"Very low-growth firms often have high PEs" seems counterintuitive at first, but it can be true under specific conditions.

The statement that "very low-growth firms often have high PEs" seems counterintuitive at first, but it can be true under specific conditions. Let's break down the mechanics and rationale behind this phenomenon.

The Core Principle: The P/E Ratio is a Function of Multiple Factors

The standard Gordon Growth Model (a simplified dividend discount model) helps explain this:
P = D / (r - g)
Where:

• P = Price

• D = Dividend

• r = Required Rate of Return (discount rate)

• g = Perpetual Growth Rate

Since Earnings (E) and Dividends (D) are linked by the payout ratio (p), we can reframe this for the P/E ratio:
P/E = p / (r - g)

This shows that the P/E ratio is inversely related to the spread between the discount rate (r) and the growth rate (g). A high P/E can result not only from high *g*, but also from a very low (r - g) spread.

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Why Low-Growth Firms Can Command High P/E Multiples

1. The "Stable Cash Flow" or "Bond Proxy" Effect

   • Low Risk (Low 'r'): Very low-growth firms are often mature, defensive businesses in non-cyclical industries (e.g., utilities, consumer staples, certain REITs). They have predictable, non-discretionary demand.

   • Implied Discount Rate: Because their cash flows are stable and less risky, the market assigns them a lower discount rate (r). In the formula P/E = p / (r - g), if r is very low, the denominator (r - g) remains small even if g is low, supporting a higher P/E.

   • Analogy: These stocks are treated like long-duration bonds. When interest rates fall, the value of stable, long-duration cash flows rises. A high P/E in this context reflects a low equity risk premium.

2. High and Sustainable Dividend Yield (The "Income Stock")

   • Payout Ratio (p): These firms typically have limited reinvestment opportunities (low growth). Therefore, they return a large portion of earnings to shareholders as dividends, resulting in a high payout ratio (p). In our formula, a high p directly increases the justified P/E.

   • Yield Support: Investors bid up the price to capture the attractive, reliable dividend yield. This price appreciation pushes the P/E higher. The high P/E is not a bet on future earnings growth but a reflection of current income attractiveness in a low-interest-rate environment. If the dividend yield is 5% and 10-year bonds yield 3%, the stock becomes compelling despite no growth.

3. The "Maturity" and "Fade" Assumption

   • For a high-growth firm, a high P/E embeds expectations of sustained high growth. Any stumble in growth (a "growth scare") leads to a severe P/E contraction (derating).

   • For a 0-2% growth utility, there is no growth to disappoint. The market already assumes perpetual low growth. The risk of a negative growth surprise is minimal, so the multiple is less volatile and can sustain at a higher level than the simplistic "growth vs. P/E" heuristic would suggest.

4. Accounting and Cyclicality Factors

   • Low Point in the Cycle: Sometimes, a firm's trailing earnings (the 'E' in P/E) are temporarily depressed due to a cyclical trough or a one-time charge. If the market prices the company based on normalized future earnings, the trailing P/E will appear artificially high, even though the business is stable. This is a "P/E illusion."

   • Asset-Intensive Businesses: Some low-growth firms (e.g., industrial, telecom) have large depreciation charges that reduce accounting earnings (E) but do not impact cash flow. The Price-to-Cash-Flow multiple might be more normal, while the P/E looks high.

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Important Caveats and Nuances

• This is not a universal rule. Many low-growth firms trade at low P/Es (e.g., legacy automotive, some banks). The high P/E scenario applies to a specific subset: low-growth plus low-risk plus high payout.

• Interest Rate Sensitivity: This phenomenon is most pronounced in low-interest-rate environments. When risk-free rates (like the 10-year Treasury yield) are low, the relative appeal of these "bond proxies" is high, inflating their P/Es. When interest rates rise sharply, these stocks are often the hardest hit because their low (r - g) spread widens, causing their justified P/E to contract dramatically. 2022 was a perfect example of this.

• The Growth Trap: A firm with a 5% growth rate but high volatility and risk might trade at a lower P/E than a firm with 2% growth but extreme stability. Risk (r) is just as important as growth (g).

Real-World Examples (Hypothetical & Historical)

1. Utility Company (XLU): Grows at ~2-3% per year. Often trades at a P/E of 18-22x, higher than the market average, because its earnings are government-regulated, demand is inelastic, and it pays a ~4% dividend. It's a classic "widows-and-orphans" stock.

2. Consumer Staples (KO, PG): Historically traded at premium P/Es (25x+) despite low growth, due to global brand stability, pricing power, and reliable dividends.

3. Tobacco (PM, MO): A stark example. Facing long-term volume decline (negative growth), these companies often traded at high P/Es because they generated enormous, predictable cash flows and paid very high dividends, making them attractive income vehicles.

Conclusion

Your statement is astute. A high P/E on a low-growth firm is not a paradox but a signal that the market is valuing the firm primarily for the quality and safety of its cash flows and its income distribution, not for growth. It reflects a low discount rate (r) and a high payout ratio (p), rather than a high growth rate (g).

Key takeaway: The P/E ratio alone is meaningless. It must be interpreted through the lens of growth expectations, risk profile, dividend policy, and the prevailing interest rate environment. A high P/E on a low-growth stock is often a sign of a low-risk "bond-like" equity, not an overvaluation error by the market.

Valuing Nestle Malaysia like an equity bond of Warren Buffett

Very low-growth firms (<5%) often have high PEs due to stable cash flows or dividend yields.

Let's look at Nestle.  It has very stable cash flows and also dividend yields.  We can value it like an equity bond of Buffett.

Its PBT profit in FY 2024 was RM 2.36 per share
Today, its share price is RM 114.10 per share
Its business is projected to grow at a slow pace of 2.4% per year.

The share price is the bond, the PBT is the bond interest payment. 

Thus, at RM 114.10 per share, the equity bond of Nestle is paying a bond yield of  = RM 2.36/ RM 114.10 = 2.07%.

FD fixed interest rate (risk free) today is 3.5% to 4%.

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The price of Nestle went down to its lowest in March 2025 at RM 64.

At RM 64, this equity bond (Nestle) was paying a Bond Yield of RM 2.36/RM64 = 3.93%.

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Lesson: 

When you buy a great company with a great margin of safety, the lower the price you pay, the higher the potential returns. 

Always invert. Always invest. Be greedy when others are fearful. Be fearful when others are greedy. Shut out the noise. Focus on the business, the numbers and think independently.

****Earnings Multiples by Aswath Damodaran

 

****Earnings Multiples by Aswath Damodaran

https://myinvestingnotes.blogspot.com/2009/11/earnings-multiples-by-aswath-damodaran.html

PE Ratio and Fundamentals

Proposition: Other things held equal, higher growth firms will have higher PE ratios than lower growth firms.

Proposition: Other things held equal, higher risk firms will have lower PE ratios than lower risk firms

Proposition: Other things held equal, firms with lower reinvestment needs will have higher PE ratios than firms with higher reinvestment rates.

Of course, other things are difficult to hold equal since high growth firms, tend to have risk and high reinvestment rates.


PEG Ratios and Fundamentals: Propositions

Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.

• Corollary 1: The company that looks most under valued on a PEG ratio basis in a sector may be the riskiest firm in the sector

Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.

• Corollary 2: Companies that look cheap on a PEG ratio basis may be companies with high reinvestment rates and poor project returns.

Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.

• Corollary 3: PEG ratios do not neutralize the growth effect.


Relative PE: Definition

The relative PE ratio of a firm is the ratio of the PE of the firm to the PE of the market.

Relative PE = PE of Firm / PE of Market
While the PE can be defined in terms of current earnings, trailing earnings or forward earnings, consistency requires that it be estimated using the same measure of earnings for both the firm and the market.

Relative PE ratios are usually compared over time. Thus, a firm or sector which has historically traded at half the market PE (Relative PE = 0.5) is considered over valued if it is trading at a relative PE of 0.7.

The average relative PE is always one.

The median relative PE is much lower, since PE ratios are skewed towards higher values. Thus, more companies trade at PE ratios less than the market PE and have relative PE ratios less than one.

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Simple Summary:

Think of a company's stock price like the price tag on a car.

1. PE Ratio = Price tag ÷ yearly earnings

• Faster growth = higher price tag (like a newer model)

• More risky = lower price tag (like a car with problems)

• Needs lots of repairs/reinvestment = lower price tag (takes money to maintain)

2. PEG Ratio = (PE Ratio) ÷ growth rate
Tries to be "fair" by considering growth, but has problems:

• Doesn't account for risk (a dangerous but fast-growing company looks cheap)

• Doesn't account for efficiency (a company that spends wastefully looks cheap)

• Doesn't work well for very slow or very fast growers

3. Relative PE = Your car's price ÷ average car price

• Helps see if your car is expensive compared to the market

• Most cars are cheaper than average (because a few super-expensive cars pull the average up)

• Best used to compare over time (is your car more expensive than it usually is?)

Big Picture:
You can't just look at the price tag alone. You need to ask:

• Is it growing fast?

• Is it risky?

• Does it need lots of maintenance spending?

Two companies with the same PE might be completely different—one might be a safe, efficient grower while the other is a risky, wasteful grower. The numbers tell the story only when you understand what's behind them.

Not all growth is created equal.

Good Growth (Valuable) = Higher PE
This is efficient, profitable, and sustainable growth. The company grows its earnings by:

• Reinvesting a smaller amount of money

• Into projects with high returns (like 20-30% returns)

• While taking on reasonable risk

Example: A software company that grows 15% per year simply because its existing customers love the product and pay more (high margins, low extra cost). This deserves a high price tag (high PE).

Bad Growth (Destructive) = Lower PE
This is inefficient, unprofitable, or risky growth. The company grows by:

• Reinvesting a massive amount of money (eating up cash flow)

• Into projects with low or mediocre returns (like 5-8% returns, maybe below its own cost of capital)

• While taking on high risk

Example: A construction company that only grows by taking on huge, low-margin projects with lots of debt. It's growing revenue, but destroying shareholder value. This deserves a lower price tag (low PE).

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Why the PEG Ratio Fools People:
A company with Bad Growth might look cheap on a PEG ratio because it has a low PE (bad) divided by a high growth rate (seemingly good).

PEG = (Low PE due to bad growth) / (High Growth Rate from risky projects)

The math gives you a small, "attractive" PEG number, tricking you into thinking it's a bargain. In reality, the market has given it a low PE for a good reason—its growth is dangerous or wasteful.

That's why Damodaran says: "Other things are difficult to hold equal." The moment you see high growth, you must immediately ask: "At what cost and at what risk?"

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More detailed discussion:

These are key principles from Aswath Damodaran’s work. 

Summary & Core Idea

Damodaran systematically links valuation multiples (PE, PEG, Relative PE) to the three fundamental drivers of value: Growth, Risk, and Reinvestment (which drives cash flows). The central theme is that multiples are not arbitrary but are determined by these underlying financial realities.

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Elaboration & Commentary

1. PE Ratio and Fundamentals

Damodaran’s three propositions decompose the standard discounted cash flow model into its PE implications:

• Growth ↑ → PE ↑: Because future earnings are more valuable.

• Risk ↑ → PE ↓: Higher discount rate reduces present value.

• Reinvestment Needs ↑ → PE ↓: More capital must be plowed back to sustain growth, reducing free cash flow to equity.

Key Insight: In practice, these variables are correlated. High-growth firms often face higher risk and require high reinvestment, creating a natural tension. A firm with high growth but very high risk and reinvestment may still have a low PE. This explains why a simplistic “high PE = overvalued” approach fails.

2. PEG Ratios and Fundamentals

The PEG ratio (PE / Growth Rate) attempts to standardize for growth, but Damodaran shows its severe limitations:

• Proposition 1: Risk is ignored in PEG. A risky firm with high growth may have a deceptively low PEG, luring investors who don’t adjust for risk (Corollary 1).

• Proposition 2: Reinvestment efficiency (ROIC vs. Cost of Capital) matters. Two firms with 20% growth aren’t equal if one achieves it by investing 50% of earnings at a 40% return, and the other invests 80% at a 25% return. The more efficient firm deserves a higher PEG (Corollary 2 warns of “cheap” PEG traps).

• Proposition 3: PEG is non-linear and skewed. Very low-growth firms (<5%) often have high PEs due to stable cash flows or dividend yields, inflating PEG. Very high-growth firms (>30%) often have high PE due to anticipation of sustained advantage. Thus, comparing a 2% growth firm (PEG=15) to a 25% growth firm (PEG=1) is misleading.

Bottom line: PEG does not neutralize growth and can be dangerously misleading across different risk, return, and growth ranges.

3. Relative PE

Relative PE (Firm PE / Market PE) is a normalization metric to compare across time or against historical norms.

• It controls for market-level interest rates, risk premiums, and macroeconomic conditions affecting all PEs.

• Comparison over time is its strength: If a firm historically traded at 0.8× market PE but now trades at 1.2×, it signals overvaluation relative to its own history, assuming fundamentals haven’t changed.

• Skewness note: Damodaran highlights that the average relative PE is 1.0 (by definition), but the median is less than 1 because the PE distribution has a long right tail (some very high PE firms pull the average up). This means more than half of firms trade below the market PE—a crucial statistical insight often missed.

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Critical Implications & Practical Use

1. Multiples are proxies for DCF: Every multiple embeds assumptions about growth, risk, and reinvestment. Use them only after understanding what those assumptions are.

2. PEG is flawed but popular: Its simplicity drives its use, but it’s unreliable for cross-sectional comparisons unless firms have similar risk, reinvestment needs, and growth rates. Better to use a PEG adjusted for risk and ROIC.

3. Relative PE for historical context: More useful than absolute PE when judging whether a stock is expensive relative to its own historical range or the market cycle.

4. The “other things held equal” caveat: This is the entire challenge in practice. When comparing multiples, you must ask: Are growth, risk, and reinvestment profiles similar? If not, difference in multiples may be justified.

5. Screening pitfalls: Screening for low PE or low PEG often selects firms with high risk, poor growth prospects, or low efficiency—precisely the “value traps.”

Finding great companies: What you want to see on their financial statements?

Finding great companies: What you want to see on their financial statements?

If you're committed to finding great companies and investing in them, it is time to state clearly what you should actively seek out on financial statements.  Here now is what you should hope to find when you're studying the report of a company that you're considering for investment. 

https://myinvestingnotes.blogspot.com/2010/06/finding-great-companies-what-you-want.html

Main Points of the Article:

1. The Ideal Profile: Look for companies with a cash-rich, asset-light business model that demonstrate operational dominance, pricing power, and financial resilience—similar to Microsoft or Coca-Cola.

2. Balance Sheet Checklist:

   • Lots of Cash: Provides safety and funds growth without external help.

   • Low Flow Ratio (<1.25): The key metric. Indicates operational efficiency and supply chain power: low inventories/receivables and strategically high payables.

   • Manageable Debt: Debt is a tool, but prefer companies with more cash than long-term debt.

3. Income Statement Checklist:

   • High & Consistent Revenue Growth: Sign of strong demand (8-10%+ for large caps, 20-30%+ for small caps).

   • High & Stable Gross Margin (>40%): Indicates a "light" business with pricing power and a competitive moat.

   • Rising R&D Spending: An investment in future growth (especially for tech/pharma).

   • Full Tax Rate (~34%): A quality-of-earnings check. Be wary of profits boosted by temporary tax credits.

   • Strong & Rising Net Profit Margin (>7-10%): The result of a successful, defensible business model.

4. Cash Flow Statement Mandate:

   • Positive Operating Cash Flow: A non-negotiable sign of a self-sustaining business for public companies. Investigate any negatives deeply.

5. Critical Overarching Principles:

   • Context is Key: No rule is absolute. Metrics must be judged relative to industry norms and company life cycle.

   • The "Why" Matters: The story behind the number (e.g., why inventories are high) is more important than the number itself.

   • This is a Quality Filter, Not a Valuation Tool: The checklist identifies great businesses, but does not tell you if the stock is a good buy at its current price.

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Article Summary:

This article provides a practical, fundamentals-based checklist for identifying high-quality companies with durable competitive advantages. It moves beyond simple profitability to focus on operational efficiency, financial strength, and strategic positioning.

The core philosophy seeks businesses that generate so much demand and possess such market power that they:

• Sell inventory quickly.

• Collect payments from customers upfront (low receivables).

• Can delay payments to suppliers (high payables), using that cash as interest-free financing.

• Fund all growth internally with abundant cash, avoiding excessive debt.

The guidelines emphasize looking for strengthening financial trends—rising margins, growing cash, and efficient use of capital. It stresses that while few companies are perfect, this framework helps investors ask the right questions, distinguish operational brilliance from financial distress, and ultimately find businesses built to thrive and generate real wealth over the long term.

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A detailed discussion

This is a highly practical guide to fundamental analysis, focused on identifying high-quality, well-managed companies with sustainable competitive advantages. It moves beyond simple profitability to assess operational efficiency, financial strength, and strategic positioning. Let's break down, discuss, and summarize the key points.

Core Philosophy: The "Ideal" Business Model

The article champions a specific, powerful business archetype: the cash-rich, asset-light operator with pricing power. Think Microsoft or Coca-Cola. These companies:

• Generate products/services with high demand (high revenue growth).

• Have low capital intensity (high gross margins).

• Exercise such market strength that they get paid upfront by customers (low receivables) and can delay paying their suppliers (high, strategic payables), all while holding minimal inventory.

• Use this operational dominance to fund growth internally (plentiful cash, minimal debt).

Summary & Commentary on Key Guidelines

1. Balance Sheet: The Fortress of Financial Health

• Lots of Cash: The ultimate safety net. It provides optionality for investment, acquisitions, or weathering downturns without relying on external capital. Comment: While crucial, context matters (e.g., a mature tech giant vs. a fast-growing biotech startup). The key is why the cash is there and how it's being (or not being) deployed.

• Low Flow Ratio (<1.25): This is the article's most nuanced and insightful metric. It measures operational efficiency and supply chain power.

  • Low Numerator (Non-cash Current Assets): Means the company isn't tying up cash in inventory (it sells quickly) or waiting on customers to pay (it collects quickly).

  • High Denominator (Non-debt Current Liabilities): Means the company is using its suppliers' money as interest-free financing—a sign of strength, not weakness, if done from a position of cash abundance.

  • Comment: This is a brilliant way to separate operational genius from financial distress. The caveat about small-caps is vital; they lack the clout of giants, so a higher ratio isn't automatically a red flag.

• Manageable Debt: Debt is a tool, not a sin. The guideline wisely avoids a hard rule, favoring a preference for companies with "more cash than long-term debt." Comment: The debt-to-equity assessment must be industry-specific (utilities vs. software). The critical questions are: What is the debt for? Can operating earnings easily cover interest payments?

2. Income Statement: The Engine of Profitability

• High Revenue Growth: The primary indicator of demand. The article sets good benchmarks: 8-10%+ for large caps, 20-30%+ for small caps. Comment: Sustainable growth is key. Growth from acquisitions or price hikes alone is less robust than organic, volume-driven growth.

• Controlled Cost of Sales & High Gross Margin (>40%): This is the moat indicator. A high and stable/rising gross margin shows pricing power and an ability to scale efficiently. The "light business" bias is clear—intellectual property and software are favored over heavy manufacturing. Comment: Absolutely critical. A shrinking gross margin is often the first sign of competitive pressures.

• Rising R&D: Framed as an investment in the future, especially for relevant sectors. Stagnant or falling R&D can signal a company is milking a legacy business at the expense of its future. Measuring it as a % of sales is smart.

• Full Tax Rate (~34%): A clever quality-of-earnings check. Companies using loss carryforwards or other credits boost current earnings artificially. "Taxing" them at the full rate reveals the true, sustainable profit growth.

• Strong & Rising Net Profit Margin (>7-10%): The bottom-line result of all the above. High margins in a capitalist system signal a successful defense against competition. As the article notes, some great businesses (e.g., high-volume retailers) operate on thin margins, but they are exceptions that prove the rule.

3. Cash Flow Statement: The Reality Check

• Positive Operating Cash Flow: Non-negotiable for a mature public company. Earnings are an opinion; cash is a fact. Negative operating cash flow means the business isn't self-sustaining. Comment: This is the ultimate litmus test. You must investigate the reason for any negativity (e.g., a temporary inventory build for a hot product vs. soaring receivables because customers won't pay).

Critical Discussion Points & Caveats

1. The "Ideal" is Rare: The author admits few companies hit all marks. The checklist is a framework for excellence, not a pass/fail test. It helps you compare companies and ask the right questions.

2. Industry Context is Everything: Applying these rules rigidly across sectors is a mistake. Comparing the flow ratio of a software firm (low inventory, high payables) to a supermarket chain (high inventory, low payables) is meaningless. The guidelines work best for evaluating companies within their peer group.

3. The "Why" is More Important Than the "What": This is the article's most important lesson. A high flow ratio could be brilliant or disastrous. Spiking inventory could be mismanagement or preparation for a blockbuster launch. Your job as an investor is to discover the narrative behind the numbers.

4. No Valuation Consideration: The article explicitly stops at quality identification. A great company can be a terrible investment if you pay too much. The next critical step is to determine if the company's stellar characteristics are already reflected in an inflated stock price, or if there's an opportunity to buy a wonderful business at a fair price.

5. Quality of Earnings: The guidelines subtly emphasize this throughout (tax rate, cash flow vs. net income, receivables). They push you to ask: "How sustainable, real, and repeatable are these profits?"

Final Summary: The Investor's Checklist

You are looking for a company that demonstrates:

• Operational Dominance: Low Flow Ratio. It controls its working capital cycle like a master, collecting fast and paying slow because it can.

• Financial Fortress: Ample cash, minimal (or smartly used) debt. It is self-funding and low-risk.

• Profitable Growth: Strong, consistent revenue growth combined with high and expanding margins (both gross and net). It sells more while keeping more of each dollar.

• Real Cash Generation: Consistently positive cash flow from operations. The profits are genuine and liquid.

• Future Focus: Willingness to reinvest in the business (R&D) to maintain its competitive edge.

• Clean Accounting: Pays close to the full corporate tax rate, suggesting earnings are not being boosted by non-recurring credits.

In essence, you are seeking a business that is not just profitable, but efficiently, powerfully, and sustainably profitable, with a model that throws off excess cash and fortifies itself against competition and hardship. This framework provides a powerful lens to separate truly exceptional businesses from merely adequate ones.