Case 042Relative valuationWarm up

Palvora Consumer trades at 45x earnings against its ten-year average of 38x and a range of 30x to 50x, while EPS growth is accelerating from 10% to 15%. Is it expensive?

The situation

Palvora Consumer makes packaged snacks and beverages. Over the last ten years its year-end P/E has been 31, 34, 30, 37, 42, 40, 35, 44, 50 and 37 times, an average of 38x, while EPS grew about 10% a year. Today it trades at 45x trailing earnings.

EPS growth has picked up to 15% over the last four quarters, and management expects that to continue as a new distribution push reaches smaller towns. A colleague says the stock is 18% above its historical average and therefore expensive.

Your task

Is 45x expensive, and what would the answer depend on?

Quick check

If 15% growth continues, roughly how long before 45x today looks no dearer than the old 38x at 10% growth?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Not necessarily: 45x is above Palvora's 38x average, but the average was earned on 10% growth and the business now grows 15%. On a growth-adjusted basis the stock is cheaper than its history, a P/E to growth of 3.0 against 3.8. The 18% premium is earned back if 15% growth lasts about 3.8 years longer than the old 10% would have. So the question is not the multiple but how long the acceleration lasts.

Step 1Why is the historical average not the right yardstick here?

A flat in a neighbourhood that has just got a metro station is not overpriced because it costs more than the flats sold there five years ago. The thing being priced has changed. A P/E band tells you what the market paid for the company as it was; if growth has changed, the average belongs to a different company. Palvora's 38x average was paid for 10% growth. Comparing today's 45x with it assumes growth has not moved, which is the one thing the case tells you is false.

Palvora's P/E over ten years: today's 45x against the average and range30x40x50x10-year average 38xRange 30x to 50x (shaded)Y1Y2Y3Y4Y5Y6Y7Y8Y9Y10Today 45xNowEPS growth was about 10% a year across this history; it is now running at 15%
Palvora's P/E has ranged from 30x to 50x over ten years with an average of 38x, earned on about 10% EPS growth; today's 45x sits above the average and inside the range.
Step 2How do you adjust for the change in growth?

The quick check is the PEG ratioThe P/E divided by the expected EPS growth rate in per cent; a rough way to compare multiples of companies growing at different speeds.: 38 over 10 is 3.8 historically, 45 over 15 is 3.0 today. The better check is the payback: how long must faster growth last before the premium you pay today is earned back? Paying 45x means paying 18% more than 38x. Earnings growing 15% instead of 10% pull ahead by about 4.5% a year, so the premium is recovered in about 3.8 years. After five years at 15%, today's price is 22.4x those earnings; at the old 38x and 10% it would have been 23.6x.

When is the premium earned back? P/E on today's price against future EPS20x30x40x45x today, EPS +15% a yearDashed: 38x with EPS +10% a year, the old normalLines cross at 3.8 years0123456Years of earnings growth from today
Measured against earnings n years ahead, Palvora's 45x falls faster at 15% growth than the old 38x did at 10%, and the two cross after 3.8 years, so the premium is earned back if the faster growth lasts at least that long.
The relationship
n=ln⁡(45/38)ln⁡(1.15/1.10)≈3.8 yearsn = \frac{\ln(45 / 38)}{\ln(1.15 / 1.10)} \approx 3.8 \text{ years}
45 / 38today's P/E against the historical average, an 18% premium
1.15 / 1.10how much faster earnings grow each year than before
nyears of faster growth needed to earn the premium back
What it says in wordsThe premium is repaid once the extra growth has compounded to the same 18%.
Step 3What decides the answer, then?

Where the acceleration comes from. Growth from new towns and new customers can last for years; growth from a fall in input costs or a round of price rises usually lasts one or two. If 15% lasts only two years and then returns to 10%, the stock is on about 26x year-5 earnings rather than 22x, and the colleague is right. Ask for the split of the 15% into volume, price and margin before you give a verdict.

Where candidates lose it

The common loss is agreeing that above average means expensive. Mean reversion in multiples assumes the company has not changed; when growth changes, the average is the wrong anchor.

The second is the opposite error: accepting 15% as permanent because it is the latest number. Four quarters of acceleration is a claim to test, not a fact to capitalise.

What the interviewer asks next

  • What would make you think the 15% is a margin blip rather than volume?
  • How would you compare Palvora's 45x with a peer at 35x growing 8%?
  • Palvora's P/E hit 50x in year 9. What was likely happening then?

Company names and figures are illustrative.