Equity Valuation Methodologies

Contributed by: Kailash Chhabria, CFA

We are all very watchful for the price we pay for the things we buy. For example, if one is to buy a mobile phone, he would visit all the online portals, compare the price with Brick & Mortar store, check for offers and arrive at the best value for the product. We are extremely vigilant in determining the right value for the product. Investments are no different. Be it Real Estate, Gold, Equities, Bonds; we attain satisfaction only when we have paid the right price. But how do we really determine the right price while making Investments? What are the inputs one considers while making investments and how do we filter noise?

I was fortunate to attend a session on “Equity Valuation Methodologies” conducted by Indian Association of Investment Professionals (IAIP) and presented by Mr. Sampath Reddy, CFA, CIO Bajaj Allianz Life Insurance.  It was a very thought provoking session wherein we discussed what drives valuations and how we could have a quick check while making investment decisions.

There is no doubt that approach like DCF is exhaustive and considers all aspects of mature businesses we are valuing. We consider all relevant criteria while applying DCF and base our assumptions on a lot of research we do on companies.  The approach requires time and ability to make right judgements. Could we not consider other time bound relative valuation approaches while making an investment decision? The question then arises what is the right P/E or P/B ratio for a company & an Industry. How should one interpret the value of a company, its future potential by usage of mere ratios?

Below are some of the key takeaways while considering relative valuation (Method of Comparables) approach to compare companies:-

While Brand visibility, distribution, Technology, Monopoly, access to natural resources are important for a business to succeed, they are not the sole drivers and firms could trade at low multiples to their peers in their respective industry. The likes of SBI trade at low multiples to peers and may not necessarily be the best investments.  Low multiples do not necessarily mean attractive investments.

The most important driving factor for a business is ROE. What’s in it for the investor? When businesses generate ROE greater than their cost of capital they tend to enjoy good multiples. It is the ability of the business to continuously report strong ROE’s which makes a good investment.

The growth of a business tends to have a direct relationship with the firm’s PE. Companies with growth rates higher than their cost of capital tend to enjoy healthy multiples. PE is constantly adjusted and rerated keeping growth in mind. For example, Infosys which commanded a PAT CAGR of 46% in FY04-07 period traded at 21.7 1 yr forward PE. While FY10-13 saw growth no’s come down to 15% the 1 yr forward PE was rerated downwards to 16.2.

The relative valuation approach may not work best for commodity driven companies and other approaches should be considered. The PE & EV/EBITDA ratios appear to be cheap at the peak of the business cycle and vice versa which could be misleading. Tobin’s Q could be considered as an alternative measure.

In addition to the above pointers, one needs to be watchful of the quality of the management which runs the business. Initiatives and policies adopted by the management go a long way in determining the prospects of business. The capital allocation decisions, dividend payout policies, disclosures, accounting policies, diversification in new businesses which are done at management discretion can make or break a business.

In words of Warren Buffett, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.
Happy Investing!!

-KC