Valuation is a tricky concept that helps separate the professionals from the amateurs. I have found it to be relative, flexible and context dependent. Often the definition of ‘fair’, ‘undervalued’ and ‘overvalued’ changes depending on the particular company’s life cycle, industry, broader markets and macroeconomic factors. So naturally, most investors look for a shortcut because making sense of (occasionally contradictory) factors is a very difficult and time consuming task without any guarantees of success. Those who think in terms of fixed rules often lose out on great opportunities. If we go by conventional definition, there are plenty of ‘overvalued’ stocks that have given brilliant returns and plenty of ‘undervalued’ stocks that have performed poorly. Valuation is dynamic and evolves as the business undergoes fundamental changes.
Before we talk about some important valuation techniques, here are some points to consider and be aware of:
Industry
Cyclical industries selling commoditized products have no pricing power. They face immense competitive pressure from both domestic and global peers. Their profitability depends on where they are positioned in the supply cycle which is not in their control and government protection. Hence their valuation fluctuates between undervalued to fairly valued depending on market conditions. Secular industries like FMCG companies are almost perennial growth stocks with very low cyclicality. They enjoy high margins, sell differentiated products and have loyal customers. So their profits are more consistent, predictable and have a long visible runway. Hence the market gives them significantly higher valuation than otherwise justified. Sunrise industries with a long runway like indigenous defence production, renewable energy, electric vehicles command richer valuations than sunset industries with a shrinking runway like newspapers, traditional batteries and fossil fuels.
Optionality
Optionality is the right (and not obligation) to enter adjacent categories and industries. Companies with a high degree of optionality command richer valuations than those without it. This is because their long term survival is guaranteed. Not all options are explicit or publicized as it can be in the company’s interest to not boast about its strengths. It has generally been observed that companies with strong balance sheet and good cash flows have high degree of optionality. When they choose to exercise it, the market may reward them with even higher valuations. A great example is Astral, which started out as a piping company but today is also involved in paints, adhesives and water tanks. Another great example is Info Edge, which is the parent company of Naukri.com and is also an investor in Zomato, Policy Bazaar and numerous other platforms and start-ups.
Market attractiveness
India, a vibrant democracy, is at an early stage of development with an approximate GDP per capita of $2400. The average Indian is just 28 years old and our population is still growing. Stock market participation is barely 5-7%. Corruption exists but is much lesser than a decade ago and base case economic forecasts project 6% GDP growth/year for the next decade. English is spoken widely and consumption is booming. Contrast this with the Western world’s demographics and economic outlook and you’ll understand why India is so attractive to foreigners. India has a large domestic market making it relatively immune to global headwinds. So Indian stocks are valued higher than those of developed countries and even vis a vis other emerging market stocks where there may be a language barrier, more corruption, less robust fundamentals etc.
Life Cycle
Microcaps and small caps are generally (not always) undervalued. This is because they are not in the radar of institutions who invest huge sums of money. Institutions are also more risk averse than retail participants hence they avoid smaller companies where there is less of a track record of consistent sales growth, profitability and capital allocation at scale. They prefer companies whose names feature in the media, promoters are recognised and where other institutions also hold stakes. This is very advantageous for retail participants because they get to invest in companies before they are discovered and can generate huge returns when things become obvious and the institutions come rushing in. They key risk (possibly a big one) is that the probability of fraud is also much higher in such small companies. They often fly below SEBI’s radar and can dupe investors of their hard earned money.
Ownership
Listed companies in India need to have a minimum of 25% free float. This essentially means that 25% of the company should be available for the public (institutions, HNIs, retail) to hold or trade. In some of the larger cap names (and some smaller companies) where promoter stake is much lower – 30 or 40%, the publicly held chunk is much larger. It has been observed that when a stock is widely owned, the valuation is efficient i.e. directly corresponding to its sales growth, profit margin and cash flows. When the stock is under owned or when the available free float (which can often be less than 10-15% as is the case with a lot of small names where some institutions have bought large chunks and want to hold for the long term) is very less, then the valuation is inefficient i.e. the stock will often be very richly valued because demand is much more than supply. This is not a hard and fast rule.
Media Coverage
If a company is widely covered on various news channels, YouTube videos and social media then the chances are that it is either fairly valued or overvalued because it has been widely discovered and those who can buy have either already bought or are in the process. The less talked about stocks are often undervalued simply because they get no attention from big investors and fly under the radar.
Government regulation
Government policy plays an outsized role in developing countries like India. The PLI schemes, import/export duties and subsidies channelize investments into particular industries which the government deems a priority (for various strategic or electoral reasons). Hence, it makes sense to be invested in such sectors where there is a good degree of support, cooperation and encouragement from the government. Some good examples are digitalisation, renewables, electrification, e-commerce etc. However, one should keep in mind, that in a noisy democracy, political priorities can change with or without a change in power. Electoral compulsions can lead to rollback or modification of certain policies hence investors should be mindful and alert of this.
Macroeconomic factors
There are several factors which are very difficult for common investors to comprehend and map out. These include global interest rates, geopolitics, natural/man-made disasters, FTAs, technology pivots and commodity cycles. All of these have a bearing on our country’s inflation, exchange rates, FDI inflow/outflow, competitiveness and growth rates. While the factors are numerous and complex, the key learning here is however hard you may try, there will always be some unpredictable factor that could impact your portfolio. So you just need to be mindful and alert to major global developments. Case in point, the global switch to electric vehicles, concerns about climate change and China’s increasing control of Lithium supply chains, is forcing India to focus on green hydrogen, ethanol blended fuel and sodium ion batteries for its electric cars.
Broader Markets
The stock market is very moody. It goes up, down, sideways as and when it feels like. However, as investors we need to maintain a balance between our trust of the market’s wisdom and our scepticism of the market’s irrational behaviour. If the market is bullish, most companies (good or bad) will be fair to overvalued and if the market is bearish, the opposite conditions will prevail. Sentiments and not logic drive valuations in euphoric phases both on the way up and the way down. Sideways market are more difficult to decipher as then the market is confused and valuation would depend on other factors.
Consensus forecasts & Miscellaneous information
Institutional reports can give us an idea of what the consensus forecasts are about the company’s earnings, initiatives and overall future potential. If the majority of analysts believe that a company will soon deliver massive earnings growth, then the market will discount this and the valuation will go up. If the analysts are wrong, the valuation will fall back in line. Reports may not be available for small companies so in that case we will need to check credit ratings, do some scuttlebutt, check online reviews, scour news articles etc to determine company’s attractiveness.
Individual Characteristics
Some companies exhibit monopolistic behaviour, while others have perfected their business model in a way which give it tremendous firepower and advantage over their peers. This naturally leads to higher valuations than the industry or sector norm. When APL Apollo switched to a cash and carry model, it’s working capital days fell to single digits and the market rewarded this decision by doubling the valuation. Consumer names like Vedant Fashion and Metro Shoes outsource their manufacturing to third parties while staying focused on quality control, marketing, and supply chain analytics. This enables higher gross margins and free cash flows which in turn help them command rich valuations from the market. A good filter is businesses with 18%+ ROCE.
Qualtitative factors help build narratives about companies. One should always investigate narratives and try to understand why the market considers a particular company as high or low quality. This will help us pin down some important factors like the few described above and be useful in determining if the stock is cheap or fair or expensive. If you want to understand the different methods of Valuation do check out our blog : Valuation : Quantitative Methods.
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