Buying Tata Motors shares at these levels could be a costly mistake

Although the formula is quite simple, a big mistake usually creeps in. I've seen even the best analysts fall prey to this error. They constantly keep changing both the PE multiple as well as the EPS of a stock.

I strongly believe that unless there is a huge structural change in the business, the PE multiple should be kept constant and only the EPS should be played around with.

If you fiddle with the PE ratio too much, you end up assigning a higher PE multiple to a stock during good times and a lower PE multiple during bad times. This leads to terrible investing decisions as it often makes an expensive stock look cheap and a cheap stock look expensive. In other words, your valuation is not objective – you are effectively dancing to the tune of the market.

This is why I have always believed in keeping the PE multiple constant unless there are very strong reasons to change it.

Besides, I like to keep things simple even when assigning the PE multiple. I don't like paying more than 15-16 times earnings for an average business and more than 30-35x for a good one.

I also like to be methodical when evaluating the true earning power of a company. If there is plenty of fluctuation in earnings over the years, taking the average earnings of the past few years is a good idea.

On the other hand, if the earnings have seen an upward trend, one may consider the latest EPS as a reflection of the true earnings power of the company.

Let us understand this with the help of a couple of examples.

Shown above is the EPS trend of two companies for the past 10 years. Both are PSUs, gave good returns this year, are debt-free, and have solid business models.

What should we consider as the true earnings power or earnings potential of company A?

It seems the company is capable of consistently hitting an EPS of at least ₹10, if not more. The huge ₹38 per share it earned in FY23 seems like a one-time thing. The same can be said for the loss in FY21.

So it would be fair to say that ₹10 a share could be considered a good indicator of the earnings power of the company, so long as it has a strong balance sheet and has a long history of operations, which it does.

Assigning a PE multiple of 15, which you assign to a normal business, you arrive at a fair value of ₹150 per share ( ₹10 EPS multiplied by the PE of 15). Keeping a margin of safety of around 30%, this business could be considered if available at ₹100 or less. Beyond ₹150, it may be expensive.

Well, the stock was priced below ₹100 back in January 2022 and has multiplied almost four times since then. Yes, that's correct. In under two years, the stock has surged 300%.

Forget the gains for a moment. Pay attention to how we arrived at the earnings potential – how we kept the PE constant at 15x and were rewarded for it.

Let's move on to the second stock now.

Here, earnings have increased every since FY17 except FY21, which was the pandemic year.

So instead of calculating the average EPS, we can consider its FY23 earnings, ₹8.1 a share, as the company’s earning power as there is a strong chance its earnings will continue to grow at a decent pace.

So, multiplying ₹8.1 by a PE ratio of 15 you get an intrinsic value of ₹120 a share.

Assuming a margin of safety of 30%, the stock could be attractive below ₹95. Well, it was priced at ₹63 until a year ago but is now at ₹173. That’s a gain of almost 3x or 200% in a year.

These two stocks are none other than the mining major GMDC and the railway infrastructure company IRCON.

As you can see, by understanding the business model and being disciplined in valuing a company, you can ensure the risk-reward equation is in your favour. Changing the multiple based on market conditions or taking the wrong earnings potential can lead to overvaluation or undervaluation errors.

Let us consider another example.

What do you think of this company? What should its earning potential be?

Well, this looks like a more volatile business than GMDC and IRCON. There have been four years of losses (three if we exclude FY21 due to covid). Its earnings have swung from a low of ₹7 a share in FY23 to a high of ₹37 in FY14 and FY15.

Should we take its FY23 earnings as its earnings potential? I don't think so. It has done much better in other years. Should we take its FY14 and FY15 figures as its earnings potential? I’m not sure of that either, as earnings have been very poor in other years.

There are two options here. You can consider earning power to be around ₹20-25 a share and ask for a much higher margin of safety as the business is quite volatile, or you can ignore the business altogether.

Let's say you want to consider investing in the business provided you have a margin of safety of 40-50%. Multiplying the earnings potential of ₹25 a share by a PE ratio of 15 gives you a fair value of close to ₹375 a share. Insisting on a big margin of safety of 50% translates to an investing price of ₹180 a share or less.

If you haven't guessed by now, the stock is none other than Tata Motors. Yes, that's right. India's largest commercial-vehicle maker and one of the largest passenger-vehicle makers has had a bumpy ride over the last 10 years. Its true earnings potential has thus been quite hard to figure out.

Has the stock traded below ₹180 in the recent past? The last time it was that low was back in December 2020 when it was mired in losses and investors thought it was heading towards disaster.

However, disciplined investors who considered the true earnings power and the right PE multiple are a happy lot today. The stock has almost quadrupled since then, earning a cool 300% return over three years.

The reason the stock is trading so high today is because its EPS from the past 12 months stands at ₹46, and investors seem to believe the company can improve on this.

We agree that the company is going through a great phase right now. However, it is the same company that has seen earnings plunge in the past and even incurred losses. There is always the possibility that this can happen again. Hence, valuing the company on the basis of its most recent earnings alone is fraught with risk.

Understand that the auto sector is brutal. Companies need to fight the economic cycle, the interest-rate cycle, the product cycle and the capex cycle regularly. These cycles are the reason why their earnings fluctuate a lot.

So assuming that Tata Motors has become immune to these cycles is probably incorrect.

Taking a more balanced view and considering its average earnings, not just the most recent one, would be more prudent in my view.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com