Relative Valuations – A Critique

Valuation, though a subjective matter, has many elements of objectivity. In the year 1934 Benjamin Graham and David L. Dodd published their book on Security Analysis that was precursor to many work in this field of finance. This was followed by ‘The Theory of Investment Value’ in the year 1938 by John Burr Williams. While William stressed on the value of a stock being equal to the present value of all future dividends, the duo of Graham and Dodd emphasized on what we call earning multiple or relative valuation.
Which mode of valuation is better? And why? Can any investment professional answer this question without annoying coterie of analysts and fund managers? In the tech boom of 2000-01 in the Wall Street the average P/E of stocks had risen to as high as 228 . Will anyone buy a stock, today, at or near that level? The answer is no as you know, when you can get all the stocks at around P/E of 11 why would you buy so high. This is why subjectivity in the valuation becomes important. One more question, given the current scenario in the global market, will you buy a stock tomorrow at a P/E of 200? If you said, no, you better watch out!
Given a stock, in how many ways can it be valued? And whether all such methods will lead to the same value? Market analysts value common stocks based on the following methods:
• Discounted cash flow(DCF) method
• Relative Valuation method
• Residual Income method
Each of the methods stated above carries some degree of bias. In the DCF based valuation companies are assumed to be going concern, however, given the nature of many firms in the market no one can guarantee the continuity of a firm. Having decided to use DCF, still the task is a little complicated when it comes to valuing emerging market stocks. The Analyst has to choose between adjusting the discount rate or the cash flow when it comes to emerging market stock in an inflationary scenario. Adjustment of cash flow is preferred over the discount rate as the emerging market risk is diversifiable. Normally, future dividends, cash flow to firm or cash flow to equity may be used as an input to valuation in DCF approach. The point to note, however, is all the methods should ideally give approximately the same result. If not, then, the analyst has to change his assumptions. In the dividends discounted valuation approach, the perspective is that of a minority shareholder who owns the stock to reap the benefits in terms of dividends. Stocks in the Mature Industries can be valued with this approach. For a majority shareholder, however, the perspective is that of control and hence the relevant cash flow is free cash flow to firm (FCF) or free cash flow to equity (FCFE).
Having chosen the relevant cash flow to discount, the most important thing that remains is the growth trajectory. This is where the subjectivity takes the centre-stage. A growth stock may grow in future till a few years and then may return to the industry’s normal growth rate. The same stock may grow at a very high (read abnormal) growth rate for few years, then to decelerated growth and to finally the industry’s normal growth rate. It is up to the analyst to forecast the growth duration. Again the classification of industry is very important, viz. the industry may be a pioneer, in growth, or achieving maturity or may have reached the decline. Each of the above categories will have different growth rates. The reason why stocks value don’t always equal to the one projected by analysts is because of various assumptions used in the analysis. During the period of extreme optimism stocks prices rise much above what is predicted by analysts and during the period of extreme pessimism stocks fall much below their intrinsic value. You may call this irrational exuberance in the words of former Fed Chairman, Mr. Alan Greenspan. Since this has happened in past, history will be repeated again.
Relative valuation is easier to work out compared to absolute valuation –as in the case of all DCF based valuations. This is based on law of one price. In reality, however, not all stocks in the same industry are priced at the same level. The range of P/E in one industry may not vary much but there always is premium for a brand. The reasons why companies in the similar industries are priced at different multiples compared to their peers is because of the growth estimates, management’s reputation (read corporate governance) and the model of business, patents, industry structure among others.
The industry leaders always command high price, hence their earning multiple is higher than their peers. Even if a stock is valued in terms of its cash flow to be received in future, the estimate of its future P/E is required to arrive at its terminal value. How do you justify a stock paying dividend yield of 1.5 %? If this stock is kept for five years the cumulative yield is 7.5%, assuming no price change. Definitely, then, any one having the stock would like to sell this for a better investment. In other words, people buying dividend stocks also have some expectations of price appreciation or the future P/E. In the earning multiple (P/E) based valuation the following multiples are used by the analysts, the price of the stock remaining the same.
• Price to Earnings (P/E) ratio
• Price to Book Value(P/B)
• Price to Sales(P/S)
• Price to Cash flow(P/CF)
• Enterprise value (EV) to Earnings before Interest Taxes and depreciation (EBITDA).
The problem in these earning multiples is all the stocks do not and can not be a candidate for one of the above ways of valuations. A software solution(ITeS) company, for example, has its little assets in real estate, stationeries, computers, furniture and mostly in the human resources. The P/B of a this tech stock will be much higher than that of a finance (banking) stock. As will be clear later in this essay, these tech companies are expected to have very high residual income or income above their cost of equity. A bank stock has most of its asset in liquid form; hence they trade very close to their book value. Compare this with a tech company that trades at over 8 times its book value. Two frontline stocks in IT and Banking listed on BSE and part of benchmark index Sensex, Infosys Technologies Ltd. and ICICI Bank Ltd. are trading at P/B of 7.3 and 1.62 respectively as on August 20, 2008. Similarly stocks in pharmaceutical industry trade at a very high P/E ratio.
The market always expects them to come out with one great discovery! The problem with P/E based valuation is they can not be used in case of capital intensive company or companies in the beginning of their life- company in a pioneer stage and requiring huge capital expenditure. Companies whose stocks give negative earnings can be valued based on Price to Sales (P/S) or Price to Cash Flow (P/CF). The advantage of using P/S is sales are not as easy to manipulate as the earnings, though companies can always do it. Cash flow in that sense is very hard to manipulate, but as stated above, some companies generate negative free cash flow in the early years of their operation and in such cases the best candidate is sales. An analyst often has to run a regression equation with top down approach. If the GDP grows by a certain percent, industry picks up some fraction out of it. Within an industry, a company may have a particular share that may remain constant or may grow at certain percentage. Sales can then be estimated based on the regression equation. EV to EBITDA based valuation is used when a company spends a lot on machinery or capital goods and hence their depreciation is very high. All this effort ultimately has to be compared with values obtained in case of various companies.
Compared to individual stocks, indices trade within a particular multiple. Hence, comparison can always be made as to whether the basket is trading at historical high earning multiple. The table below shows the highs and lows of P/E, P/B and Dividend yield of S&P CNX Nifty for the period 1999-2008(July).
As stated, the P/E of the S&P CNX Nifty is more volatile compared to its P/B, as the standard deviation of the P/E (3.65) is much higher than P/B (1.06). This proves what we stated that earning based measures are more volatile than book value based measures.
The Residual Income approach uses concepts like Economic Value Added (EVA), which is based on the premise that there is a cost to equity which is not charged in case of the accounting based earnings. The cost of equity is charged to Net Operating Profit adjusted for taxes (NOPAT) and the income so obtained is called the residual income. If the company is growing and is likely to grow further then its residual income is also adjusted upward for growth. The analyst has to again use his judgment about the time when the residual earning drops and the company earns just normal earning. What is relevant in the EVA based valuation is book value is used in the valuation equation and present value of the residual income is discounted. Many analysts, therefore, feel that this is a better way of valuing a stock as the major part of the Valuation equation is known in advance, i.e. the book value.
Which method is the best?
In global scenario assets are being bought and sold based on different perspective in mind. Real estates are mostly valued on the basis of income method, however, on many occasions their market value is far above their intrinsic value. In India, almost all research reports are being prepared based on relative valuation. Probably the market does not want to be wrong in forecasting cash flow beyond a horizon. In a study of research reports published by broking firms in India, ICRA, a credit research agency, found that stocks perform well just after the report is made public, however, in the long run no such evidence was found. Even between the sell side and the buy side report there are differences in the way the report is being presented . Illiquid stocks trade at a discount to their fair price. The value of an illiquid asset is generally lower than the value of a similar asset that is readily marketable . The difference in the earning multiples of various stocks may be justified today if tomorrow can be seen today! While analysts will always remain busy in their valuation, market will keep moving in its random walk only to remind that valuation is never a constant!
Jainendra Shandilya
The author works as Assistant General Manager at Securities and Exchange Board of India, Mumbai, India. The views expressed are personal and does not belong to the organisation.