Dilemna of valuations in stock investing

The year 2013 has been a see-saw for Indian stock markets. The Current Account deficit, the gold demand, the FED tapering, the American debt ceiling all provided the unhindered volatility in prices. 4 months ago, the rupee depreciation caused everybody to write off Indian equity markets with huge sell-off by FIIs. And on this date, Indian stock exchanges are making daily 5-year highs. This is being done primarily on account of huge FII buying while there is little Indian participation, either on retail or institutional front.

There must be a sense amongst the common lot that they have been left out. And they will be eager to ride the bandwagon. And there comes the question of stock selection and valuations. Equity investments is for long term and not for momentum trading. While stock selection is the easiest job when it comes to equity investments, people err when it comes to valuations. In the internet world of today, there are readymade models of valuations available everywhere. But do they suffice, its arguable.

Analysts study valuations either on relational or intrinsic premise. Relational valuations are about comparisons between peers and indices. For example, PE ratio or Market Value-to-Book Value ratio are relational valuation measures. We can compare different stocks or companies using these ratios. Intrinsic valuation is that valuation when we try to value a company on a standalone basis based upon its intrinsic parameters. The most common intrinsic valuation known is Discounted Cash Flow (DCF) method. Here we tend to measure the present value of future cash flows generated by the business of the company.

Lets take the instance of the Discounted Cash Flow valuation. It seems the best method to value any business based upon its future cash generation. But here comes the question: is a business dynamic or static? DCF valuations are generally carried over a future 10-year period of a business. We suppose that the business will not undergo any change during this period. Is this feasible? In the world we live in, businesses undergo changes every 3rd or 4th year. Jyothy Labs acquires Henkel which nobody knew about 3 years ago. Piramal Enterprises sells its bread and butter business to Abbott nobody could dream about. Some company undergoes equity dilution. Some takes a huge debt to fuel its big expansion. There are scores of examples all around. We simply can't crystal gaze a business beyond a 5-year period and its still difficult. Then in that case, is DCF valuation reliable?

The most general and widespread method of valuation is relational valuation method. Amongst them, PE ratio is the most widely accepted method. Almost every investor uses this terminology while commenting upon investments or business analysis. PE ratio gives an easy way to compare businesses on earnings parameter. Sometimes, its used specific to sectors and sometimes, its used in a universal sense. Even indices are considered undervalued or overvalued based upon PE ratio. Now, what is an undervalued PE ratio or overvalued PE ratio? Such a judgement is subjective in nature. I generally compare PE with fixed deposit (FD) returns. Suppose, a bank gives 10% on FDs. That mean on every Rs. 100 invested in FDs, you get Rs.10 as earnings. That gives you a 10 PE. I was listening to a discussion on a news channel wherein Manish Chokhani, MD and CEO of Axis Capital further simplified the concept of undervalued or overvalued PE ratio. He stated that the highest interest returns in India can be around 9% which gives you a 11 PE. And the lowest interest returns will be around 5% which gives you a 20 PE. In a way, this gives you a range of 11-20 PE.  One can decide the PE ratio valuation using this range. But PE ratio only reflects earnings. It doesn't take into account the inherent strengths of business like brandings, advance payments etc. This is its foremost shortcoming.

I will advise upcoming investors to take a holistic approach. One can never ignore the fundamentals of businesses. The stock selection is the stage one cannot falter at all. One will have to be farsighted when selecting a business to buy. And the valuation will be based upon the very assumptions made during stock selection. Whether to go beyond a PE range of 20 to buy a business will be based upon those assumptions and the same goes with DCF analysis too. But this doesn't let the investor to drop guards post investment. The businesses change so rapidly that one will have to be always on the lookout. Any sudden changes should be factored in immediately.

This article is also posted at http://stockmusings.com/dilemma-valuations-stock-investing/.