"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite-that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find..."- Warren Buffett

One morning, a friend came to me and said, " You have to buy this stock, it is trading at a P/E of only ten times this year's earnings, and everything else in the sector is over 20 times! It is also growing a rate of 20%, thus PEG is 1/2".

I was stumped. I asked, " How did you arrive at the calculation?"

My friend said, " I just read a report of a prominent brokerage house that has given a buy on this stock, based on its low P/E multiple and high growth rate compared to its peers."

I retorted, "If the investing funda was so simple then we all would be very very rich. You are hoping this stock somehow wakes up one day, realizes it doesn't get the same respect as its peers, and starts to go up. I have analysed the company. Its return on capital (ROIC) is less than its cost of capital. Thus with high growth it is only destroying shareholders value faster".

That meeting is still fresh in my mind to this day. It serves as a reminder about how the valuation metrics used by most of the analysts are inadequate in projecting stock price movements. It has also taught me the ultimate importance of defining in clear terms what edge does the company have over others.

P/E multiple is the most used and the most abused multiple in the investment world. It is generally believed that company with high growth rates will have high multiples and vice versa and if one finds a stock with high growth but low P/E than it's a good buy. But what we fail to appreciate is the important role that returns on capital (ROIC) play in channelling growth into a high or low multiple. It's common sense: growth requires investment, and if the investment doesn't yield an adequate return over the cost of capital, it won't create shareholder value. That means no boost to share price and no increase in the P/E multiple.

To illustrate, most Retail companies, like Pantaloon, are witnessing high growth. To give high P/E multiples to retail companies just because of their high growth is misleading, as it doesn't take into account returns on capital (ROIC). Retail companies fight it out primarily on price, which translates into lower margins and relatively low returns on capital. Such high P/Es, based on the high growth rate of the company, will not be sustainable.

To demonstrate the relationship between Growth, ROIC & P/E, Michael Mauboussin, CIO of Legg Mason Capital Management, developed a grid describing growth and return for a theoretical company.

The grid clearly proves that P/E is determined by both ROIC & growth. The table is shown below: -

ROIC and P/E Multiples: Theory

NM = not meaningful.

Note: Assumes all equity financed; 8 percent WACC; 20-year

forecast period.

Source: LMCM analysis.

Thus we see that it is both growth and ROIC that determines whether company will create or destroy value. We as investors should look for the rare company that can combine high growth with high returns on capital.

We should remember that we should not avoid stocks just because it has a high multiple relative to peers or buy a stock with high growth but low P/E multiple. We should try and understand the complex chemistry of growth, return on invested capital, and P/E multiples while making investment decision.

To summarize, we see that P/E and company's investment success or failure will be determined by:

· Growth rate of the company

· The magnitude of capital required to sustain the growth

· The spread between the return on capital and the cost of capital and how long a company can deploy capital at positive spreads

Views expressed in the article are personal and does not represent that of the company where the author is working. This article is for information only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.