We all want to own superstar companies, but they are often at steep valuations. Here is what you should do
31-Jul-2019 •Yash Rohra
No matter how good the business is, Buffett buys it only if he finds value for the price he is paying. This is a good lesson for investors who tend to overpay for a business to catch the market momentum and end up losing their hard-earned capital when the stock price corrects.
An investor should understand that the stock market evaluates a business based only on its future earnings potential. So if a company is in a mature phase and growing in single digits or low teens, then its high valuations may see a steep correction in the near future, leading to a significant loss for investors. However, companies may command superior valuations on the back of higher corporate-governance standards or management quality, but at the end, it is the stock price that will decide your future returns.
For example, take Wipro. During the dot-com boom in the early 2000s, Wipro's stock made a high of Rs 367.5. After 19 years, its stock still trades at 19 per cent below that price. Till date, it has never touched that high, even though during these 19 years, the company has earned a total profit of Rs 90,000 crore and did not report any loss.
In the current market scenario, companies like Avenue Supermarts, Gillette, P&G Hygiene and Health Care, Titan, Hatsun Agro and others trade at sky-high valuations. However, the question is whether they will be able to meet investors' expectations in the future.
As an important indicator, the P/E ratio links the stock price to the company's earnings. For instance, a P/E of 15 means that an investor will earn the amount he is paying for the stock in the next 15 years, assuming that the company does not witness any growth.
The accompanying table will help you find the duration required for a company to earn what its investors are paying today. In the end, we shouldn't forget that we are buying ownership in a business, not just its stock.