I covered my approach to estimating the appropriate PE for a stock and reverse engineering the current valuations in the previous posts. This is ofcourse not the approach taken by analysts. The typical approach is to look at the past history and decide on the likely earnings (and not even free cash flow). If the analyst is optimisitic he slaps on a high PE and voila ..we have the price target.
To support the argument, the analyst does a comparison with other companies in the sector and tries to justify the PE. So we may have an optimisitic earnings estimate and on top of that a high PE attached to it, which would amount to double counting.
That is an incomplete approach. If the sector is in a bull run or has very high valuation then you are committing the same mistake twice. First assuming an optimistic estimate of earnings and then applying a high PE. Don’t believe me ? …well several IT companies sold for a PE of 100 in 2000 and real estate and capital goods companies sell for similar high valuations. Average PE for IT companies is now below 20 and mid caps in IT sometimes sell for less than 10 times.
This brings me to some interesting observations which you can derieve from this table below
For a company to justify a PE of 30+ the following has to happen – The company has to grow a more than 15-18% per annum for 9-10 years and maintain a ROE or ROC of 15% or higher. That would justify the PE of 30. If a company sells for that PE, then for you to make money the company has to do better than that. PE ratios of higher than 40, require higher growth, higher ROC and much longer CAPs.
Is that likely ? well it can happen …but don’t bet on that. Industries which have high growths and high ROC tend to attract a lot of competiton which drives the returns down. That’s a given rule of economics.
As a result I am wary of companies having a high PE. To justify an investment, the company has do better than the implied value (which you can get from the table above).
Final point – I have put comments on the right of the table with color schemes. Red means stay away for me !