The Zomato Stock Puzzle: Value Investing Versus Growth Expectations

A friend sent me a WhatsApp message a day after Zomato announced its December results.

It had views of reputed brokerage houses on the stock.

Apart from one brokerage house, all the others either had an OUTPERFORM or a BUY rating on the stock.

Knowing that I research stocks for a living, my friend couldn't resist asking my own view on Zomato.

Well, I sent him a rather cryptic reply.

I told him that just as beauty lies in the eyes of beholder, BUY and SELL lie in the eyes of the investor.

A BUY for a value investor could be a SELL for a trader or a momentum investor and vice versa.

Let's play a small game to understand this better.

If you have no other information, can you tell whether one should buy a stock priced at Rs 100 or the one priced at Rs 200?

Next to impossible to pick the right stock, isn't it? Even if you manage to pick one over the other, you will be relying on luck and nothing else.

Let's change the equation a little bit.

What if I tell you that the first one has a book value of Rs 150 while the second one has a book value of Rs 180?

Well, if the fundamentals of the both the stocks are nearly the same then the first stock should be preferred over the second one.

This is because the first stock is trading at a discount to its book value while the second one trades at a premium.

Thus, everything else remaining the same, the first stock has a better chance of going up and at least reaching its book value than the second one which may even fall and go below book value.

Well, this is nothing but value investing at work.

Value investing is all about trying to figure out an approximate fair value of the company and then buying the stock at a small discount to this value to ensure a decent upside.

It is not a perfect measure of value, but it certainly acts as an anchor and helps separate the price of a stock from its true value.

The problem with book value however is that not all companies generate the same amount of profit on their book values.

There are some that are more efficient than others and hence, book value may not be the right way to value more capital efficient companies.

These companies can thus be valued using the earnings power method.

But before we use earnings power, here's another small puzzle.

Would you rather invest in a corporate bond of a company or its shares?

Well, it depends. If the bond is paying me 8% interest, then I will at least need 12% from the shares because earnings of a company are more volatile than its interest payments.

In other words, I will demand a higher return on my investment in shares than a bond of the same company.

When translated into the PE ratio language, this means that while you are willing to assign a multiple of 12.5x to the company's interest coupons (inverse of 8% is 12.5x), you are assigning a PE of only 8.3x to the company's earnings per share (inverse of 12% is 8.3x).

Thus, you will buy the company's shares only if it is available at a PE of 8x or lower and would sell it at a PE of 12x-13x because at that multiple it will become less attractive than its bonds.

Now, if a company has average earnings per share or earnings power of Rs 100, you will buy the stock at Rs 800 or lower and sell it at Rs 1,200-1,300 per share. Thus, you are buying at a PE of 8x and selling at a PE of 12x-13x.

There are some companies however where you should assign a PE multiple that is much higher than 8x.

Why? Simply because these companies can grow their earnings power significantly higher than Rs 100 per share and thus, bring about a significant increase in their fair value.

What if the Rs 100 earnings power becomes Rs 200 in 3 years and Rs 400 in 6 years?

In that case a higher PE multiple than 8x is justified. But how much higher?

Well, it is almost impossible to know in advance exactly how much the earnings of a company will grow in 6-7 years. Even the management of the company will be hard pressed to answer this.

Which is why a thumb rule of assigning a maximum PE multiple works the best.

A lot of value investors do not believe in paying more than 30x-35x for a company's earnings no matter how bright the prospects.

To them, this PE of 30x-35x is the boundary between investment and speculation.

Anything inside this is classified investment as per them and anything outside of this zone is speculation.

With that, let us go back to Zomato.

The stock currently trades at Rs 220 per share. Now, the stock's book value per share is around Rs 22 per share. This makes the stock 10 times more expensive than its latest reported book value per share.

Thus, it is far from being a value stock from a book value perspective.

What about earnings power then?

Well, Zomato recorded an EPS of Rs 0.75 per share for the trailing twelve-month period. Assigning a maximum PE multiple of 35x gives us a value of around Rs 30 per share.

Yes, that's right. The maximum a value investor can pay for Zomato is Rs 30 per share.

Anything more than that and he would be in the speculative zone.

I am sure you are wondering if a value investor can pay a maximum of Rs 30 or say even Rs 40 per share for Zomato, what explain the stock's huge premium?

Why is it trading at a price of more than Rs 200 per share?

Well, some great things are expected of the company in the future. It is expected to take a quantum leap in earnings and grow its earnings so fast that even a price of more than Rs 200 per share seems justified.

However, a value investor is someone who does not believe in paying a huge premium for growth expected in the future.

As per him, there are plenty of examples where investors ended up paying a big premium for future growth but the growth never materialised.

The eloquent Morgan Housel sums it up brilliantly when he says that every stock market valuation is a number from today multiplied by a story about tomorrow.

Well, value investors don't believe in extremely fancy stories no matter how believable they sound.

Yes, for them the stock could be a speculation or a momentum play.

But for Zomato to even come on a value investor's watchlist, it may have to correct a lot more than the correction it has seen recently.

Until then or until the profits grow a lot and the multiples become reasonable, Zomato may lie well outside a value investor's watchlist.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)