Why Paying up can cost you – Analysis using payback box
Motilal Oswal wealth studies are great source of learnings for any investor, They adopt a unique approach of taking up a theoretical concept every year and then explain it through numbers.
In year 2000, they introduced a concept called payback period, this is what the study said
Focus on payback period
As the legendary Warren Buffett says, “Investing is laying out money now to get more money back in the future in real terms, after taking inflation into account”
Generally, it is observed that market price is often based on the assumption that earnings will grow at their current rate for another five or more years and then remains constant
P/E is a very useful tool of valuation but does not reflect growth assumption upfront
PEG is another useful tool but assumes stable growth rate for a long time. It also relies too much on current growth rates. But the reality is that new economy companies record high growth rates in the initial stages, but are unable to sustain for a long period. This leads to mis-pricing
Keeping the above shortcomings and market wisdom in mind, we decided to examine the concept of “pay-back ratio” or “purchase price recovery in five years”. We defined payback ratio as the result of market capitalisation in the year 1995 divided by the sum of profits for the years from 1996 to 2000.
Then they showcased, how <=1 payback period has resulted in maximum number of wealth creators (multi baggers) in their annual study
In principle this sounded very reasonable as this is what Walter Schloss meant when he answered below question [see highlights]
Would you rather buy outstanding companies at fair prices, or fair companies at outstanding prices?
“That’s a good question. I don’t think I’d like to buy good companies at what I think they’re worth. I have no problem buying a good company, but I want to buy it at a discount. I’m looking to make a profit, and I don’t want to lose money. You can, at times (when) people get very nervous, buy a good company at a fair price. I can’t generalize because each company is different. But if you want to make a profit, you really want to buy a stock at a price where you feel the stock will go up 50%. Now it may take several years, and you have to be patient.”
I plotted various PE and PAT growth rates to put together a simple payback graph
As an investor you want to operate on the left diagonal of this plotted box
In fact the 2012, Motilal Oswal wealth study asserted
Payback ratio of less than 1x continues to guarantee highest returns
Now let’s do some time travel and go back to year 2010
The arrow in the above image indicates place in payback box, e.g. Astral Polytechnik’s PAT was expected to grow at 20-22% and it was available at 8-9 PE in year 2010
Now time travel to 2015,
The boxes below logos (in green) are changes in market cap of the company, heavy wealth creators are in the left diagonal of above plotted box. The message is clear
The most important factor to create wealth is price paid at the entry, at least for regular retail investors
Quality bought at any price will kill your returns.
I also tried plotting same companies with 2015’s PE and next 5 years expected PAT growth rates, this is how they stacked up
4 out of 6 companies are plotted in extreme right indicating a payback period of greater than >4, Only time will tell how much of wealth they will create in coming years 😉
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