Can a high P/E stock be cheap?

In the stock market, the price-to-earnings (P/E) ratio often takes centre stage. It's easy to see why: a lower P/E suggests value, while a higher P/E appears frothy. But this simplistic view often obscures more than it reveals. Consider a revealing exercise: what P/E should one have paid for a company in 2004 to earn an 11 per cent annualised return (similar to the Sensex's long-term average) over the next two decades?

We performed this analysis on BSE 500 companies , and the results were striking.

When expensive was cheap

As it turns out, some of the "cheap" stocks in 2004 were deeply overvalued, while the "expensive" ones were astonishingly cheap. Take Esab India , which traded at a seemingly high P/E of 258 times back then. Retrospective analysis reveals that an investor could have paid up to 1,500 times earnings - nearly six times its actual valuation - and still enjoyed substantial returns!

Conversely, consider Tata Steel , which appeared a bargain at a P/E of 6 times but would later struggle to generate meaningful investor returns. The lesson? A company's true growth potential often lies hidden beyond the surface of its valuation metrics.

Suggested read: Don't invest solely based on P/E

Valuation meets hindsight

Investors of 2004 could not have foreseen which companies would dominate their industries. Companies like Titan and UltraTech Cement , with high P/E ratios, continued to dominate their industries and deliver stellar returns. Meanwhile, names like Alok Industries - trading at attractively low P/E ratios - would languish in mediocrity.

The counterintuitive conclusion: great companies deserve much higher valuations than initially seem reasonable. Conversely, businesses with poor fundamentals and lumpy industry dynamics may be overpriced even at low P/E ratios. Investors who focus solely on valuation metrics miss the forest for the trees.

Furthermore, traditional valuation metrics such as the P/E ratio sometimes fail to capture the future potential or sustainability of market dominance and profitability. Some companies might emerge as new winners, while others may lose their position over the years. Take the example of Trent . While there are many apparel companies in the market, Trent has capitalised on the growing demand for affordable fast fashion. On the other hand, companies like Vodafone Idea have lost their edge due to changes in competitive intensity. Simply put, those who ignored qualitative attributes would have remained at a significant disadvantage.

Suggested read: A low P/E doesn't equal a higher margin of safety

Beyond the numbers

We are not dismissing valuation altogether. Instead, it's an argument for nuance. Valuation is as much about the company's future prospects as it is about present metrics. Metrics like the P/E ratio must be contextualised within broader assessments of industry trends, competitive dynamics, and management quality . Today, companies like KEI Industries may look wildly expensive by traditional metrics, but history suggests it might also be wildly cheap. (No! This is not a recommendation!)

The real trick

Identifying companies that can continue to generate high returns on capital and reinvest the surplus cash flows at those high rates for a long period of time is the crux of good stock-picking. This requires combining quantitative analysis with qualitative judgement. Look beyond numbers to assess the intangible factors that drive long-term success, such as a company's culture, leadership, innovation, and robustness.

For instance, companies that invest heavily in research and development or have an entrenched customer base with strong brand loyalty often possess competitive moats that justify higher valuations. Conversely, businesses with weak leadership or a reliance on cyclical demand might appear undervalued but are likely to underperform in the long run.

Suggested read: Spotting companies with moats

A balanced perspective

Valuation is a critical component of investing, but it's not a standalone metric. The interplay of numbers and narratives - of hard data and qualitative insights - offers the most reliable path to identifying truly great investments. Investors who learn to master this balance will be better equipped to separate the diamonds from the duds, even in a market where valuations often defy conventional wisdom.

As history shows, the winners often surprise us. It's up to the smart investor to look beyond the obvious and embrace a more holistic approach to valuation.

Want to make better sense of valuations? Value Research Stock Advisor can help you identify quality stocks with the potential to outperform, using a blend of numbers and insights.

Also read : 5 high-growth stocks that became attractive the past week