Tata Motors: Watch Out for this Costly Blunder 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

I was once asked for a formula which gives the fair value of a stock.

The answer is an appropriate PE ratio multiplied by the company's earnings power or the EPS.

Although the formula is quite simple, there's a big mistake that usually creeps in. In fact, I've seen even the best analysts fall prey to this error.

They constantly keep changing both the PE multiple as well as the EPS of a stock.

I strongly believe that unless there is a huge structural change in the business, the PE multiple should be kept constant and only the EPS should be played around with.

If you fiddle with the PE ratio too much, you end up assigning a higher PE multiple to a stock during good times and a lower PE multiple during bad times. This leads to terrible investing decisions.

It often makes an expensive stock look cheap and a cheap stock look expensive. In other words, your valuation is not independent but biased. You are effectively dancing to the tunes of the market.

This is why I have always believed in keeping the PE multiple constant unless there are very strong reasons to change it.

Besides, I like to keep things simple even while assigning the PE multiple. I don't like paying more than 15-16x PE for an average quality business and more than 30-35x for a good quality one.

I also like to be methodical while evaluating the true earnings power or the true EPS of the company. If there is a lot of fluctuation in earnings over the years, then considering the average earnings of the past few years is a good idea.

On the other hand, if the earnings have shown a growing trend, one may consider the latest EPS as a reflection of the true earnings power of the company.

Let us understand this with the help of a couple of examples.

Shown here is the EPS trend of two companies for the last 10 years. Both are PSUs. Both gave good returns this year. Both are debt free and have solid business models.

What should we consider as the true earnings power or earnings potential of company A?

It seems that the company A is capable of earning an EPS of at least Rs 10 per share on a consistent basis if not more. The huge Rs 38 per share it earned in FY23 seems one time in nature. The same can be said for the loss in FY21.

Hence, it would be fair to say that Rs 10 per share can be considered to be a good indicator of the earnings power of the company as long as it has strong balance sheet and has a long history of operations, which it does.

Assigning a PE multiple of 15x that you assign to a normal business, you arrive at a fair value of Rs 150 per share (Rs 10 EPS multiplied by the PE of 15) for the company.

Taking a margin of safety of around 30%, this business can be considered if available at Rs 100 or lower. Beyond Rs 150, it may become expensive.

Well, the stock was priced below Rs 100 back in January 2022 and it has multiplied almost 4x since then. Yes, that's correct. In under 2 years, the stock has given a huge 300% returns.

Forget the gains for a moment. Pay attention to how we arrived at the earnings potential and how we kept the PE constant at 15x and were rewarded for it.

Let's move to the second stock now.

Here, earnings have shown an increasing trend from FY17 onwards and have grown every year except FY21, which was the pandemic year.

Hence, instead of considering average EPS as the earnings potential of the company, we can consider its FY23 earnings i.e., Rs 8.1 per share as the earnings potential of the stock. There is a strong chance its earnings in future years will continue to grow at a decent pace.

So, multiplying Rs 8.1 by a PE ratio of 15x - which is decent given the business fundamentals - you get an intrinsic value of Rs 120 per share.

Assuming a margin of safety of 30%, the stock can become attractive below Rs 95 per share. Well, it was priced at Rs 63 until a year back and its priced currently at a much higher Rs 170 per share, this is a gain of almost 3x or 200% in a year.

Well, these two stocks are none other than the mining major GMDC and the railway infrastructure company IRCON.

As you can see, by having a small understanding of the business model and being disciplined in valuing as well as assessing the earnings potential, you can firmly put the risk-reward equation of investing in stocks in your favour.

Changing the multiple based on market conditions or taking the wrong earnings potential can lead to overvaluation or undervaluation errors.

Let us consider another example.

What do you think of this company? What do you think should be its earnings potential?

Well, this looks like a more volatile business than GMDC and IRCON. There have been 4 years of losses (3 if we exclude FY21 due to covid). Its earnings have swung from a low of Rs 7 per share in FY23 to a high of Rs 37 in FY14 and FY15.

Should we take its FY23 earnings as its earnings potential? I don't think so. It has done much better in other years. Should we take its FY14 and FY15 earnings as its earnings potential? Not sure of that either as earnings have been very poor in other years, even incurring huge losses.

There are two options here. You can consider earnings power to be say around Rs 20-25 per share and ask for a much higher margin of safety as the business is quite volatile or you can ignore the business altogether as it is quite volatile.

Let's say you want to consider investing in the business provided you get a margin of safety of at least 40-50%. So, multiplying the earnings potential of Rs 25 per share by a PE ratio of 15x gives you a fair value of close to Rs 375 per share.

Insisting on a big margin of safety of 50% translates into a price of Rs 180 per share below which the stock can be considered.

If you haven't guessed by now, the stock is none other than Tata Motors. Yes, that's right. India's largest commercial vehicle maker and one of the largest passenger vehicle manufacturers, has had a bumpy ride over the last 10 years. It's true earnings potential has been quite hard to figure out.

However, has the stock ever traded below Rs 180 per share in the recent past? Well, the last time it traded so low was back in December 2020 when it was mired in losses and investors thought it was heading towards disaster.

However, those investors who would have been disciplined and considered the true earnings power and the right PE multiple, would be a happy lot today. The stock has almost quadrupled since then, earning a cool 300% returns over 3 years.

The reason the stock is trading this high today is because its EPS of the last 12 months currently stands at Rs 46 per share. And investors seem to be of the view that the company can improve on the same.

We agree that the company is going through a great time right now.

However, it is the same company where earnings have plunged in the past and have also gone into losses. Therefore, besides growth, there is also the possibility that earnings can plunge and even go into the negative once again.

Hence, valuing the company on the basis of its most recent earnings alone is fraught with risks.

Please understand that the auto sector is brutal. The companies in the sector need to fight the economic cycle, the interest rate cycle, the product cycle and the capex cycle on a regular basis. These cycles are the reason the earnings of the companies in the sector fluctuate so much.

Hence, assuming that Tata Motors has become immune to these cycles is asking for too much.

Taking a balanced view and considering its average earnings and not the most recent one would be a more prudent thing to do in my view.

So, do consider this point carefully before buying a stock like Tata Motors.

That's all from me today. I will see you again next time. Happy Investing.