Sep 24, 2004|
Commodities: Buy or Sell?
Even after the sharp rise in valuations of commodity stocks over the last two years, the stock market continues to remain optimistic about the ‘further upside’. The common reason attributed to the same is the sustenance of strong demand going forward, and hence valuations look cheap. Therefore, a belief that there is still some steam left! We highlight the pitfalls of this ‘cheap valuation assumption’ by taking Tisco as an example.
The chart alongside shows the price to earnings ratio (P/E) of Tisco over the last ten years. The P/E is calculated by taking the average of high and lows during the respective fiscal year divided by the corresponding year’s earnings per share (EPS). From the look of it, it is apparent that the current P/E multiple is close to its ten year low levels. Is it a good sign? We do not think so. Sure, the company has reduced its employee strength by more than half during the last decade and it is far more efficient. More importantly, the dependence on the domestic market has reduced and it is among the most cost efficient manufacturers of steel in the world.
Despite all these positives, the fact of the matter is that steel, cement, aluminium are all commodities i.e. the ability of the manufacturers to differentiate in terms of branding or better product quality is reduced when it comes to top rung players. The most cost efficient player has a better chance of survival and more importantly, the basic technology for manufacturing of steel and cement has not changed dramatically unlike other industries.
Now consider the graphs above. While the P/E multiple is close to the ten year low levels, the price to book value multiple is up again! This is typical of any commodity stock. When prices are rising or are at new highs (be it steel, aluminium or cement), the EPS is also on the higher side. This consequently, deflates the P/E multiple (because the base is higher). While this may indicate that the stock ‘may be’ cheap now, it may not necessarily be the case. Just to put things in perspective, In FY02, Tisco was trading at a P/E multiple of 20.5 times its FY02 earnings. Was it expensive? If one ignored Tisco in FY02 on the basis that it was ‘expensive’ on a P/E multiple basis in FY02, the opportunity loss is as much as 350%.
Lets consider another example. When we compare the EBDITA margin (earnings before depreciation, interest and tax) of Tisco with its P/E multiple (the graph above), there is a negative co-relation! This means that during period when operating margins at their historical highs, the stock market expects the cycle to reverse and therefore, the P/E multiple tends to be lower.
Given this backdrop, we suggest investors exercise caution when it comes to ‘the cheap valuation’ argument doing rounds in the stock market circles currently. While there may be upside left, it is upto to investor to understand what is the risk-reward ratio i.e. for a given amount of risk, will I be compensated by higher returns? Are risks that could affect the ‘upside’ higher than the potential upside?
To understand more about Price to Earnings multiple, click here
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