PE at 100x! What investing in a stock at astronomically high valuation suggests

The domestic stock market appears to be fairly benevolent or complacent with basic issues such as market size and profitability being sidelined, given its obsession with narratives, Kotak Institutional Equities said in its latest strategy note. The brokerage said valuation methodologies have low or no linkage to fundamentals, at present, which makes high multiples palatable, "no matter how outrageous the implied math for underlying parameters becomes at higher multiples."

Kotak noted that 104 companies are at present trading at above 50 times PE (one-year forward consensus) in the Indian market. While nine companies trade above 100 times PE. A 100 times PE company should have 83,000 times earnings in the 100th year to justify its current multiple, if earnings were to compound at cost of equity of 12 earnings.

A 100 times PE should grow its earnings at 20 per cent over 20 years and lower growth rate after that to justify its multiple in a hypothetical higher-growth scenario, Kotak said.

Kotak said the current benign mood has resulted in much higher number of high PE companies currently compared with history. The brokerage said even ignoring ‘young’ companies in ‘young’ industries, the number of companies with PE of 50 times and 100 times on a one-year forward basis is very high. 

"It is interesting to see that several such high PE companies are in ‘traditional’ sectors, which face massive disruption risks," the brokerage said. 

Kotak said an easy but stark way to appreciate a PE multiple is that the PE multiple is the number of years a company will have to grow its earnings at the current cost of equity (ignoring terminal value). Thus, a stock trading at 100 times PE would theoretically need to compound its earnings (FCFE) at the rate of cost of equity over 100 years. 

"Such a company will need to deliver 10,000-83,000 times current earnings in the 100th year, depending on the cost of equity. Ceteris paribus, the sector will need to expand by a similar quantum," Kotak said.

Such companies would be requiring sharper and higher growth rates over a shorter period to justify very high PEs. A 100 times PE company, which may be in the growth phase over the next 40 years, will need to report an earnings CAGR of 20 per cent over the next 20 years and 9 per cent CAGR over the subsequent 20 years, according to Kotak's simplistic DCF model. 

"If the industry’s growth phase were to be shortened by 20 years, required growth rates will be even higher. Even if we assume (1) stable market structure and (2) stable profitability, the particular sector will then require becoming 200 times in the first scenario and 30 times in the second one. Only a few sunrise sectors may pass this small test! Current profitability is already elevated, even as competition is ramping up," it said.

Kotak said many sectors and stocks enjoy very high profitability and returns, which are unlikely to last beyond the next 5-10 years, as forces of disruption have strengthened across sectors. The implied market size would need to be even higher in case profitability were to decline from current elevated levels. 

"The latter is extremely likely, the former is unlikely," it said.