The easiest way to justify a high PE stock is to say that it has a moat or in other words a sustainable competitive advantage. Once these magic words are uttered, no further analysis or thinking is needed. If there is a moat, it does not matter if the stock sells at a PE of 30 or 70. It is all the same.

On seeing this type of analysis I am reminded of the following the quote from warren buffett

“What the wise do in the beginning, fools do in the end.”

Moat =high PE, but high PE is not always = Moat

A company with a moat may be justified to have a high PE, but a high PE does not mean the mean presence of a moat.

Even if the company supposedly has a moat, it is important to judge the depth and durability of this moat. In addition , the company should also have the opportunity to re-invest future cash flows into the business at high rates of return to create further value.

Lets explore some of these aspects in further detail

More than knee deep

The depth of the moat is simply the excess returns a company can make over its cost of capital. If a company can earn 30% return on capital, we can clearly see that the moat is deep (18% excess return).

This aspect of the moat is the easiest to figure out – Just pick the financials of the company for the last 10 years and check the return on capital of the company. If the average returns are higher than the cost of capital , then we can safely assume that the company had a moat in the past (the future is a different issue).

I personally use 15% return on capital as a threshold. Any company which has earned 15% or higher over an entire business cycle (roughly 3-5 years) is a good candidate for the presence of a moat in the past. Its important not to consider a single year in the analysis as several cyclical companies show a sudden spurt in profitability, before sliding into mediocrity.

The durability factor

The presence of a moat in the past, is only the starting point of analysis.

The key questions to ask are

– Is the moat durable – will the moat survive in the future ?
– How long will the moat survive ?
– Will the moat deepen (Return on capital improve), remain same or reduce.

All these factor are very important in the valuation of a business. Let try to quantify them. I will be using the discounted flow analysis (without doing the math here) and will also be making some simplifying assumptions

1. EPS = 10 Rs
2. Return on capital (ROC) = 22%
3. Growth in profits = 15 %
4. Company is able to maintain this return on capital and growth for 10 years. After that the ROC drops to 12% and growth to 8% (leading to a terminal PE of around 12)

If you input the above numbers into a DCF model, the fair value comes to around 230 (PE = 23)

Lets play with these numbers now – Lets assume we underestimated the durability of the moat. The actual life of the moat turns out to be 20 years and not the 10 years when we first analysed the company. If that is the case, the fair value comes to around 430 (PE=43)

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I just described the case of several companies such as HDFC bank, Asian paints, Nestle etc. In case of these companies, the markets assumed a certain excess return period, which turned to be too conservative. Anyone who bought the stock at a high looking PE, was actually buying the stock cheap.

The above point has been explained far better by prof. sanjay bakshi in this lecture.

Lets look at a few more happy cases. Lets assume that the company actually ends up earning an ROC of 50% with a growth of 20%. If you plug in these numbers, the fair value turns out to be around 440 (PE=44). I may have just described what has happened to page industries since 2008.

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So what are the key points?

The market when valuing a company is making an implicit assumption on the future return on capital, growth and the period for which both these factors will last (after which they regress to the averages).

An investor makes an above average return only if these numbers turn out to be better than the assumptions built into the stock at the time of purchase.

What happens if the moat turns out to be weak or non existent ?

You have a dud !

Lets assume in our example, that the business tanks after you buy it. It is never able to earn more than 12% return on capital and grows at around 8%.

If the above unhappy situation happens, then the true fair value of the company is around 120 (PE=12). If this turns out to the case, then you will suffer from a 50% loss of capital as the market re-values the company.

Examples ? Look at the case of bharti airtel. The company was selling at around 470 or PE of 23 in 2007. The company had an ROC of 31% and growth in excess of 15%. The market was assuming an excess return period of 8-10 years at that point of time.

What has happened since then ? The stock price has dropped by around 25% from its peak over the last 8 years – a loss of 2% per annum, which is not exactly a great return.

The reasons are not difficult to see (as always, in hindsight). The telecom market after growing at a breakneck speed till 2007-08 started slowing down. In addition the competitive intensity of the industry increased with almost all other players losing money for most of the time. If these problems were not enough, Bharti went ahead and made an expensive acquisition (Zain) in Africa which suppressed the return on capital further.

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In effect all the key drivers of value, turned south from 2007-08 onwards resulting in a loss for the long term investor.

We can derieve some key points from the discussion till now

– A high return on capital in the past is a necessary, but not a sufficient condition to demonstrate the presence of a moat
– It is also important to judge the depth and longevity or durability of moat. If your estimate is correct and turns out to be higher than that of the market, then you will excess returns. If not, be prepared to lose money or at best make market level returns .
– As a corollary a buy and hold works only if you get the durability aspect correct. If the moat shrinks and disappears, a buy and hold strategy will not save you

So how does one figure out the durability of the moat. There is no magical formulae where you can punch in a set of numbers and out will pop the duration. It is a highly subjective exercise and the topic of the next post.

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