Can a 25 x P/E stock be good value when there are many trading at 5x?

Assuming we bought high PE stocks 10 or so years ago with perfect foresight of their financial numbers, were they overvalued or undervalued at that time? Can a 25x PE stock be good value?

Most traditional value investors would stay away from a 25x PE stock.

How to Value Companies

Let’s start by figuring how to value these companies.

In his 1989 letter, Warren Buffett wrote, “Intrinsic value—the figure indicating what all of our constituent businesses are rationally worth…this number can be calculated by taking all future cash flows of a business—in and out—and discounting them at prevailing interest rates.”

Let’s turnback the clock

Assume 10 years ago, we purchased a stock and knew exactly what the earnings of the company would be for the coming decade. With perfect foresight we calculate the intrinsic value at the point of purchase.

Professor Sanjay Bakshi studied how purchasing good quality businesses in India would do for investors. He calculated each company’s intrinsic value by discounting the company earnings back 10 years to the start date of the purchase. This would tell him if the purchase price was good value. What did Prof Sanjay find?

We simplified the process in Prof Sanjay’s research using operating profit as a proxy. You can calculate intrinsic value using earnings per share, free cashflow, or operating profit/cashflows. Each has its pros and cons, but the results are pretty similar.
Let’s do this for Google and turnback the clock

Capital IQ: Google PE Ratio (TTM) Chart

Since the IPO of Google, the PE has traded from a couple hundred times to the lows of 17x in the depths of the financial crisis in 2008. Let’s just take 25x as a reasonable PE level to buy the stock in 2010. Obviously, if you had bought it at 200x PE when they IPO in 2004, you would have made even more. By 2010, the stock had gone up 6x from $42.5 (split adjusted) to $288.

Barchart – Google Stock Price

Let’s assume you wait a couple of years for Google to prove itself after listing to get a better understanding of its financials and to evaluate its quality and ability to execute.

Since we already know how much operating profit Google has generated since 2010, we can calculate its intrinsic value based on the 10 years of reported financial results.

Intrinsic Value of Google in 2010

In this study, we use a discount rate of 10% and a terminal growth rate of 2% for Google. We can then calculate the present value (PV) of the stock. From this simplified computation of Google’s intrinsic value in 2010, it was worth 78x PE in 2010 based on the reported financials after that. So, purchasing it at 25x PE in 2010 turns out to be very good value. The market was underpricing quality of earnings and the runway of growth.
So, let’s look at what happens to those who bought the stock at the 25x PE in 2010 over 10 years and held on to it.

Barchart – Google Stock Price

You would have made 9-10x your money even if you bought at $288, after it had already run up 6 x from its IPO price. With perfect hindsight, I wish I had bought Google at IPO at 200x PE and rode it all the way up making 64x my investment. But even waiting a couple of years, for Google to show its true capabilities resulted in a very good outcome. Here is  an article we wrote on this: Was Warren Buffett right that Great companies tend to stay Great?

There are four important criteria for this to work. Our study does not apply to cyclical companies.
1. These businesses were great many years ago.
2. They still remain great business.
3. They still outperform over long periods of time.
4. Put a heavier weight on certainty and predictability.

There is another important caveat. Most companies out there do not retain their high rates of returns due to competition and do not have a sustainable competitive advantage. Their rates of returns will decline over time as they are not able to defend against competition. Profits will decline over time, so it may not justify a high valuation.

Paying a reasonable price for a good quality company is better than buying something cheap from a lousy company.

Need help?