Do rating agencies deserve such lofty valuations? - Views on News from Equitymaster

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Do rating agencies deserve such lofty valuations?

Apr 18, 2012

They are not the only blue eyed babies of stock investors in India. There are plenty in their class, when one compares pedigree, fundamentals and management. But these entities, unlike their peers in the West have managed to do what even the MNC parents haven't. They look the regulators in the eye while the likes of Standard & Poor's and Moody's face the fury of the SEC.

In fact India can be called a paradise for rating agencies. There are six of them, with the biggest of them all, CRISIL, having a market value in excess of US$ 1.3 bn. Each of these entities shares the same business model as that of their global counterparts, albeit with slight differences.

The issuer of debt pays for the credit rating resulting in conflict of interest on the part of the rating agency. That the likes of CRISIL and ICRA also offer ratings on IPOs and stocks and consulting services makes their business model slightly more resilient to volatility in bond markets.

But what really intrigues us is that fact that irrespective of market cycles, the rating agencies have managed to fetch valuations that very few blue chips can boast of. That too despite the fact that the Indian regulators too have frowned upon the loopholes in their business model.

Leave aside debt, many listed companies are happy to share 'sponsored' research reports on themselves citing attractive investment prospects by the rating agencies.

However, one cannot deny that it is lure of zero debt balance sheets, high return ratios and mouth watering dividend payouts that attracts investors to the stocks of rating agencies.

However, investors cannot lose sight of the fact that the high PE ratios have diminished the dividend yields despite the handsome payouts.

Hence unless they have been early investors in the stock, they are less likely to benefit from the extra returns. Also since the dividend yields now account for only a couple of percentage points of return, investors will have to rely on at least 15% to 20% profit growth to fetch good returns.

Steep valuations diminish returns
 P/E ratio (x)Dividend yield (%)
CRISIL
CY0812.7 2.8
CY0919.9 2.3
CY1020.5 3.4
CY1130.1 1.2
ICRA
FY0824.2 1.5
FY0912.6 2.5
FY1016.5 1.9
FY1122.5 1.6
Data source: Ace Equity

At the same time, regulatory hurdles could sooner or later deal a blow to the conflict of interest in the business model of rating agencies.

The cases of micro finance and gold loan companies are there for us to see. Hence we believe that instead of getting blinded by the high return ratios and dividend payouts, investors should get more realistic about the valuations the companies deserve for sustainable growth rate.

Tanushree Banerjee

Tanushree Banerjee (Research Analyst), is the editor of Stock Select and Forever Stocks. Tanushree started her career at Equitymaster covering the banking and financial sector stocks and scrutinising RBI policies. Over the last decade, she developed Equitymaster's research processes that helped us pick out various multibaggers, across all sectors. A firm believer of "safety first" when it comes to investing, Tanushree closely follows the investing philosophies of Warren Buffett, Jeremy Grantham, and Joel Greenblatt.

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1 Responses to "Do rating agencies deserve such lofty valuations?"

rk77

Apr 18, 2012

Yes they do. Ask Warren Buffet.
In Indian context there may be a question on ethics with conflict of interest going unnoticed as the regulator may be asked by the Govt to look the other way or it may do so on its own. A good, ethical ratin agency will definitely command a premium in the market as there will be few who can match it in quality.

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