At what price does Asian Paints become a good investment?

But first, a quick recap.

Asian Paints, the bluest of blue chips, is not having the best of times in the Indian stock market. The stock is down almost 30% from its 52-week high at a time when the broader index is down just 4%. This means Asian Paints has lost seven times as much as the benchmark.

Its performance over the last three years hasn’t been spectacular either – it’s down 20% over this period while the benchmark index is up almost 40%.

There is good news if you’re a long-term investor in the stock, however. Over the past 10 years, Asian Paints stock has delivered a compound annual growth rate of 13% versus the 11% for the benchmark index.

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What about the next three or 10 years, though? Will Asian Paints be able to outperform the benchmark index or will its stock remain underperform thanks to growing competition in the paints industry?

To answer these questions, we have to understand why the stock is down 30% from its peak and whether those factors are reversible.

Profits collapsed after price cuts

The stock fell 30% because investors don’t expect a company like Asian Paints to record a 40% drop in profits. Yes, you read that right. Asian Paints suffered a massive fall in profits recently as it had cut prices to combat intense competition and a general industry-wide slowdown.

I believe the company had to make a difficult choice between protecting market share and protecting margins, and decided to protect market share at the cost of margins.

To make matters worse, while it is expected to do significantly better in the second half of the financial year, overall performance may still lag that of FY24. It’s expected to close the year with a lower earnings per share than the ₹57 it achieved in FY24.

Let us assume this number to be around ₹50 a share. The stock has traded at a median price-to-earnings (PE) ratio of around 61 over the past 10 years. Multiplying these two numbers gives us an intrinsic value of ₹3,050 for the stock. This is around 25% above than the current stock price. If the stock hits this price within two years, it could deliver a decent return to the investor. However, anything more than two years and it would be considered below-par performance in my view.

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Another possibility is that the stock trades at its 20-year median PE of around 50. With this, the fair value works out to around ₹2,500 a share, which is close to the current price. This makes the stock unattractive from a risk-reward perspective.

Do note that an average stock in the Indian stock market does not command a PE of more than 18-20 on a consistent basis. But Asian Paints is certainly not your average stock. It is one of the best-run companies in India with a stellar long term track record, a great management team and a bright long-term future.

Valuing the intangible

But what are these qualities worth? Are they really worth the 3x premium that Mr Market has given Asian Paints over the past 10 years or the 2.5x premium over the past 20 years?

You see, one way to look at valuations is to break down the PE ratio into two components – the ‘normal’ component and the ‘quality’ component. The normal component is the PE ratio that you would give a normal business. The quality component is the premium that you will pay for the superior quality. So if a stock commands a PE ratio of 40, it means investors are willing to pay a 2x quality premium over a normal business.

At its peak, Asian Paints commanded a PE of 120, meaning the market was willing to pay a 6x premium for the stock. This premium is now down to 2.5x, but is it still too high?

To be honest, the answer to this question lies in the future. Only time will tell whether the 2.5x premium is sustainable or on the higher side. It all comes down to management’s plan to tackle the intense competition and ensure long-term growth.

You don’t have to play every ball

If the past is any indication, however, management will pass the current test with flying colours. However, as investors, we should certainly err on the side of caution.

Put differently, the premium that one gives to even the best companies should not be more than 1.5x to 2x in my view. This translates to a PE of 30 to 40. To be honest, I have no logic to back up this number. I only have my 20 years of experience to rely on.

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Of course, Asian Paints is not within the safe or conservative range yet. Whether it will fall that much is hard to say.

But this is the stock market, where – to use cricketing terminology – you don’t have to play every ball. If it’s outside your hitting range, you can very well let it go and wait for the next one.

So, while I love Asian Paints as a company and feel it has a great future, I also believe there is a certain maximum premium value one should pay for a stock. You have to decide this premium yourself and not be influenced by an external source.

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