PE Ratio and growth

Market tends to give a pe rate closer to the growth rate if it believes the stock can grow in same rate in future too.

Thats why you see a PE of 40-50 in few stocks because markets believe these companies can grow at 40-50% in next 5-10 years cummulative.

Take this example.

Stock A trading at Rs. 100
EPS 10
growth for next 5 years 10%

Stock B trading at Rs. 100
EPS Rs. 10
Growth for next 5 years expected at 30%

Now after 3 years, Stock A will give a EPS of Rs. 13.3 and stock B at Rs. 22.

When you almost know this in advance, will you not be ready to pay a better rate than 100 for stock B?

I will be more happy to buy stock B at Rs. 200 today than stock A at 100 today because even at 10 PE stock B will give me Rs. 371 where as stock A will give me just Rs. 160 that is 85% instead of 60%.

But most likely stock be will quote near 30 PE, because market will believe more in stock B to continue growing at 30%. Hence I will get a rate near Rs. 1100 in 5 years.

Hope it is clear.

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