Equity Investing: How to identify stocks ready for re-rating

To conclude, whether you are a value investor or a growth investor, in order to boost the performance of your portfolio add shares of companies into your portfolio which have a higher chance of getting re-rated.

By P Saravanan & Aghila Sasidharan
The term ‘re-rating’ is often used by analysts in their report or while talking to the media. When such headlines are published, investors generally do not fully understand what it means for them and its significance. Let us discuss in detail what re-rating means, how investors should interpret and adjust their portfolio to earn higher return.

What is re-rating?
Re-rating in the share market means that investors are willing to pay a higher price for shares, anticipating higher earnings in the future. Such an anticipation is owing to investor sentiment and future prospect of the company. Let us understand the same with a simple example. For instance, shares of company X are trading at Rs 100 per share with earning per share (EPS) of 10 times. This means that price earnings (P/E) ratio is 10.

When the share price moves up to Rs 200 and the EPS also goes up to 15, then the new P/E will be 13.3, which is higher than 10 in the previous period. If the market is willing to pay a higher price compared with earnings for the shares of company X, it is known as ‘re-rating of shares’ by the market. Basically, change in investor sentiment about the long-term prospects for the company’s earnings leads to re-rating.

P/E expansion creates wealth
It is clear from the above example that when the company is re-rated, its P/E expands with a significant improvement in fundamentals. The key point to be observed by the investors is that though the earnings improve, the P/E enhancement alone creates wealth for the investors. There are various reasons for P/E enhancement.

First and foremost, when there is a re-rating, generally institutional investors are excited about the prospects of the company and start buying the shares. Sometimes, out of favour share or sector might also be re-rated and catch the interest of investors. For instance, of late, sectors such as banking and PSU have got re-rated and fresh buying in the above sectors by institutional investors are being witnessed.

How to identify re-rating?
Generally, when a company shows consistent growth, then re-rating happens and at the same time, if there is uncertainty regarding the prospects of the business, then de-rating happens. Identifying a share before re-rating is not an easy task. However, one can identify a company with low P/E ratio. Re-rating will not happen in shares which are already trading at higher multiples, say, 50 or 60. The firms that could show better than anticipated growth for a longer period could record a re-rating.

To assess companies which are most likely to get re-rated, one should have a thorough understanding of valuation, ability to identify the key successful factors for the industry, etc. For instance, if firms in the paper segment who are trading at a lower P/E multiple currently could reinvent themselves and take advantage of the plastics ban, could see increased interest and re-rating may occur in the entire segment.

To conclude, whether you are a value investor or a growth investor, in order to boost the performance of your portfolio add shares of companies into your portfolio which have a higher chance of getting re-rated.

P Saravanan is a professor of finance & accounting, IIM Tiruchirappalli.
Aghila Sasidharan is an assistant professor at Jindal Global Business School, Sonipat

share valuation
If the market is willing to pay a higher price compared with earnings for the shares of a company, it is known as ‘re-rating of shares’ by the market
When a company is re-rated, its P/E expands with a significant improvement in fundamentals
When there is a re-rating, institutional investors start buying the shares
To identify firms most likely to get re-rated, one needs to have thorough understanding of valuation, and ability to identify the key successful factors for the industry