Is Trent Ltd's Sky-High PE Ratio of Nearly 200 Justified? An In-Depth Analysis

Understanding the Basics of PE Ratios

Having spent nearly a decade researching stocks, there are a few thumb rules that I hold very close to my heart. These guidelines help in making disciplined investment decisions and avoiding common pitfalls. One such rule is setting an upper limit on the Price-to-Earnings (PE) multiple for any stock.

The Upper Limit for PE Multiples

For me, this limit is a PE multiple of 35x to 40x. This means the maximum PE multiple I am willing to assign to any stock is within this range. If a stock trades at a significantly higher PE multiple, I reject it immediately, irrespective of its quality or growth prospects. This approach aligns with Ben Graham’s famous advice that you should make Mr. Market your servant, not your guide. By insisting on a fixed upper limit, you ensure Mr. Market serves you only the stocks that meet your criteria.

The Risk of High PE Multiples

Stock market history suggests that buying a stock at a PE of 100x leaves very little room for error. A lot of growth expectations are built into such a high PE multiple, and even a slight delay or mistake in meeting those expectations can cause the stock to crash. Therefore, it is always safer to invest in stocks where there aren’t excessive growth expectations built into the PE multiple.

The Case of Trent Ltd

Trent Ltd, part of the retail venture of the Tata group, is an interesting case study. Despite trading at a PE multiple consistently higher than 100x, the stock has performed exceptionally well over the last decade. It has become a 47-bagger over the last 10 years and an 11-bagger over the last 5 years.

Historical PE Multiples

Approximately ten years ago, Trent Ltd had a consolidated PE multiple of close to 140x. This was also the case five years ago. Currently, the PE multiple has soared to an astounding 183x. Remarkably, there hasn’t been a single day in the last ten years where the stock traded significantly below a PE multiple of 100x. Even during the Covid crash of March 2020, the PE multiple remained well above 100x.

Growth and Fundamentals

In the long run, growth and fundamentals are what truly matter. Trent Ltd has demonstrated consistent growth and robust fundamentals, which are essential to sustaining high PE multiples over an extended period. The management has grown the consolidated net profit from a loss of Rs 19 crores in FY14 to a profit of Rs 1,500 crores in FY24. The topline has increased sixfold during the same period, all while maintaining negligible debt and relying primarily on internal accruals.

Competitive Advantage

Trent Ltd derives a significant portion of its revenues from its own private labels. This not only ensures high profit margins but also provides better control over the supply chain, resulting in substantial savings on the working capital front.

Valuation Concerns

Despite these impressive achievements, the extremely high valuation multiples, now approaching the 200x mark, are concerning. When you like a company and its management quality but are uncomfortable with its valuations, you have two options:

1. Move On: Accept that sticking to your discipline and staying within your circle of competence means passing up on such opportunities.

2. Speculate Wisely: Allocate a small portion (5-10%) of your portfolio to stocks like Trent Ltd. This approach acknowledges the speculative nature of the investment without risking a significant part of your portfolio.

In Conclusion, Trent Ltd is not an investment for me based on my rule of having an upper limit for PE multiples. However, it could be considered a speculation as long as the speculative nature is understood, and only a small percentage of the overall portfolio is allocated to it.