The multi-bagger formula

In Formula 1, it’s not the sleek design or the paint job that wins races. It’s the precision engineering of the engine and the aerodynamic brilliance of the chassis that does. The two work together to propel the car to the finish line. Stocks aren’t any different. Think of each stock as a high-performance vehicle. Its engine is capital efficiency and the chassis is the capital that’s put back into the business to sustain growth. This duo together pushes earnings forward and essentially compounds your wealth. But an equally important third factor to win the race is the driver. Even the fastest car can lose with the wrong person at the wheel. And in investing, that driver is ‘valuation’. A great business bought at a foolish price can disappoint. But when you pair a powerful engine with a skilled driver, magic happens. This month’s cover story dives into these three levers of long-term wealth creation. We tell you how the twin engines drive stock returns and how valuation, often overlooked, makes the difference between a winner and a wreck. We have also unearthed nine stocks that offer excellence on all three and can keep lapping the field. Strap in! We’re heading to the track. The engines that make your stock a Ferrari The traditional method of looking at historical growth to spot fast growers might be reliable but it lacks a forward-looking lens. That’s where this elegant formula fills the gaps: Operating earnings growth = Return on capital employed (ROCE) x Reinvestment rate These two variables, ROCE and reinvestment, tell you how companies compound earnings by generating higher returns over their cost of capital (investments) and putting a part of the profits back into the business to keep growing. Here’s how this works: A 20 per cent ROCE on Rs 100 crore of capital means Rs 20 crore in operating profit. If the company reinvests half of this profit, its capital base expands to Rs 110 crore. Maintain the same ROCE and next year’s profits rise to Rs 22 crore, pushing earnings forward by 10 per cent. However, as it is with an F1 car, both of these engines must fire together. A high ROCE without reinvestment goes nowhere. A high reinvestment rate with poor ROCE is like burning fuel but gaining no speed. True acceleration comes from balance. As the below figure shows, a combination of high ROCE with high reinvestment delivers the highest growth. An 80 per cent ROCE but only 10 per cent reinvestment grows no faster than one with the reverse setup. Both land at 8 per cent growth, crucial to remember for those that might get enamoured by exceptional numbers on just one side of the equation. The capital markets are littered with such mismatches. GMR Airports reinvests heavily, but has a five-year median ROCE of just 4 per cent, yielding a low expected growth. While Abbott India boasts an impressive 41 per cent ROCE, it reinvests just 27 per cent, limiting expected earnings growth to 11 per cent. Long-term wealth creation requires both levers working in tandem at the highest rate possible. Most importantly, this exercise crucially depends on your judgement. Can the business sustain its ROCE and will it have the opportunity (and discipline) to reinvest? Answering this will require assessing its industry and business model. This brings us to a deeper layer of analysis, where this framework meets the one variable that can amplify or destroy its potential: valuation. The star driver Valuation to investing is what a star driver is to racing. Had Lewis Hamilton not joined Mercedes in 2013, the team would not have surged to the dominance it did in the following years. Similarly, a company may have excellent fundamentals—high ROCE and robust reinvestment—but unless it’s paired with the right valuation, it may not deliver great returns or may even erode them. So, how does one find the right price to pay? This is a two-pronged approach. You have to estimate the expected earnings growth of a business, using the earlier formula by estimating the ROCE and reinvestment it can sustain in the long run, and its likely exit P/E—the multiple the market might assign to the company, let’s say, a decade from now. Predicting an exit P/E requires understanding mean reversion. It simply means that a company’s valuation tends to drift back toward its industry average over time. So, if a stock trades at a lofty P/E of 50 today, it’s possible it can compress to the broader market average of 20 to 25 times in the next decade. Why? High P/Es reflect high growth expectations. But as companies mature, growth naturally tapers off and so do valuations. For most businesses, some degree of valuation reset is inevitable. However, the magnitude is not uniform. A weak business with no moat sees sharp compression. A strong one, with durable competitive advantages like brand power or scale, may see a more graceful decline. Assessing business quality, thus, can help you predict the possible extent of valuation compression in the long term. Once you have reasonably estimated a business’s earnings growth and exit P/E, you can reverse engineer the maximum multiple at which you should pay today for a desired investment return. Our guide below shows how to conservatively project the three variables. To illustrate better, we backtested this exercise on Astral. In FY15, the company had a five-year median ROCE of 31 per cent and reinvestment rate of 94 per cent at a P/E of 69 times. To stay conservative, we estimated it would maintain its ROCE at 25 per cent and reinvestment at around 90 per cent based on its capex plans at the time. We assumed its multiple would contract 40 per cent over 10 years, arriving at an exit P/E of  40 times. By calculating the expected earnings growth and using the exit P/E, we worked backward and arrived at an entry P/E of 78 times for a 15 per cent annual return over 10 years. This means even 78 times, seemingly high at first blush, would have been justified in 2015. The stock in fact clocked 21 per cent annual returns in the last decade. Why not just look at P/E? The point of this exercise was to figure out the right price to pay today for returns you hope to get in the future. Simply looking at the P/E alone or compar

This article was originally published on June 01, 2025.