Just about a year ago, the rumour mills were working overtime, leading to speculation about the survival of ICICI Bank. This was soon after the global economic crisis hit the Indian shores and ICICI Bank owned up to subprime losses. After it announced the extent of the losses, the bank’s share price went into a tailspin as panicky investors started offloading their holdings. Within two months, the share price crashed from Rs 650-700 to Rs 310. The fall may have seemed scary, but not to analysts and brokerages, who upgraded their rating of the bank from ‘underperformer’ to ‘buy’ in October 2008.
What prompted the upgrade in the midst of a downturn? The answer lies in the value of the stock. As the stock corrected to Rs 310, analysts found that the price was lower than the market value of the bank’s investments, or the book value per stock. “If we factor in the worst case scenario and erode the entire non-government foreign investments from our target price, our rock bottom valuations are at Rs 445,” say Prabhudas Lilladher’s banking analysts, Abhijit Majumder and Bharat Gorasiya. On an average, analysts valued the bank at Rs 440 per share (book value).
Given the fact that bank shares usually trade at two times their book value, ICICI Bank soon became the most favoured stock. The stream of upgrade calls were not wrong. Since then, the stock price has more than doubled to Rs 755 and is currently around 1.5 times its estimated 2009-10 book value.
This case offers an important lesson for equity investors - get the price right. No matter which stock you invest in, the cardinal rule is not to overpay.
Yardsticks to Value Stocks in Different Sectors
Best measure of value
|Auto||Price to Earnings (PE) multiple|
|Banking||PE and Price to Book Value (PBV) or Adjusted PBV multiple|
|Cement||PE, Enterprise Value to Earnings before interest, tax, depreciation & amortisation (EV/EBITDA), EV/tonne|
|Engineering||Forward PE, which reflects the order book position of the company|
|FMCG||PE, Return on Equity (RoE) and Return on Capital Employed (RoCE) ratios|
|Real Estate||Net asset value (NAV), which is book value at market prices. Also look at debt levels|
|Telecom*||PE and DCF, because there is a future stream of cash flows for upfront heavy investment|
|Oil & Gas||Residual reserves of energy assets|
|Technology||Trailing PE and its growth|
* Includes utilities
Unlike fixed income options, such as bank deposits, where the returns are guaranteed, the performance of equity investments is determined by the purchase price as well. Once the stock is bought, there is very little that retail investors can do apart from buying more or selling them. So, if they invest at the right price range (or low valuations), the probability of earning greater returns is higher.
How do you know you are paying the right price for a stock? The answer is to check the target investment using a couple of financial parameters. “Depending on the nature of the business and the sector’s growth prospects, an appropriate tool must be used to value the company,” says Hitesh Agrawal, head of research, Angel Broking. This tool is the ratio or financial metric that determines the value of a stock.
Unfortunately, there is no single tool for all industries and stocks. “One ratio cannot be applied blindly to value stocks across sectors,” says Manish Shah, associate director, Motilal Oswal Financial Services. This is due to the inherently different nature of businesses. Broadly, there are two valuation metrics: PBV (price to book value) and PE (price to earnings). The former calculates the value of assets and the latter determines the price investors are paying for the company’s earnings per share. A high growth, low capital-intensive company must be valued on PE, whereas the PBV or the replacement value is the appropriate tool to value capital-intensive businesses.
Another ratio that takes care of the debt leveraging aspect across companies is the EV/EBITDA (enterprise value/ earnings before interest, tax, depreciation and amortisation), or the enterprise multiple. But, as Agrawal says, it is always advisable to consider two or three valuation tools before taking an investment decision.
The tools that apply to different sectors and industries vary. Cement manufacturers are best valued using EV/EBITDA, real estate firms using NAV, while engineering companies can be valued using forward PE (see graphic). The PBV is used for capital-intensive businesses like banks and power companies.
Public sector bank stocks are attractive when they are trading below their book values. For a private bank, depending on its size, the ideal PBV ratio is around 2. In case of FMCG companies, the PE multiple is a better yardstick because these companies invest upfront in building brands and facilities and derive the earnings in subsequent periods.
What Impacts Stock Valuations in Sectors
Best measure of value
|Auto||Volume growth, realisations, operating profit margins, new product launches|
|Banking||Loan growth, non-performing assets, net interest margins, CASA ratio|
|Cement||Dispatches, operating costs, regional demandsupply equation|
|Engineering||Order book inflows, execution skills, margins|
|FMCG||RoE, RoCE, margins, volume growth, new products, marketshare|
|Real Estate||Debt levels, liquid assets, inventory levels, promoters’ ability to raise funds|
|Utilities/Power||Project costs, plant load factors, raw material costs, debtequity ratios|
|Telecom||Revenue per user, growth in usage, new subscribers, non-wireless revenues, EBITDA|
|Oil & Gas||Reserves, efficiency ratios, free cash flow generation|
|Technology||Order inflow, ability to contain costs, service verticals, profitability, client attrition|
Comparing with peers
After deriving the book value, a peer group comparison is needed. “Always conduct a peer analysis. Consider the sector’s potential and see how the company compares with its peers,” says Sonam Udasi, vice-president, Brics Securities.
However, peer group valuation has its own limitations. The target company’s valuations might be lower than the benchmark or industry average due to constraints regarding market share or economies of scale, and it might continue trading at a discount. Infosys, which is considered to have superior margins and a high-yielding business portfolio, has always traded at a premium to Wipro, Tata Consultancy Services and the information technology industry as a whole.
“One also has to look at the reasons for the valuation discount versus the benchmarks. Most likely, there is a good reason for the discount. For instance, if a company can address adverse issues going forward, the discount will narrow and the stock valuation will improve. If it fails to do so, then the stock will continue to trade at a discount to its peers,” says Udasi.
To refine the research process further, comparing the efficiency and return ratios of the stock with the industry or benchmark would help investors take informed decisions. In case of banks, the loan growth, net interest margins and the rise in bad loans can help find the right stock. Likewise, FMCG stocks can be sorted on the basis of return ratios like the return on equity (RoE), return on capital employed (RoCE) and the company’s operating margins.
How does an investor find out if a particular valuation method is a good parameter? According to Macquarie Research, the valuation parameter is considered good “if the sector consistently shows increasingly strong returns from progressively lower levels of the valuation metric, and increasingly weak or negative returns from progressively higher levels of the valuation metric.”
The sustainability of the earnings momentum is crucial because all the financial parameters or metrics are based on this presumption. “The valuation of the financial parameters needs to be done on expected or estimated earnings potential and growth. This is the most difficult and critical part for any analysis,” says D.D. Sharma, senior vice-president, research, Anand Rathi Financial Services.
Apart from comparisons with benchmarks, the management quality, transparency, earnings growth and earnings volatility are key factors for driving the valuations of a stock. “Any change in these factors will re-rate or de-rate a stock. So, a standalone comparison of a stock with its peers or benchmark indices will not help much. Look for a change in the earnings potential, growth or management for a re-rating trigger,” says Sharma. Hence, a company that is currently not earning profits cannot be valued at zero or close to zero.
A typical example is dishtv. The direct-to-home cable service provider is still in the investment process and is not making a profit now. The loss-making company is currently trading at Rs 42. “This is because it is developing a business, which will earn significant profits in the next few years,” says Sharma.
The bottom line
Clearly, valuations are not static, but dynamic. Depending on broader factors, such as market sentiment and sectoral preference, these change with time. A stock that trades at a discount to benchmark valuations, but shows superior earnings growth rates and scores better on operational efficiencies, can be a good investment pick. Investors should use the valuation methods mentioned above to zero in on the stocks that have value, while avoiding the ones that trap them by appearing to offer value.