Buying High P/E Stocks: Was Benjamin Graham Wrong?

The 'Price-to-Earnings' Ratio is perhaps the most commonly used Valuation tool in Stock Markets around the world. The concept was popularized by Benjamin Graham of 'The Intelligent Investor' fame. The general notion was that 'Low P/E' stocks produced better returns in the long run. But is that really the case?


In the book, Mr. Graham imposes a criteria for the 'Defensive Investor' as such:

(Source: 'The Intelligent Investor' by Benjamin Graham)

Ben Graham proposed that, as a rule of thumb, stocks having a P/E greater than 15 should be considered as expensive. Some may argue that a Defensive Investor is likened to a Passive Investor and hence, is not comparable to an Active Investor or Enterprising Investor, as Ben Graham put it. But later when he defines the stock selection process for the Enterprising Investor, he uses a 9-10 P/E limit and later, saying that his research found out that these (9-10 P/E) 'low multipliers' produced good returns:

(Source: 'The Intelligent Investor' by Benjamin Graham)

(Source: 'The Intelligent Investor' by Benjamin Graham)

So, clearly, regardless of whether the investor was Active or Passive, Ben Graham suggested an upper limit of 10-15 P/E. But was he really correct in saying that, or was he wrong? Let's find out.

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In his introduction to the 1989 Berkshire Hathaway Chairman's Letter to the Shareholders, Warren Buffet wrote the following:

What counts, however, is intrinsic value - the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business - in and out - and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become economic equals.

My last post offered a way to do this. But let's take a step back. The aim in this post is to find the following combination:

1. A stock which has traded, on average, significantly above 15 P/E

2. A stock which has created massive wealth (Say, in the last 10 years)

I started out by identifying some of the biggest wealth creators in the Indian stock market for the past 10 years (2008-2017). Motilal Oswal's 22nd Annual Wealth Creation Study was of great use. Out of all those companies, I picked 3 which show up in most places (Absolute Returns, Longevity and Great Management): Tata Consultancy Services, Asian Paints and Sun Pharmaceuticals. I picked them from completely unrelated industries, just to diversify.

Since we can easily access the Annual Reports and Financial Figures of these companies for the last 10 years, we have what Warren Buffet calls a perfect foresight. We could just look at their actual Cash Flows, assume a conservative figure for the Terminal Value and discount them back at Risk-free Rate in India on 2008. This would give us the Value of each stock as on 2008. We will compare this with how much they were actually trading at as on 2008.

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Tata Consultancy Services has been a household name in India for a good part of the previous decade. In fact, the IT Outsourcing space kick-started a new era of employment growth in India. So, it's little wonder that TCS tops the list of the biggest wealth creator in India for the past several years. But what did Mr. Market feel about TCS way back then?

Here are TCS' Financial Numbers over the 10-year period:

(Source)

TCS was trading at around 18 P/E on March 2008 and crossed the 20 P/E limit 2 years later. But I digress. We should carefully pick items we need for a Foresight Valuation and use them. Here is the output:

As you can see, TCS should have ideally traded at a 38.70 P/E, if Mr. Market had considered all possible future income from the company. In reality, the P/E was only 17.65, well above the 15 P/E limit suggested by Ben Graham. But could this be just a one-off example? Let's consider the others.

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Asian Paints was most Indian house owner's choice of paint for the past decade or so. When it comes to very personal stuff such as a residential property, the owners take extreme care in picking out parts that go into the property. Asian Paints, with its wide array of color palettes and long-standing quality, has single-handedly won the honor of being the most liked exterior paint in the country. So, how did Mr. Market account for this distinct advantage in his price?

The Financial Numbers of Asian Paints over the last 10 years looks stunning. Here is an overview:

(Source)

However, Mr. Market never fails to amaze us:

Asian Paints should have traded at a P/E of 35.88. Market assigned a 28.44 P/E to the stock instead. Do you still have hopes for Mr. Market? Hold on to that hope just a little bit more.

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We come to our final research item, Sun Pharmaceuticals or Sun Pharma for short. Sun Pharma was the cream of the crop in the 10-year long Bull run in the Pharma space, generating returns in excess of 25% for many, many of those years. What does Mr. Market have to show for this amazing company in an amazing business?

But of course, the numbers first, at a glance:

(Source)

They say the third time's the charm. Not in this case, it looks like.

Once again, Mr. Market had assigned a P/E of a mere 18.31, when Sun Pharma should have traded at a 45.66 P/E.

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Mr. Market, as Ben Graham was so astute to note, is often identified as having human behavioral manic-depressive characteristics, it:

• is emotional, euphoric, moody
• is often irrational
• offers that transactions are strictly at your option
• is there to serve you, not to guide you.
• is in the short run a voting machine, in the long run a weighing machine.
• will offer you a chance to buy low, and sell high.
• is frequently efficient…but not always.

In this context, along with our above findings, we come to the conclusion that P/E Ratios are not worth much when it comes to the question of Value. By extension, I might add, Ratios like P/E, PEG, EV/EBITDA, EV/EBIT, Price/Sales are equally useless.

But how do some 'Stock Pundits' correctly Value a stock using the P/E Ratio or any of the other Price Ratios and still manage to make huge profits? They suffer from the peculiar condition of the Stopped Clock Syndrome.

You see, a clock that has stopped working is of no use to anyone. However, twice a day, the clock actually shows the correct time. You just don't know when. Similarly, in the stock market, hundreds of 'Stock Pundits' use the Price Ratios to Value stocks. A handful of them actually hit at the correct Value range of the company. You only ever read about the ones who do that, because of yet another condition in Behavioral Finance called the Survivorship Bias. Or as the old saying goes, the history is written by the victor. In Stock Market parlance, 'history' is often very short. Most investors jump from one 'multibagger prediction' to the next and pay no attention to the stocks that are slowly compounding towards an exponential Value creation.

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Finally, I should remember to answer the question initially posed.

Was Benjamin Graham wrong?

Yes and no.

Yes, because when Mr. Graham first started investing, it was a very different world. It was a world recovering from the 1929 recession. Fear and company foreclosures were abound. Add to this the fact that a company's Financial Information was very incoherent and presented in the silliest of ways, and you will learn to appreciate just how far ahead of his time he was.

No, because Mr. Graham introduced the P/E Ratio as a rule of thumb. In later editions of 'The Intelligent Investor', a warning was added in the footnotes:

The final proposal from Mr. Graham, it looks like, is that you should only use the P/E Ratio (Or any other Financial Ratio for that matter) to filter for a stock, along with a bunch of other inputs. It's completely up to you what limits you impose. Use websites like Screener.in to make diligent use of Ben Graham's 'Screens' (Again, you should appreciate how far ahead Mr. Graham was -- thinking about 'Screening' for stocks, possibly 3-4 decades before the electronic variants came around). Prof. Aswath Damodaran has written a long, engaging blog post on Screening for stocks. Here is the link, should you be interested.

But Valuing a stock using a single, too-easy-to-be-useful Ratio like the P/E is beyond reprieve. Yet, a majority of the market still believes in discussing about 'Expanding P/Es' or 'Costly P/Es'. I do not understand the logic behind such a line of thought. According to me, the only question that needs to be asked is the question of Value. To imprint this, let's read Warren Buffet's letter one more time:

What counts, however, is intrinsic value - the figure indicating what all of our constituent businesses are rationally worth. With perfect foresight, this number can be calculated by taking all future cash flows of a business - in and out - and discounting them at prevailing interest rates. So valued, all businesses, from manufacturers of buggy whips to operators of cellular phones, become economic equals.

Dear reader, I hope by now that you have understood what counts.

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Prof. Sanjay Bakshi used a similar study in his 2013 lecture on 'What Happens When You Don't Buy Quality And What Happens When You Do'. I suggest you check it out.

If you would like to use the Foresight Valuation template for your own research purposes, I have linked it below. All the inputs in the first sheet are taken from Screener. The second sheet (The actual Valuation sheet) calculates an automatic Value based on your inputs. Should you require any changes, feel free to make them. But know what you're changing and how it affects the Value. If you don't know how my Valuation logic works, here is a primer. The template deviates a little bit from my actual DCF Valuation template, but it holds good for approximations.

(Download Foresight Valuation Template)

Do share your comments and criticisms. If you regularly use the P/E Ratio to Value stocks, I am most interested in starting a conversation with you. I may change your mind, but perhaps, you may change mine too. In any case, a good discussion is always worth it.