With regards to value investing approach, a majority of financial articles published in the top financial papers/magazines tell you to find and invest in undervalued stocks that have fallen the most, and currently have low P/E ratios. Retail investors are bombarded with information on low P/E stocks trading in the market and available at significant bargains. This metric makes one believe that a stock trading at P/E of 10 is a better investment than a different stock trading at P/E of 50.
However, one must understand how this can be severely wrong. The below example illustrates this point with the concept of Return on Capital (ROC).
Return on capital employed in a business is a fundamental and most important parameter to assess its capability to generate earnings.
Return on Capital is defined as a ratio of the Annual Earnings out of a business to Capital employed . Lets look at this through a very simple example.
ROC = Earnings/Capital
Business A generates $ 10 annual revenue for $ 100 capital invested into it. Business B generates $ 15 on $ 50 invested. The return on capital ratios highlight that Business B has a capability to generate higher returns than Business A on same capital invested. This also translates to the fact that if Business A needs to expand and increase its earnings, for every $ 10 increase in earnings , it will need to invest additional $ 100 (Assuming ROC remains unchanged), while Business B can increase $ 10 earnings by investing only $ 33 (ie 66% less capital). Business B is a comparatively wonderful business as it allows you to grow rapidly with lesser capital.
Now lets take the perspective of a stock market investor , if he intends to buy stocks of these two businesses. The below table highlights various scenarios and your likely returns in the two businesses over a 5-10-15 yr period.
For Business A, it is assumed that average long-term PE of this industry is 10. If you happen to buy the stock at even 25% discount to avg P/E , you can earn 16% annual CAGR for 5 years. As the period increases, it will go down and will converge closer to 10% (which is the Return on Capital).
Looking at Business B, even if you happen to buy the share at P/E of 60, you will earn 19.8% in 5 years.
The above example highlights Munger’s principle “It is better to buy great businesses (which are high ROC ) at fair price , than buying lousy businesses (low ROC) at great prices”. The above scenario clearly depicts that even if you pay a bit more to buy a great business, compared to buying a low ROC business at a discount, you will be able to compound your investments at a higher rate in a great businesses . Additionally, the longer your holding period is, the more your returns will ultimately converge towards the sustainable Return on Capital.
The above example also highlights why PE should not be a major metric to decide your investments