One valuation ratio you can totally rely on

Jun 17, 2015

In this issue:
» An overhaul of the public sector banks is necessary!
» Does it make sense to 'monsoon proof' your portfolio?
» ...and more!

 Chart of the day
You only need two things to do well in the stock market. One, have the right framework in terms of thinking about market prices and two, know how to value stocks. No, it is not us who are saying this. It's the legendary investor Warren Buffett himself.

Requirement number one is of course of the behavioural kind. It involves changing some of the default settings of our brain at the time of investing. This is to ensure they are in sync with traits that successful long term investing requires.

Requirement number two is where there is likely to be some confusion we believe. Simply because there are a lot of ways in which stocks can be valued. Buffett himself is a big fan of the discounted cash flow method of valuation. And why not. After all, a business value is nothing but the cash flows that can be taken out of the business during its entire lifetime discounted at an appropriate discount rate. However, this method comes with one serious limitation.

There are a lot of businesses out there that have characteristics that may render DCF non-useful. It is argued that all that DCF does is adds reliable information (near term cash flows) to relatively less reliable information (cash flows far into the future). And as any statistician will tell you, the result is that the less reliable information dominates.

There is one bigger drawback that DCF suffers from. And it has to do with the fact that it cannot be all that useful when comparing asset values on a relative basis. In other words, if you have to value an asset based on how similar assets are priced in the market, DCF may prove to be a bit too clumsy. Consequently, it is the relative valuation method or the multiple based approach that dominates most discussions on stock valuations.

However, the dilemma around valuations does not end here. Yes, the multiple based approach to valuation is simpler and comes in quite handy when comparing different assets. But there is literally an assortment of these valuation metrics to choose from. You have the price to earnings ratio, price to book, price to sales, price to cash flow and what not. And if this is not enough, what has really caught on these days is the usage of enterprise value as the numerator of most of these equations. Consequently, the question that arises is which of these is the most trustworthy and can lead to the best long term results.

Well, this was exactly the kind of question that bothered two gentlemen who answer to the name of Wesley Gray and Tobias Carlisle. The result of this curiosity was a study that went as back as 47 years (1964-2011) in the US markets and is highlighted below in the form of a chart.

Valuation ratio with the best returns over 47 years

Please note that these are returns that have been earned by a value portfolio. In other words, the cheapest 10% of the stocks based on the respective valuation ratios.

So for e.g. if my universe is 500 stocks and I am using the price to earnings ratio then a value portfolio will be the one where I am creating a portfolio of the cheapest 50 stocks based on price to earnings. Also worth adding is the fact that all the value portfolios created using different valuation multiples ended up beating the benchmark index which as per the study, returned 9.5% per year over the duration of the study.

So, which ratio emerged as the winner? As can be seen it is indeed the Enterprise value to EBIT ratio or what we know as the EV/EBIT multiple. And while the difference may not seem much, please note that given the power of compounding, over a long period of time, it does add up to a lot. For e.g. an investor the best performing EV/EBIT would have ended up with a corpus that's more than 3 times the corpus of the person using the price to cash flow ratio!

Now, enterprise value as you all know comes in useful when one compares firms with different levels of debt and cash and other liquid assets on the book. In other words, firms with vastly different capital structures may end up looking the same when compared on a price to earnings basis but can have very different enterprise value multiples. As a result, enterprise value multiples do end up presenting a more accurate picture of where relative valuations are.

Having said that, I think one should simply not junk all the ratios and adopt just one like say EV/EBIT. I am of the view that each of these ratios is of value to investors. It is just that in a particular context, one may be more useful than the other. And what also matters is how correctly each of these is calculated.

What do you think? Which valuation ratio according to you is the most reliable or is it more horses for courses kind of an approach for you? Let us know your comments or share your views in the Equitymaster Club.

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The stark difference in valuations of private sector banks (PVSBs) and public sector banks (PSBs) has been a topic in discussions for many years. After all, there is a big difference in how these banks are managed. This can easily be gauged by the quality of assets that these banks possess.

It would not be wrong in saying that PSBs are going through a rough time - with asset quality concerns on one side and lack of key management personnel on the other. After all, how long can organisations operate with no one at the helm? As reported by the Business Standard, there are PSBs having no chief executives for months now! This has been a key issue as to why their recent efforts to raising funds were scrapped quickly.

Also, it was for the first time that the doors to the corner office at the PSBs were open to private bankers. However, the response, it seems, was very dull, despite being promised industry level compensation with three-year fixed tenures. As per the daily, 26 candidates were shortlisted, of which 19 were from PSBs. A key reason for such dull response is the lack of autonomy, as most believe that political interference is and will be part and parcel of the job. In addition, the composition of the board coupled with the banks being forced to carry out the government initiatives with rigor as well as the fact that they are answerable to many more bodies (as opposed to none for PVSBs) are other factors that come with the job.

Further, PSBs also run the risk of being poorly capitalised. And with the government looking to further invest in only the good performers, it brings up a big question mark on the growth of most of the PSBs. A way out of this rut is to essentiality bring down stake - entirely or partly - in the poor performers and work towards improving their functioning overtime. After all, it would only be a bad idea to throw good (taxpayers' money) money after bad. While the government has lowered the budget for this purpose (as compared to the past), considering that PSBs have a lion's share of India's deposits and credit, the rest of the banking system will find it impossible to meet the funding requirements for the envisaged growth rates of the nation. A sustainable, but quick solution is certainly the need of the hour.

We came across an interesting article today. It discussed how market participants may possibly be relieved by the fact that monsoons for the first fortnight in June have been well above average. And that this feat increases the probability of India receiving adequate monsoon (for the entire season) at around 65% levels. At the same time, there are others who indicate that the odds of a far more intense El Nino are very high. The article further went on to state how these developments would impact the RBI's decision to cut interest rates, as the government would take supply side actions to contain inflation; rather than the RBI taking monetary measures to curb the same. All in all, investors would do well to take the necessary strategies to exit businesses that would be impacted by the dull monsoons and rather focus on companies that directly or indirectly benefit from poor monsoons; the author also added that defensive stocks could be considered as they would be in favour during such times.

If you ask us, there is just too may ifs and buts out here. Not only would this lead one to pick out poor businesses but would also leave a lot to chance in the process.

Why not just take another simple approach? Identify good companies and buy them are right prices, those which build in margin of safety. And mind you, taking actions on such developments that are likely to play out for a few months rather than the long term would only make it a frivolous effort. A bottom-up approach to picking stocks is what we advocate. And better yet! Any panic sell offs on account of 'poor monsoons' and its impact on corporate India's short term profits should in fact be welcomed by long term value investors.

At the time of writing, the Indian markets were trading well above the dotted line with the BSE-Sensex up by about 264 points or 1%. Gains were seen in stocks across the board, with those from the consumer durables and capital goods spaces being the preferred lot. Mid and smallcap stocks were in favour too with their respective indices up by about 1.8% and 1.5% respectively.

 Today's investing mantra
"Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labelled speculation" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst) and Devanshu Sampat (Research Analyst).

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1 Responses to "One valuation ratio you can totally rely on"

Yashpal Mehta

Jun 17, 2015

And may I know is EV. I thought EV refers to the Enterprise Value which itself is arrived at by the various methods. The EV if first arrived at and then you buy a share of it. Damodaran does not provide any clue on the EV. In one of the readings earlier I recall that EV was debunked. I would rather use the Multiplier any day and restrict the valuation to the lower of P/E and the Net Assets

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