Quality Vs Valuation Relationship Explained With Example

4 High Quality Premium Valuation Stocks

Introduction

In this article, Quality vs Valuation relationship is explained with example. Analysis of 4 High Quality Premium Valuation Stocks is done. Does valuation of a quality stock really affect its returns in long run? Should you refrain yourself from buying quality stocks at premium valuations? To answer the above questions we look into the numbers of few quality stocks and analyse the significance of valuation parameters.

Quality Vs Valuation Relationship Explained

4 High Quality Premium Valuation Stocks

A Lesson in Value Investing

• Benjamin Graham, the Dean of Wall Street built a great fortune by following his own advice on Value Investing – ”Invest in low-priced, solidly run companies with good dividends.”
• Warren Buffett is a also great role model for value investors. Over the years Buffett moved towards buying high-quality businesses and did not hesitate to pay up for quality time and again and again.
• The term ‘value investing’ is widely used to imply the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield
• The bottom line is – Pay up for quality, but don’t overpay. If the fundamental performance of the stock justifies its subsequent upward re-rating, then the idea of paying up for quality makes great economic sense, as Buffett figured out.

Quality Vs Valuation Relationship Explained

• High valuation comes hand in hand with the quality stocks or quality businesses. There are 2 scenarios of high valuation :
  1. Overvaluation
  2. Premium Valuation
• In case of overvaluation, the stock can’t remain overvalued or can’t sustain higher valuation for a long time. It will go through a correction phase cyclically after sometime and same trend can be repeated in the long term.
• On the other hand, if the stock is trading at a premium valuation, then the stock go through a cycle of re-rating of PE ratio (Price to Earnings Ratio). It means its PE ratio is re-rated upwards ie. increases after a certain period of time.
• As far as quality vs valuation relationship of a stock is concerned :
  • Does valuation of a quality stock really affect its returns in long run?
  • Should you refrain yourself from buying quality stocks at premium valuations?
• To answer the above questions we look into the numbers of few quality stocks and analyse the significance of valuation parameters.

Let see which are those 4 High Quality Premium Valuation Stocks.

4 High Quality Premium Valuation Stocks

Nestle India

• Nestle has been in India for over a century and has grown along with the growth in the Indian economy.
• Average disposable income of Indians is in an upward spiral. It offers an advantage to the companies like Nestle as more disposable income means more consumer spending which in turn means more revenue for sectors like FMCG and Consumer Durables.
• Compounded Annual Growth (CAGR) of Sales, Profit and Share Price over the last 10 years are as follows :
  • Sales Growth 10-years CAGR = 10.07%
  • Profit Growth 10-years CAGR = 11.61%
  • Share Price Appreciation 10-years CAGR = 18.61%
• Along with the consistent top-line as well as bottom-line growth, the PE ratio of Nestle was consistently rising from 2009 till 2015 to almost 99.7 (Refer the above chart). After the issues with company’s flagship brand Maggi, the PE ratio came down drastically in 2016 to 58.06. Still the ratio was sustained around 50+ range. And then the valuation again started rising continuously as on today.
• This clearly indicates that Nestle India is enjoying a premium valuation on account of its strong fundamentals and decent future prospects.

Asian Paints

• Since 1967, Asian Paints has been a leader in Indian paint Industry. It is an undisputed king in the sector with more than 50% market share. The company is having very strong brand penetration across its target market.
• Compounded Annual Growth (CAGR) of Sales, Profit and Share Price over the last 10 years are as follows :
  • Sales Growth 10-years CAGR = 13.91%
  • Profit Growth 10-years CAGR = 18.44%
  • Share Price Appreciation 10-years CAGR = 26.82%
• Thus it is evident that the appreciation in share price of the company is a reflection of its sales and profit growth.
• Many a times inexperienced value investors gives much attention in buying stocks when at very low P/E multiples. Successful investors value quality over ratios.
• In 2015 PE of the stock rose by 35% to 55.6. The stock has almost always sold at a premium valuation. An investor who paid up for quality and bought the stock at PE 55 times earnings in 2015 still did very well. Because its premium valuation has been sustained as it is trading at 66 in 2019.
• Thus, Asian paints remains to be an attractive stock irrespective of its all- time premium valuations.

Pidilite Industries

• Since its inception in 1959, Pidilite Industries has been a pioneer in consumer and specialities chemicals in India. The company is having a diverse and ever-evolving product portfolio including – adhesives, sealants, waterproofing solutions and construction chemicals, industrial resins, polymers etc.
• Over the last 60 years, Pidilite is having virtually no competition from its peers. Its flagship brand – Fevicol is enjoying a strong monopoly in the segment.
• Compounded Annual Growth (CAGR) of Sales, Profit and Share Price over the last 10 years are as follows :
• Sales Growth 10-years CAGR = 13.55%
• Profit Growth 10-years CAGR = 23.75%
• Share Price Appreciation 10-years CAGR = 31.26%
• There has been a consistent rise in the valuation of the company over last 10 years and currently it is enjoying a premium valuation. Thus, Paying up for quality paid off very well for Pidilite’s long-term investors.

HDFC Bank

• The bank is engaged in providing a range of banking and financial services including retail banking, wholesale banking and treasury operations. With a sequential growth of its retail banking , the
• HDFC Bank is another name of the consistency in delivering the performance.
• Compounded Annual Growth (CAGR) of Sales, Profit and Share Price over the last 10 years are as follows :
• Sales Growth 10-years CAGR = 20.48%
• Profit Growth 10-years CAGR = 25.82%
• Share Price Appreciation 10-years CAGR = 31.98%
• Although lending in India has increased tremendously in the past decade on the grounds of faster loan approvals, India is still way behind developed economies.
• However, enhanced spending on infrastructure, speedy implementation of projects and continuation of reforms are expected to provide impetus to growth.
• All these factors suggest that India’s banking sector is assured for robust growth. The rapidly growing business would turn to banks for their credit needs.

Conclusion

• If a company has good fundamentals and decent future prospects, valuation does not play an imminent role in deciding returns of stock in long term.
• India has a class of high-quality businesses that will continue to prosper on account of the demographic position of the country.
• Regardless of the growth delivered over the last few decades, these businesses are still nowhere near saturation.
• Thus, paying up for these quality businesses, but not overpaying for them, should work out very well for long-term value investors.
• So, one should stop associating value investing with low P/E multiples. Now its a time to move towards buying high-quality businesses. One should not hesitate to pay up for quality.