Financial Planning & Securities Market - Chapter 5

To understand valuations, let us first focus on what valuation is all about. Valuation is essential for equity and also for debt. Let us look at debt first. When it comes to debt, there are two essential perspectives to valuation. There is the interest rate based valuation and the default risk based valuation. As the interest rate goes down, the bond value goes up and as interest rates go up, the bond value goes down. Secondly, bonds with a higher default risk tend to quote at higher yields and therefore at lower valuations. On the other hand, bonds with lower default risk tend to quote at lower yields and hence higher valuations.

Equity valuation is a lot more complex. It entails a combination of macro, micro and qualitative factors  to arrive at a valuation. Normally, the cash flow projection is where equity valuation begins. Then the future cash flows are discounted back to the present using an appropriate cost of capital. Once the basic valuation is arrived at, it is normally ratified based on market comparable factors like the P/E ratio, P/BV ratio, Dividend yield etc. In addition, the qualitative aspects like management quality, standards of corporate governance, entry barriers and brand value is also added up to arrive at the final valuation.

Approaches to Valuation

Broadly, you can research stock based on fundamentals or technicals or adopt an eclectic approach that also includes behaviour science. Researching a stock is all about estimating a likely value for the stock and taking a buy or sell decision based on the gap. Let us now look at the approaches.

Fundamental analysis

This entails taking a valuation view based on the three primary financial statements viz. income statement, balance sheet and cash flow statement. In addition, ratios are evaluated to arrive at an indicative valuation for the stock. Finally, the qualitative factors are also added to get a fundamental valuation for the stock.

Technical analysis

This is a chart based approach. The assumption in technical analysis is that the markets price covers most of the valuation aspects of the stock and hence the best way to buy and sell stocks is to focus on past patterns and extrapolate the same to the future. While technicals are not a stand-alone science, it is normally used as an adjunct to fundamental valuation.

Eclectic or behavioural analysis

This is a mixed approach to stock valuation. Here the analyst looks at fundamentals, technicals and also adds market behaviour, investor behaviour, trader behaviour, impact of sentiments like greed, fear, panic etc. Behavioural analysis of stocks can be short term and also for the long term.

Our focus in this chapter will be more on the nuances of fundamental valuation.

Role of Risk in Valuations

Why do investors expect higher returns on equity than on debt. Simply, because debt is risk free and equity is not. That is too simplistic a statement. Not all debt is risk-free and even the most risk-free debt is not entirely risk free. Here are the levels of risk and return.

Level 1 - Government Treasury Bills

These are the most risk free in every sense of the term. Since they are backed by the government they do not have any default risk. Secondly, since they are of a very short term nature they also do not have price risk. This is normally called the risk-free rate and the yields on Treasury Bills are the lowest.

Level 2 – Long Term government bonds

These entail a higher level of risk compared to government treasury bills. While long term government bonds are free from default risk they are prone to interest rate risk. That means if the interest rates go up then these bond prices go down. Thus price risk is a major risk in case of long term government bonds.

Level 3 – Corporate and Institutional bonds

Corporate bond are obviously subject to interest rate risk like in case of long term government bonds. However, these bonds do not have the  guarantee of the government and hence cannot be classified as entirely risk free. Of course, corporate bonds issued by reputed business groups will not default as they have a reputation to protect. But many mid-cap company bonds are vulnerable to default to risk.

Level 4 – Hybrid Mutual Funds

These funds combine equity and debt with focus on one of them. While balanced funds are predominantly into equity, MIPs are predominantly into debt. So while MIPs are more risky than government bonds they are less risky than balanced funds.

Level 5 – Index Funds

Index funds are those equity funds that just replicate an index like the Sensex or the Nifty. The returns on this fund will mirror that of the Nifty. This is also called a Beta fund since it only runs the market risk. The risk of an index fund is as much as the stock market as a whole. Since there is no stock selection involved here, index funds are free of selection risk.

Level 6 – Diversified Equity Funds

These are purely equity funds. They are invested in a wide array of equities and do not have any debt component. They are less risky than direct equities or sector funds because in both these cases there is the risk of concentration. Diversified funds have the advantage of professional management which makes them less risky than direct equities.

Level 7 – Direct Equities and Sector Funds

Both these categories of assets have concentration risk and stock selection poses a major risk in both these cases. They are therefore higher on the risk scale compared to equity diversified funds. As a result the expected returns on these funds will also be higher.

Importance Of Above 7 Levels in Risk Premium Determination

They are important because it is these levels of risk perception that actually determine the risk premium. For the purpose of understanding risk premium let us only focus on the equity part.

• Government securities returns are a good approximation for the risk free rate. We are only talking about default risk and not about price risk and hence the G-Sec returns are a good approximation. That is called the Risk Free Rate (Rf)
• The index fund is a good approximation for Beta or the market returns. The expected market returns will be higher than the returns on a debt fund because there are market risks involved. The Market Return (Rm) is nothing but the Rf + market risk premium. Therefore Rm > Rf
• If you just want market returns you are happy investing in an index fund. But if you want stock selection that means you are searching for alpha. That is why return expected on an equity diversified fund will be higher than an index fund. That can be represented as Re > Rm
• Direct equities and sector funds represent a concentration risk. They are betting on a particular stock or sector to do better than the other sectors. You can represent this as Rce > Re.

So our final risk premium equation will look something like this…

Rce > Re > Rm > Rf

The differential return expectation at each stage is what equity risk premium is all about!

What Questions To Ask In Fundamental Analysis?

Fundamental analysis help investors identify if the stock is overpriced or underpriced. To be more specific, fundamental analysis enables you to answer the following 10 questions pertaining to a stock that could have a bearing on its valuations:

1. Is the global macro environment like Fed rates and Chinese demand conducive to the growth and profitability of the company?
    
2. Are the domestic macros like CPI, IIP, PMI, fiscal deficit favourable to the company from a medium term point of view?
    
3. Is the industry in which the company is operating undergoing a major shift in terms of business model and demand / supply dynamics?
    
4. Are the company’s revenues growing and how sustainable is the company’s growth in the top-line?
    
5. How is the company operating profit being driven? Is it being driven by growth or by better cost management?
    
6. How is the company level of leverage and are the company operating profits sufficient to cover the interest burden?
    
7. How does the company manage working capital; do the current assets pay for the current liabilities
    
8. How is the company ROE and its ROCE? Is the company able to earn more for its stakeholders than the cost of capital?
    
9. How does the P/E ratio, P/BV ratio and the dividend yield of the company compare with competitors in the same industry?
    
10. How is the management quality within the company and what are the levels of corporate governance that the company is pursuing right now?

EIC Analysis – What Are The Factors To Be Considered

To understand the variables impacting the stock price, one needs to look at these variables from the point of view of the EIC model. The EIC model refers to (Economy, Industry, Company) model wherein the analyst first satisfies himself on the macroeconomic factors, then the industry factors and finally the company level factors. Following is the break-up of the key sub-components of the EIC variables used to select a stock…

E-I-C - Factors influencing the price of stock

Why Different Sectors Have Different Valuations?

There is nothing like the ideal valuation matrix. It largely depends on the unique dynamics of the business. Here are a few examples…

• For industrial companies with cyclical earnings, P/E valuations based on historical rolling earnings may be more representative.
   
• For industrial companies with stable and predictable growth patterns, P/E valuations based on projected earnings may give a much better picture.
   
• For banks and financials, where return on assets is the key measure of performance and efficiency, the P/BV offers a much better benchmark for valuation.
   
• In case of utility companies, the dividend yield makes a lot of sense as a measure of valuation since people do look up to utility companies for healthy dividend payouts.

Understanding the Concept of Economic Moat

The concept of Moat was put forth by Warren Buffet. Businesses survive and create wealth in the long run, when they are able to create some sustainable competitive advantage in the business. These competitive advantages cannot purely be price based as that can be easily replicated. For example, the way Microsoft makes operating systems simple and user-friendly is a competitive advantage. The way Apple creates designs from the perspective of the customer is a competitive advantage. In India the way Eicher has created virtual dominance in the upper end of the two-wheeler segment is a unique competitive advantage. Similarly, distribution is a tremendous competitive advantage that ITC has built.

The nature of Economic Moat is that their fundamental structure keeps changing continuously. As Darwin had rightly pointed, “The species that survives the longest is not the strongest but the most adaptable”. The same rule applies to companies too. Economic Moats keep changing. Great companies are flexible enough to keep rethinking and re-creating their moats continuously.

How to Analyse the Income Statement of a Company

The analysis of the income statement involves comparing the different line items within a statement, as well as following trend lines of individual line items over multiple periods. This analysis is used to understand the cost structure of a business, and its ability to earn a profit. A proper analysis of the income statement requires ratio analysis of critical margins like gross margins, contribution ratio, fixed cost coverage, operating margins, net margins, dividend payout ratio etc.

An important part of looking at the income statement is horizontal analysis. This is a side-by-side comparison of income statements for multiple periods. A good comparison is for every month or quarter in a year. Items to look for in this analysis include the following: seasonality of sales each quarter, missing expenses, employee costs, administrative costs, interest cost and the trend etc.

How to Analyze the Balance Sheet of a Company

A balance sheet gives an ownership perspective; in the sense that it shows what the company owns and what it owes. A balance sheet also gives you a time perspective; in the sense that it shows you a breakup of short term and long term assets as well as short term and long term liabilities. Here are 5 things you should read in a company balance sheet.

• Check the ratio of current assets to current liabilities. As the name suggests, the word current refers to the short term (period of less than 1 year). Current assets typically include cash, short term investments, inventories and trade debtors. Current liabilities, on the other hand, include short term loans and trade creditors. Normally, the first thing you check in a balance sheet is the current ratio. The current ratio is the ratio of the current assets to your current liabilities and show how liquid is working capital cycle to finance payables.
   
• Check out the assets turnover ratio. This is the measure of the efficiency of utilization of your assets and is measured as the ratio of net sales to total assets. A higher asset turnover ratio is positive as it indicates that the assets of the company are being churned more aggressively and more efficiently to generate sales and profits for the company. Higher asset turnover ratio results in higher ROE.
   
• What is the size and cost of debt? This is, perhaps, one of the most important factors that determine the solvency and the financial viability of the company in the long run. We are referring to long term debt here. A debt equity ratio of up to 2:1 is considered to be acceptable. This is again truer of manufacturing companies as companies in sectors like IT normally tend to be zero-debt companies. Also be cautious of foreign currency denominated debt as it can snowball in the event of the dollar strengthening.
   
• Is the company focusing on tangible or intangible assets? Normally, these are intellectual properties and sectors like IT, pharmaceuticals and FMCG companies have these properties in abundance. Remember, that not all intellectual properties are reflected in the balance sheet but these can help get better valuations.
   
• Contingent liabilities may be off-balance sheet but are equally important. They are not shown as liabilities in the balance sheet but can become liabilities subject to certain conditions. These are normally shown as a separate item under the notes to accounts. These include pending legal cases, risk of open derivative positions etc. This may appear to be small but can be quite important in bad times.

How to Evaluate the Cash Flows Of a Company

What does the cash flow statement comprise of? Broadly, there are 3 components to a cash flow statement. The first component is the “Cash flow from operations”. The second component is the “Cash flow from investing”. Here the purchase of capital assets is considered as outflows and the sale of capital assets are considered as inflows. The third component is the “Cash flow from Financing”. Here the flow of equity and long term debt are considered. Let us understand why there are important.

Cash Flow from Operations

The Cash Flow from Operations is critical as it tells you the actual cash flows that are generated from your core operations. For example what is the cash flow generated from the steel business for a steel company? There are two important aspects of this component. Firstly, since it excludes the impact of extraordinary and non-core items, it gives a clear view of the performance of the core business. Secondly, as it ignores non-cash charges like depreciation, it measures actual cash generated rather than the income statement number.

Cash Flow from investing activities

Investing activity refers to investments in core business assets only. Therefore investment in plant and machinery, expansion of capacity, diversification, and inorganic acquisitions will all be part of the company’s investment activities. All these will be investing outflows. On the other hand sale of fixed assets, sale of business lines or sale of subsidiaries will all be categorized as inflows from the investment activity. Normally, a healthy company will have negative investment flows because any growing company will have to focus on growing by expanding its assets rather than by selling its assets.

Cash Flows from financing activities

This segment refers to how the cash flows pertaining to your long term capital providers are structured. For example, issue of fresh shares, rights issue to existing shareholders, debt through long term loans will all constitute inflows from financing activities. On the other hand buyback of shares, payment of dividends to shareholders and repayment of long term loans will all be classified as outflows from financing activities.

Company Valuation – Putting the Pieces Together

Essentially, there are 3 steps in company valuation.

Step 1: DCF Analysis

Discounted Cash Flow (DCF) analysis is an intrinsic value approach where an analyst forecasts the unlevered free cash flow of the business into the future and discounts it back at the Weighted Average Cost of Capital (WACC). For diversified businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are valued individually and added together with the impact of synergy.

Step 2: Comparative Analysis

Comparable company analysis is also called peer group analysis. It is a relative valuation method in which you compare the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other ratios. Multiples of EBITDA are the most common valuation method. The peer group valuation method provides an observable value for the business, based on what companies are currently worth. They offer market ratification to the analysis.

Step 3: Replacement value

Replacement value analysis is also a form of relative valuation where you compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired.

Valuation of companies is a lot of science and a little bit of art. It is this function that defines the core activity of a research analyst.