Length x width equals the area of a rectangle. What does this have to do with stocks? But before we come to that, here is an illustration to consider based on the above formula.

Take a quadrilateral with length of 10 metres and width of 10 metres. Based on the above formula, its area will be 100 square metres. Now increase the length by 100 per cent and the width by 100 per cent to 20 metres each. What happens to the area? It increases by not 100 per cent, not 200 per cent, but a much higher 300 per cent to 400 square metres.

What about the reverse? Reduce the length and width by 50 per cent each to 5 metres (from base of 10), the area of the square falls not by 50 per cent, but by 75 per cent to 25 square metres. It’s important to note here the outsized impact relative to change in the two variables in both instances.

Now, replace length and width here with PE and EPS, the two variables that determine the price of a stock (let’s ignore negative EPS for nowr). A stock price can be expressed as PE multiple x EPS. So similar to area of a quadrilateral determined by 2 variables – length and width, the price of stock is determined by the EPS (actuals or estimated) and PE multiple that investors deem is fair for that stock, given its business prospects. And just as change in two variables can have outsized impact on area of a quadrilateral, so too the change in PE and EPS can have outsized impact on price of a stock. This is why we see some stocks moving up by 1,000-2,000 per cent as well as fall by 80-90 per cent in a decade and sometimes just in a couple of years as well.

If you analyse many multi-baggers, there usually (while not always) will be a case of PE rerating as well as strong growth in EPS. For example, take the case of the stock of TVS Motor Company, which in the last 10 years is up from ₹78 in January 2014 to ₹1,950 today. Back then, its price of ₹78 was a product of EPS of 3.86 x PE of 20.2. Since then EPS has increased by 694 per cent to 30.67, while PE has increased by 215 per cent to 63.57. The combined impact of this has been a staggering increase in share price of 2,400 per cent!

Pure earnings growth-driven multi-baggers are more likely only in early-stage businesses where the business is just about beginning to explode in terms of growth.  A recent example is the global chip giant at the centre of the AI frenzy — Nvidia.  The stock is up by 215 per cent in the last one year. However, its PE ratio has declined by 27 per cent to 81.29 now, from 112 same time last year. But this was more than made up by 335 per cent increase in EPS in the same time, driving the stock upside. But it is important to note here that although earnings grew by 335 per cent, the stock upside was lower (spectacular it was, nevertheless). This, too, is an outcome of the product of the change in variables

Key learning for investor

So, what is the key learning we can take from this? An investor needs to have high clarity on the comfort factor with regard to the variables he/she is dealing with — both PE multiple and likely trend in EPS of a stock and, more importantly, how changes in these can impact the value of your stock. If both variables are in your favour, then your chances of success with a stock are higher.

At the same time, if you bet only on one variable, you can still succeed like Nvdia investors did, but you need to be doubly sure of the EPS variable. For not only does it have to grow, it also has to grow more to compensate for the PE variable declining/derating. Same is the case when you bet on a stock with declining earnings potential, trading at low PE. The PE rerating must more than compensate for decline in EPS.

Misjudging the variables and the compounding impact of changes to the variables, is what results in extreme wealth destruction. During the dotcom boom, IT stocks traded at PE multiples of 150 to 200 and the premise for this was excessive EPS growth assumptions to justify the same. EPS growth tapered and the PE derated to mid-teen levels or lower by the time the bubble broke. So was the case with real estate and infrastructure stocks in 2007-08.

Today, there are many investing themes that have resulted in high PE multiples in many sectors — ER&D companies in the IT space, EMS and manufacturing companies, FMCG, Paints, Capital Goods, etc. With PE multiples in range of 60-100, if not higher, it would be a worthy exercise for investors seeking to buy stocks in these sectors to do the math and see how the change in two variables can impact the price of the stock a few years down the line.

What about companies with negative EPS, like many new-age companies that are unprofitable? You can replace PE multiple and EPS, with EV/revenue multiple and revenue or EV/EBITDA multiple and EBITDA.

A final note

While dealing with two variables might not sound complicated, here is the catch. Each of these two variables is impacted by multiple other variables. For example, PE multiple will be impacted by EPS growth, prevailing interest rates, liquidity, investor sentiment, management quality, balance sheet strength, geopolitics, etc. Similarly, the EPS variable will be impacted by multiple micro and macro-economic factors and geopolitics. Understanding the interplay of all these variables and picking a stock is what makes investing a really interesting game of probability rather than certainty.