How much more could Divis Labs fall?

Well, if you look at the magnitude of the stock’s decline over the past year, the answer can probably be a simple ‘yes’. it’s not every day that a high quality midcap Like Divis Labs fell 35%.

However, it would be better if we delve deeper into the reasons behind the decline.

sitting pretty 5,000 per share about a year ago, the stock has lost a lot of ground since then. That’s behind a lukewarm market for stocks and the company’s own struggles with growth and profitability.

Feather 5,000 per share, the stock was priced for perfection, commanding a high PE ratio of 60x. For perspective, this is almost double the long-term average of 30x.

When a stock trades at 2x its long-term multiple, the growth juggernaut tends to roll out better and roll faster. If there is even a small question mark on future growth, the prices may decline in a few months.

And that’s exactly what happened with the stock. Over the past few quarters, the annual growth in profits has been declining steadily.

In fact, for the most recent quarter of September 2022, the company reported a nearly 20% drop in profits. Things are not looking as good for the rest of the year as well. Most likely, the company will close out the year with only a small increase in profits or perhaps flat growth.

The recent performance certainly hasn’t gone down well with investors. The stock has been taken to the cleaners, with a 35% drop from the top probably going to hurt more.

However, as is often the case, has the improvement been overdone? Just as investors got too greedy and took the stock to a PE ratio of 60x, are they too intimidated now? Has the stock now found a place in our undervalued stock list?

Well, as I write this, the stock trades at a PE multiple of 29.1x its last twelve month (TTM) earnings. Now, how good or how bad is this?

This is certainly much better and more reasonable than the 60x PE multiple that the stock was commanding near its top. This is slightly less than the 32.9x multiple on average over the past 10 years.

However, a lot depends on the profits going forward. If the stock manages to grow its profits at a CAGR of 15-20% over the next 2-3 years, the current PE of 29.2x can definitely be sustained.

In fact, it may even improve slightly if the growth story continues. Therefore, a return of around 20% in the next three years is very likely if the growth continues.

However, I looked at the company’s performance between FY15 and FY18, between FY16 and FY19 and even between FY17 and FY20. The numbers hardly inspire confidence.

The profit CAGR in each of these three years was 1%, 6.3% and 9.1% respectively. Yes that is correct. High-quality growth stocks like Divis Labs have had several three-year periods in the past where growth has been average or poor, to say the least.

So, what if the growth rate also falls below par in the next three years? What if the growth rate comes down to just 7-8% or even 1% as it has done in the past?

Well, in that case, to protect your returns, you should buy the stock at a PE multiple of around 20x or less.

Why 20x?

That’s because, historically, whenever investors have bought stocks at a PE of 20x or less, the average CAGR over the next three years has been a highly impressive 47%. Sounds incredible, doesn’t it? However, the return is real.

Buying Divis Labs at a PE of 20x or less has proved to be one hell of a business, compounding on an average CAGR of around 50% over the next three years.

In fact, even the lowest return has come in at a CAGR of 26.2%, which once again highlights the magic of buying Divis Labs at a PE of 20x or less.

However, please note that such attractive valuations are not very frequent. In the past 10 years, they’ve only happened 8% of the times. In other words, the odds of a stock trading at a PE of 20x or less are less than 1 in 10.

Therefore, the takeaway for an investor is pretty clear.

If you believe the stock is of a great pedigree and the problems it is facing are only short-term in nature, then the current price is a good price to enter the stock. This is of course provided the profits grow at a CAGR of at least 12-15% over the next 3-4 years.

But if you don’t want to take any chances and want to protect your downside even further, buying after the stock has fallen and reaches a PE of at least 20x may be a good thing to do.

If you think about it, there’s also a logic behind paying a multiplier of 20x versus the current multiplier of about 30x.

If you choose to pay a multiple of 20x, no matter how high the growth prospects, then you are a typical GARP (growth at fair value) investor. A GARP investor doesn’t like to pay too much for future growth. Hence, one does not like to pay more than 15-20x for any stock.

However, if you are a growth investor, there is no qualms in giving you a PE of 30x as long as there is good growth potential.

If the business is easy to understand and the growth visibility is good, then according to you the premium PE is justified. the way the math of investing works, a high growth stock A stock with slightly higher PE is better than a low growth stock with low PE.

Therefore, the choice is yours. If you understand the business and have confidence in management, it probably makes sense to buy it at a current PE of 30x.

However, if you want to protect your downside further, you may have to wait for the stock to drop significantly from here. In fact, chances are it may never return to 20x PE and you will miss out on a good opportunity.

Last but not least, you can also consider the middle ground where you take 50% exposure now and the remaining 50% after falling to a PE of 20x the stock.

I hope you choose wisely.

Disclaimer: This article is for informational purposes only. This is not a stock recommendation and should not be treated as such.

This article is syndicated from equitymaster.com