| Re-Rating. PE Expansion |
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In the initial phases of growth the market does not believe the growth that the company is experiencing. Also the stock remains unrecognized Therefore the PE multiple is bid up at less then the growth rate. Let us assume that a company with a growth of 40% is given a multiple of 10 for an EPS of Rs 15. The market price is Rs 150
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Period - 1
EPS 15
PE 10 Growth 40%
Market Price Rs 150 |
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One year later as the earnings rise to Rs 21(15+ 40% x 15) the growth of the company is assumed real and consistent. As the stock gains recognition and more coverage it starts getting a higher multiple of say 40 times . The price would suddenly shoot up to Rs 840
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Period- 2
EPS 21
PE 40
Growth 40%
Market Price Rs 840 |
| Stock goes up 4 times because of PE expansion and 40% because of earnings growth |
| De-Rating. PE contraction |
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Once the stock has been recognized and the market convinced about the growth rates the PE multiples move ahead of the growth rates. For instance during the 2000 technology boom Infosys was valued at more then 100 times its earnings since the company was delivering a growth of 100% year after year. Since businesses today are characterized by free entry and free exit growth rates in the longer term would never exceed 30% at most
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Period - 2
EPS 21
PE 40
Growth 40%
Market Price Rs 840 |
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Let us assume that in the example given above the company's growth rates tapers off to a more realistic 20%. These changes in growth rates do not happen year on year but still the market responds to this change earlier then they are out in the public domain because of this the PE multiple of the company will contract and due to over ownership problems the PE normally contracts to less then the growth rate “g”.
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Period - 3
EPS 25.2
PE 15
Growth 15%
Market Price Rs 378 |
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Stock comes down about 60% because of PE contraction and goes up 15% because of earnings growth. Net net it is down by a huge margin.
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