often focus on whether a company can grow its earnings over the next few years. But strong profit growth alone does not guarantee that the stock will generate good returns.
A recent investor letter from Carnelian Asset Management & Advisors highlights another risk investors need to track: valuation de-rating.
The fund house uses the example of , where profits compounded at about 20% between 2019 and 2026, while the stock delivered a negative 5% return over the period.
How can a company grow profits but still deliver poor returns?
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Carnelian explains a stock’s return through two components: earnings and valuation multiple. If earnings rise and investors are willing to pay a higher multiple, the stock can benefit from both profit growth and a valuation re-rating.
Carnelian calls such stocks “MAGIC” — companies where earnings growth and valuation expansion work together.
But the opposite can also happen. If earnings rise while the valuation multiple falls, much of the benefit of profit growth can be offset. This is what it describes as “de-rating”.
“Finding MAGIC is only half the job; avoiding de-rating matters just as much,” the letter notes.
Its analysis of 272 BSE 500 companies with more than 10 years of trading history found that 110 companies de-rated by 5% or more between March 2016 and March 2026. These companies grew profits at a 15% CAGR, while their market capitalisation grew at a 10% CAGR.
In contrast, the 162 companies that re-rated saw profits grow at a 12% CAGR, while their market capitalisation increased at a 17% CAGR.
Why do investors overpay for good companies?
According to Carnelian, one reason is comfort with companies that have delivered consistently in the past. Investors may continue to value a company based on its historical reputation even when the rate of growth or other fundamentals begin changing.
The letter points to HDFC Bank, where institutional ownership stood at about 83.5%, arguing that heavy ownership can leave fewer incremental buyers to push valuations higher.
Another risk is the excitement around a “next big thing”. Investors can end up paying very high valuations for a promising theme before earnings have caught up.
When does de-rating become more painful?
The more serious situation arises when both earnings and valuation fall. Carnelian identifies several potential triggers, including stronger competition, regulatory changes, governance concerns, and large acquisitions or capital expenditure.
For example, the letter highlights how the entry of Jio changed the telecom industry’s economics, hurting profitability and valuations.
Large acquisitions and heavy capex can create another risk because capital is committed before the resulting earnings arrive. As the letter puts it, “The market does not pay for growth. It pays for growth that earns more than it costs.”
What should investors take away?
- Strong growth does not guarantee strong shareholder returns.
- Check whether the valuation multiple already prices in future growth.
- Look for re-rating potential. Earnings growth can deliver stronger returns when the market’s expectations also improve.
- Watch for de-rating risk. A falling valuation multiple can offset even healthy earnings growth.
- Revisit the investment thesis when growth expectations or business conditions change.
- Watch for regulatory, competitive, governance, and capital-allocation risks.
- Avoid relying solely on historical valuation multiples as a measure of fair value.
- Be cautious of FOMO when a theme becomes too popular and widely owned by investors.
Disclaimer: This is purely for educational/informational purposes and should not be taken as any sort of investment advice. Always consult a SEBI-registered advisor before making any investment decisions.