First of all, let us understand what are Multibaggers…
What are Multibaggers?
By definition, Multibaggers are stocks that increased multiple times their initial investment values. A stock that doubles its price is called two-bagger while if the price grows 10-times, it would be called a 10-bagger. This term is coined by the legendary investor – Peter Lynch.
Some notable characteristics of Multibaggers include:
- Undervalued stocks with strong fundamentals
- Strong on corporate governance
- Businesses which are scalable within a short span of time.
How about P/E ratio?
Most investors would know what is P/E ratio because it is the most commonly used ratio when it comes to stocks investing. And generally, a stock with a lower P/E is perceived as a better investment than a stock with a higher one.
The idea behind this perception is that companies with low P/E ratios may indicate that the stock is undervalued. Investors can then buy them at a discount and then sell for profit when the stock price ‘reverts’ back to the mean.
However, the flip side is also true.
In actual fact, P/E ratio indicates how much investors are willing to pay for every dollar of earnings and a high P/E ratio indicates that investors expect higher earnings. In other words, people associate a high P/E ratio to a stock because they believe that it can continue to grow a lot more in future.
That brings me to one point:
Why is it that global tech or social network stocks like Facebook, Tencent, Amazon, Alibaba, Netflix can turn out to be Multibaggers despite trading at exorbitantly high P/E ratios (>30x) a few years back?
I did a little digging and found the perfect answer: The Power of Compounding
How Good can become Great
Check out the screenshot above – Reinvestment Corp (R) and Undervalued Corp (U):
Both cpy R and U start off with the same earnings base. Cpy R starting P/E ratio is 20x while Cpy U is 10x.
While Cpy R trades at double the P/E ratio than that of Cpy U, it reinvest 100% of its earnings and achieve 25% Return on Retained Earnings compared to 10% from Cpy U.
Fast Forward 10 years, if you apply the same P/E ratio to both companies, Cpy R net worth is 471% more than Cpy U! Cpy R just beat Cpy U hands down and become from Good to Great.
Read more: https://www.smallcapasia.com/why-you-should-consider-investing-in-small-cap-stocks/
Ending Note
In short, a multibagger is what i would name as a “Compounder”. Compounders have the capacity to reinvest its earnings at a high growth rate (double-digits), which results in explosive stock price performance over the long term.
As per SeekingAlpha’s Long Hill Road Capital:
“They often look expensive on short-hand valuation metrics, but investors should instead focus on returns on reinvested capital. Holding compounders for the long-term minimizes investment mistakes and behavioral errors, reduces trading costs, and defers taxes, all of which help us compound our wealth over decades.”
Simply put, don’t be spooked by the high P/E ratio of a wonderful business at 1st glance. If you predict that it will deliver consistent high growth rates over the next few years (long term), it will be considered as a “Undervalued” stock today. And the only way to know whether your thesis works out is by holding it for the long run.
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