flow) and shortcuts. i have not done a detailed analysis as the company does not pass my initial selection criteria

The stock sells at a PE of around 30 (assuming consolidated profits of around 3000 crs for the year. LY was 2250 Crs).

The ROE is around 30%+ and Debt equity is around 1:1 based on 2007 Balance sheet.

You can plug the following numbers in the spreadsheet – quantitative calculation – ROC and PE to calculate the embedded expectations

1. ROE = 30% (approximate). Use the DCF calcluations on line 88
2. Growth ~ 20% ( 5 year average growth was 50% per annum). This is clearly an assumption and one can play around with it
3. CAP – Take as 10 years. Again an assumption. Increase or decrease based on your assesment of competition and industry
4. Free cash flow = Net profit

If you plug the above numbers, the model throws a PE of around 36 (close enough!)

So the expectations seem to be

– Company will maintain an ROE of 30% or more
– Growth for the 10 years would be 20%. If you are more optimistic, increase the number and you will find the company is undervalued (as expected).
– After 10 years , L&T would be a 40 bn dollar company! , with net profit of 4.5 bn dollars (19000 crore)
So the stock market is discounting the above performance. If you think the company is undervalued you are saying

The ROE of the company will be higher than 30%
Growth with higher than 20% and hence 10 years later the company would be a much larger company, making the same margins and profits.

Suggestion: I have not done this, but look around for such EPC companies worldwide and check the size, growth and PE for these companies. That could give a hint how large and profitable L&T can get.

There was an error in the analysis of crisil in the post . I had looked at the standalone numbers only and not the consolidated numbers (as an anonymous reader has pointed out in the comments)

So crisil may not be a good example of over valuation. I am not sure how undervalued the company is. It sells at a PE of 33 (approximate Net profit of 100 odd crs for 2007). I have analysed the company earlier here …and I have underestimated the competitive advantage of this company and its ability to keep increasing its instrinsic value.

That said, if I were make my point in the post again, I would replace crisil with any of the Real estate companies or capital goods company which have a high performance hurdle to cross (due to their high PE) to deliver good returns to investors in the future.

The post was however was not an analysis of CRISL. The key point is this – A good company may not be a good stock and vice versa (important word is ‘may’) . That depends on whether the stock price fully discounts the future performance of the company or not. If one has to make money in such high PE stocks, then the actual performance has to be better than what is implied by the stock

Low PE or low valuation stocks have low expectations built in and hence a small improvement in the company performance can deliver good returns. High PE or stocks selling at high valuations are stars of the Stock market. If they stumble even a bit, the stock price can get butchered. So one has to be confident and sure that the company will meet the high expectations well into the distant future.

I have personal experience of seeing a stock drop 90% when the company was not able to meet its high expectations (see here).

Ofcourse you can say that I am not as dumb as rohit and will not make a mistake like him 🙂

Feb 23 :
Following quote from peter lynch is very relevant to the topic of this post

“It’s a real tragedy when you buy a stock that’s overpriced; the company is a big success and you still don’t make any money.” Peter Lynch, “One Up on Wall Street,” New York, Penguin Books, 1989, p. 244.

I am a big fan of Mohnish Pabrai. He is a very succesful investment manager and has recently written a great book – dhandho investor.

Following article from mohnish explains the key point of the post – A good company may not be a good stock and vice versa in a great (and much better) way.

Valuation by intrinsic value.

In addition you can find the links for a lot of mohnish’s articles here. I strongly recommend reading each article