We have talked endlessly on equity valuations. The valuations are the most important factor determining the returns from stocks in the long run. It is therefore essential to keep valuations in mind while buying and even while selling stocks.
Therefore, it is equally interesting to understand the two main things that can destroy equity valuations. These have been identified by legendary value investor, Benjamin Graham. These are true for any company. Irrespective of its size or industry or even for that matter the country wherein it operates.
The first peril for equity valuations interestingly is the government of the country. Its interference can both support as well as destroy the valuations of stocks. Let us elaborate this point further with an example. In the recent crisis, the US government went ahead with large liquidity easing programmes. These helped strengthen the valuations for the equities in the country in the recovery stage. On the other hand, increased government interference has hurt the valuations of telecom stocks in India. Thus government policies play an important role in the valuation of companies from regulated sectors.
The other peril for equity valuations is the financial community itself. The confidence that it evokes in the public is what drives the valuations. While the Wall Street was the most hit by the financial crisis, it is important to note that Wall Street itself was largely responsible for this crisis. They did all they could to destroy the confidence that the public had placed in them. Complicated products, dubious investment opportunities, false promises, name it and they did it. Even in other countries, the financial community themselves have been responsible for the fall in equity valuations.
Clearly, the latter is more damaging to valuations than the first one. The reason is that government policies can change soon. But winning back the confidence of the people takes a very long time.
The recent news on scams and lobbyists influencing the course of government's decisions has rocked the confidence of investors in India. And this has shattered the valuations especially for the mid and small cap companies. It may take longer for their valuations to recover from this stress.
Stock valuations are therefore dependant not just on company fundamentals but also investors' perception of future potential. The former can be mended over time. However, investor perception can be difficult to manage.