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

payback-1

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

payback-2

As an investor you want to operate on the left diagonal of this plotted box

payback-3

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Payback ratio of less than 1x continues to guarantee highest returns

payback-4

Now let’s do some time travel and go back to year 2010

payback-6

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,

payback-7

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

payback-8

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 😉

Leave your thoughts below in comments

24 comments

  1. Suresh VR says:

    Nice article! thanks. My clarfn is on the green ones… Leaving companies with less than 10% profit growth for 5 years, are there any companies now that fall in green?! “The days of green” are over, isnt it?

    • Vivek Bothra says:

      Suresh – There are pockets were you still find these kind of companies – Cement, Specialty chemical. However I agree with you the situation is tough to find any new ones

  2. saurabh kurichh says:

    Hi , Vivek. I am hugely happy to be a part your readership. I adore all the articles that u write . Your efforts really really show up.

    What Motilal and you ( unknowlingly ) have done putting a ratio and an arithematic equation to the whole futuristic scenario. So now it boils down to thing ” buy a good futuristic company at the best price possible”

    Wont be stock specific , but where do u see value migration in sectors in the next 5 years ?

      • saurabh kurichh says:

        Thanks Vivek, hasn’t pharma been over done or might be just needs some rest ? On home financing,almost all analysts seem to of the opinion that realty prices are bound to come down. Wont that deter the revenues and the NPA ? IT products encompasses a wide range . Have no clue about Energy

        I read the MOSL resport that in Herocorp, there was value migration from scooters to bikes. Isn’t there a similar kind of migration from rail travel to air travel ? I do not know why these airlines do not make money, but part of it could be because all other long distance travel options like rail , buses are owned by the government and the government is happy to make them bleed

        Does hospital chain too include in the value migration of Pharma.We have only 3-4 hospitals listed on nse, Easier to do research on them

  3. Obu Sama says:

    My analysis on multibaggers essentially because of three things – PE expansion from the point of purchase and PAT Growth which increases the absolute market cap. The size of the profits also matter because the multiplier effect of PE expansion works better on a larger PAT base. Else it will take more time to get the huge returns. In any case the future state of business estimation is a must, for a layman, choosing a smaller time frame will be better and choosing consumer products which tend to be defensive and so being conservative about our furture growth estimates

    • Obu Sama says:

      To further elaborate, I think payback is just combining PAT growth and current PE. It doesn’t really add any new info about the business. Just another metric I would say. It can happen, companies in the left diagonal still not give those expected multi-bagger returns if PE expansion doesn’t happen.

      • Vivek Bothra says:

        Thanks Obu for your thoughts – yes it is just another metric any investment should be based after careful research on business’s prospect

  4. The whole thing in every analysis is about the “future”. If any body can have a fairly good idea of how a company is going to perform in future, she can make a killing. Uncertainty about future only drives us to explore about it and to minimise the uncertainties / risks attached to it.
    I agree if somebody could draw some future stocks which would fall on the left hand side of the dotted line which basically means that any thing which is less than 1.5 or 2 PEG would be fine. Less than 1.5 would be great.

  5. The surprise entry in 2015 (based upon expected PAT growth) is Reliance Power. Also the likes of Astral, Page, Asian Paints and Eicher (all erstwhile stalwarts) have been relegated to a costly equation metrics. This also confirms that churn is an all important of market functioning and that happens with Infosys, TCS alike.

  6. nishanth muralidhar says:

    Now all we need to know are the companies in 2015 , who are poised like Eicher ,Astral and Page were in 2010 and we are all set:)

    Jokes aside , this is a fantastic writeup. You do provide some very good , detailed and out of the box information anybody can work with

    • Vivek Bothra says:

      For 2010 – We have benefit of hindsight, I took 5 yr PAT CAGR, For 2015 – it is my estimate as I am invested or was Invested in most of above businesses

      • taus says:

        yes the basic prob is future growth prediction. everything comes to this. a company in red box can easily go to green with different future earning prediction. could u help us how did u predict even one company! say eicher. it would be very helpful. thanks

        • Vivek Bothra says:

          First thing is even if future growth is 100% percent CAGR for a company trading at 80 PE then also payback period is 1.29 (amber) not green. So you can understand that with very high PE – growth has to be tremendous to get a place on left hand side of diagonal. To answer your second question, Eicher motors current PE is 80 last 5 years PAT growth is 22.97% and last 3 years PAT CAGR is 21.57%, Even with improved economic situations and more dispensable income I dont expect next 5 years CAGR to be more than 25%, So if you plug in 25% CAGR growth and 80 PE you get payback period of 7.80, Therefore it is high unlikely it will be a 60 bagger. However given strong predictability of its business if the PE continues to be 80-90 than even at this level it could be a 1 or 2 bagger. So my friend it’s all about odds and I don;t think paying up gives us an opportunity to get multi fold returns

          • ShodhanNV says:

            But when we think about avoiding -60%bagger than making a 60bagger then the whole scenario looks different. Can you please fit that into payback box ?

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