Fast and slow: a closer look at payback periods

Many investors use the price-to-earnings ratio as a go-to valuation metric. A related valuation measure is the payback ratio. It provides a better idea of the time required for a company's net profits to break even with its market capitalisation. It is calculated by dividing the company's current market capitalisation by the sum of the next five years' profit after tax.

In our analysis, we slightly tweaked the payback ratio. We used the current market cap of the company and divided it by the total net profit of the last five years. In doing so, we have taken a conservative approach to find out how much time its current profits would take to catch up with its market cap by assuming the company will not have any growth in profits.

However, there are limitations to the payback ratio. If a company is in a loss, the payback ratio will be negative. This would indicate that the company will never be able to break even an investment in it. Another problem with this ratio occurs when it comes to companies whose stock prices have crashed significantly. This makes their payback ratio appear low. But this could be a trap.

In order to negate these shortcomings, we checked the stability of the company's profits in addition to ensuring that they are positive in each of the last five years. To ensure the quality of earnings, we selected only those companies that have generated positive free cash flows in the last five years and have positive adjusted earnings per share in the same period. It resulted in a list of 215 companies out of the current 883 actively traded companies above the market cap of Rs 500 crore.

The two tables below list 10 companies each that have the lowest and highest payback ratios. The companies with the highest payback ratios are generally stable/high-growth large companies and that's why they command such high valuations. On the other hand, those with low payback ratios are largely smaller companies whose stock prices are currently depressed.