How much more can Divis Labs fall?

Market


Well, if you go by the magnitude of the correction in the stock in the last one year, then the answer could perhaps be a simple ‘yes’. It’s not every day that a high-quality midcap like Divis Labs falls 35%.

However, it will be better if we take a deeper look at the reason behind the fall.

Sitting pretty at 5,000 per share around a year ago, the stock has lost a fair bit of ground since then. This is on the back of a lukewarm market for stocks and the company’s own struggles with growth and profitability.

At 5,000 per share, the stock was priced to perfection, commanding a lofty PE ratio of 60x. For perspective, this is twice the long-term average of around 30x.

When a stock trades at 2x its long-term multiple, the growth juggernaut better be rolling and rolling fast. If there’s even a small question mark over future growth, the price may come tumbling down in a matter of few months.

And this is precisely what happened with the stock. Over the last few quarters, the annual growth in profits has been steadily coming down.

In fact, for the most recent quarter of September 2022, the company has reported a fall in profits to the tune of almost 20%. Things aren’t looking all that great for the remainder of the year either. Most likely, the company will close the year with only a small growth in profits or perhaps flat growth.

The recent performance has certainly not gone down well with investors. The stock has been taken to the cleaners, losing 35% from the top with perhaps more pain to come.

However, as is often the case, has the correction been overdone? Just as investors became too greedy and took the stock to a PE ratio of 60x, have they become too fearful now? Has the stock now found a place in our list of undervalued stocks?

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

This is certainly much better and much more reasonable than the 60x PE multiple the stock was commanding near its top. It is also a tad lower than the 32.9x multiple that the stock has traded at on an average over the last 10 years.

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

In fact, it can even improve a little bit if the growth story remains intact. Hence, a return of close to 20% over the next three years is very much possible if the growth sustains.

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-year periods stood at 1%, 6.3%, and 9.1% respectively. Yes, that’s correct. A high-quality growth stock like Divis Labs has had several three-year periods in the past where growth has been mediocre or poor to say the least.

Therefore, what if the growth over the next three years also comes in way below par? What if the growth falls to just 7-8% or even 1% like it has happened in the past?

Well, in that case, in order to safeguard your returns, you should buy the stock only at a PE multiple of around 20x or below.

Why 20x?

Well that’s because, historically, whenever investors have bought the stock at a PE of 20x or below, the average CAGR over the next three years have been a highly impressive 47%. Sounds unbelievable, isn’t it? However, the returns are real.

Buying Divis Labs at a PE of 20x or below, has proven to be one hell of a trade, compounding at a CAGR of almost 50% over the next three years on an average.

In fact, even the lowest returns have come in at a CAGR of 26.2%, once again highlighting the magic of buying Divis Labs at a PE of 20x or lower.

However, please note that such attractive valuations haven’t occurred very often. Over the last 10 years, they have happened only about 8% of the time. In other words, the probability of the stock trading at a PE of 20x or below is less than 1 out of 10 going forward.

Hence, the takeaway for an investor is very clear.

If you think 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 chance and protect your downside even further, then buying the stock after it falls and reaches a PE of at least 20x could be the appropriate thing to do.

If you think about it, there is also a logic behind paying a multiple of 20x versus the current multiple of almost 30x.

If you like paying a multiple of 20x no matter how high the growth prospects then you are a typical GARP (Growth at Reasonable Price) investor. A GARP investor does not like to pay too much for future growth. Therefore, does not like paying more than 15-20x for any stock.

However, if you are a growth investor then you don’t mind paying a PE of even 30x as long as there is good growth visibility.

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 with a slightly higher PE is better than a low growth stock with a low PE.

Therefore, the choice is yours. If you understand the business and have faith in the management, then perhaps buying it at the current PE of 30x makes sense.

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

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

I hope you choose wisely.

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

This article is syndicated from Equitymaster.com

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