When EPS and PE Ratio Not Good Enough for Valuation?

Why some companies even in March 2020 didn’t go below a PE ratio of 50? When EPS and PE Ratio Not Good Enough for Valuation?

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Have you ever wondered why companies like Page Industries, Pidilite, Asian Paints never fall to a single digit PE ratio? So is it that EPS and PE-Ratio may not be the right metrics for valuation?

In March of 2020, the PE ratio low of each of them was around 50. Some hit a low of 48 times earnings, and others hit a low of 52 times. When there was doom and gloom in the market, these stocks were trading at a PE multiple which traditionally looks very expensive.

Moreover, I have chosen companies impacted by COVID-19 and not considered Nestle India or HUL because they had no demand-side impact. So is PE ratio or earnings per share the right metrics to judge these stocks.

I don’t think so.

Let me explain why earning isn’t the right metric to consider undervalued or overvaluation for such growth-centric businesses.

Understand Earnings with a Simple Example

Earnings are the sole reason why companies share prices rise. However, I am sharing a contrarian view that earning is not the right metric to value shares.

So let me explain the same with the help of a simple example.

Let’s say my company makes a product and sell it to a single distributor. My production capacity is 1Lakh Rupees per day.

So daily in the morning, my company starts the production, and at the end of the day, I have the final product that I deliver. My profit margin is 10%. A daily production worth of 1Lakh Rupees. It is 90k that I pay to my suppliers and bag in 10k per day.

Assume that I bring 90k to my supplier in the morning, get the raw material, and add the raw material in my production unit and at the end of the day, I get the finished goods. Take those goods and deliver them.

In a quarter, there are 90 days. So my quarterly sales are ₹90Lakhs and profit of ₹9Lakhs.

I am damn sure the example is pretty simple to understand.

If I have 1Lakh shares in the company and a quarterly profit of ₹9Lakhs, my earning per share is ₹9.

One Critical Aspect Missing in Earnings

The total revenue and earnings don’t consider an essential aspect of the business which is when my distributor is paying for the product I sold.

Weekly Payment Terms

Now assume my distributor has to pay me in a week. It means from the 8th day, and I will be delivering the product and getting the payment for the products offered on day one.

As 1Lakh Rupees will be paid to me on the 8th day, on the 9th day in the morning when I want to purchase raw material, I will not require any capital. So I will have 90k with me along with 10k as profit.

For my business, the working capital requirement is merely 8x90k = ₹7.2Lakhs without taking any supply-side credits.

So on an invested capital of ~7Lakhs, I can earn a quarterly profit of 9Lakhs. So ROCE is 500%+ yearly.

Of course, it is way higher than any company can achieve because we have assumed no capital is needed for the manufacturing unit. Still, it will help understand the point I am trying to make for why EPS and PE Ratio are not Good Enough for Valuation.

The crucial aspect is if I want to double my capacity, I can do it after 70 days. The reason being I have been saving ₹10k per day. So in 70 Days, I will have 7L Rupees as cash to find the next distributor who will be ready to take my product.

So now I will produce products worth 2Lakhs per day. Moreover, it will not require any extra capital in debt or the sale of my stake in the company.

Monthly Payment Terms

Now assume my distributor has to pay me in a month or 30days. So it means from the 31st day when I deliver the products, I will receive the payment for the products offered on day one.

Now the working capital requirement for me is 31x90k = ₹28Lakhs.

So on an invested capital of ~28Lakhs, I can earn a quarterly profit of 9Lakhs. So ROCE is 100%+ yearly.

Now, if I want to double my capacity, I can do it after 280 days. The reason being I have been saving ₹10k per day. So in 280 Days, I will have 28L Rupees as cash to find the next distributor.

Quarterly Payment Terms

Now apply the same calculation for the 90day payment cycle.

The working capital requirement for me is 91x90k = ₹82Lakhs.

So on an invested capital of ~82Lakhs, I can earn a quarterly profit of 9Lakhs. So ROCE is less than 50% yearly.

If I want to double my capacity, I can do it after 820 or slightly more than two years.

What if my payment cycle is 150days.

The working capital requirement becomes 151x90k = ₹1.35Crores. ROCE reduces to ~25%, and I can double my capacity after 1350 days or roughly four years. If I want to double it faster, I have to either fund it with debt or sell the stake in the company and reduce the promoter holding.

ROCE and Debtor Days

In each of the scenarios, the company’s earnings remain the same till they double the capacity. So in each of the above scenarios, the sales in a quarter remain as ₹90Lakhs and profit remain at ₹9Lakhs. So EPS is ₹9.

However, the growth capital required can come from the profits if the payment is faster.

A company with 150days as payment terms that want to double its capacity every two years will require external growth capital. However, the second company with less than 100 days of payment terms will not require growth capital.

Still, both the companies will show an EPS of ₹9 only.

So, valuing a company based on EPS and PE ratio may not be ideal.

Practical Examples of Debtor Days

Debtor days is the average number of days it takes for a business to get paid.

Now let’s see the debtor days for some of the companies we discussed along with others.

Source: Screener.in

L&T will require a lot more capital to double its capacity than HUL.

Similarly, Asian Paints can double its capacity with less capital as compared to its peers.

Furthermore, companies like HUL may not have growth in the range of 20%, but because it can generate a lot of cash, it can acquire companies to fuel growth.

Final Thoughts

Only considering the PE ratio to value a company is overvalued or undervalued may not be ideal.

Companies with high growth potential and able to fuel growth from profits will seem overvalued when we use only the EPS and PE ratio for analysis.

Include ROCE and debtor days into your analysis when you are considering investing for the long term.