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Why Different Sectors Require Different Valuation Matrices

As a reader of analyst reports and an observer of news on live television you must be wondering as to why different companies in different sectors are valued on different matrices. For example, discounted cash flow method works very well in industries where cash flows are predictable. But what do you in cases like telecom with long gestation or internet companies that will only generate profits after a tipping point? Then there are sectors like banks where the Price/Book is used more often and more rampantly that the P/E ratio.
Finally, there are sectors where the EV / EBITDA are more relevant than the P/E ratio and in some sectors, we use the sum of total parts (SOTP) valuation. The question is why do we have different valuation methods for different industries? That is because each industry has its own set of dynamics and the valuation methodology must reflect that uniqueness. Let us look at what are valuation metrics for companies and some key stock market valuation metrics that can be used to give a realistic valuation of companies.

1.  Discounted cash flow method.
This is one of the most popular methods for valuation of companies. The cash flows are calculated by considering the cash from operations in the Cash Flow Statement and then adjusting it for average capital expenditure. These are projected for a period of 5 years and then the terminal value of the business is calculated at the end of 5 years. Then these terminal values and the cash flows are discounted to the present using the weighted average cost of capital.  Which sectors can use this approach? This is best suited where there is predictability of cash flows. For example, sectors like pharmaceuticals and FMCG are fairly stable and non-cyclical sectors where the DCF method can work fine. There would still be some adjustments required. For example, FMCG companies enjoy strong brands and distribution network which will have to be factored into valuations through P/E premium.

2.  Replacement cost approach
This approach is normally used in sectors which are very capital intensive and the cost of setting up the plant becomes an entry barrier. Steel and Cement are two examples. Here companies are valued based on how much it would cost to put up a Greenfield plant and then it is compared with what you are paying on a per tonne basis at the current price. In fact, most of the acquisitions in the cement and steel space take place when the stock is available at a very fair replacement value. The NCLT is seeing deals like Bhushan Steel and Binani Cement that are entirely based on the replacement cost approach.
3.  Market Comparables – P/E ratio
This may not exactly be a stand-alone valuation metrics but is very useful as an add-on metrics. This is more so for sectors like software and insurance where projecting cash flows can be quite complicated in a highly dynamic environment. Hence comparable P/Es are considered among the industry players in India, Asia and globally. That gives a quick valuation gauge of whether the stock is available at an attractive P/E Ratio or not.

4.  Market Comparables – Price / Book
A slight variant of the P/E argument for valuation is the P/BV argument. Here the market cap is gauged based on how many times it discounts the book value or the net asset value. This metrics is very popular among banks and NBFCs. These are predominantly lenders and their profits essentially emanate from the interest spread. In the case of these financials, the book value is an indicator of the net value of the lending book of the bank and the P/BV is normally indicative of the value that shareholders see. For example, private banks like HDFC Bank, Kotak Bank and IndusInd Bank are able to attract premium P/BV valuations while ICICI Bank and Axis get lower P/BV due to worries over the asset quality. In fact, most of the PSU banks are now available at a P/BV of less than 1 due to major concerns over the NPA ratio of these banks.

5.  Market Comparables – EV / EBITDA
P/E ratio and P/BV are good ways to evaluate the stock of a company when the company is already making profits and steadily growing. But what about companies like ecommerce players, telecom players and retailers who take a long time to recover their costs and have high doses of debt in the initial years. In such cases the EV / EBITDA will be a better measure of valuation. EV represents the market value of equity and debt minus the cash in the books. The EBITDA is the earnings before interest, tax, depreciation and amortization. This is benchmarked to the industry average and is also the acquisition value of the company. This is very relevant in an industry which is currently undergoing major consolidation.

6.  Market Comparables – Dividend Yield
Dividend yield is nothing but the dividend as a share of the stock price. For example, if the price of the stock is Rs.100 and the company pays a dividend of Rs.8 for the full year, then the dividend yield is 8%. Dividend yield as a valuation metrics is relevant in case of sectors like public utilities, oil marketing companies where there is no great scope for ploughing back profits and hence dividends are distributed liberally. Such companies can be compared and valued based on the dividend yield and the inverse of the dividend yield can be used to capitalize the dividends and arrive at a valuation. However, this is more of an adjunct method rather than a core method of valuation.

7.  Sum of Total Parts (SOTP) approach.
This is a recent addition to the valuation lexicon and is used in specific cases of highly diversified business groups or in case of holding company structures. For example, companies like Reliance Industries have substantial interest in businesses like oil & gas, refining, oil marketing, retailing, petrochemicals and also telecom. How do you value such a complex business? What you can do is to value of each of these businesses as an independent entity and then sums it up and imputes some premium for synergies. That is a better way to value such complex businesses. Similarly, if you take holding company structures like HDFC or SBI, they have exposure to banking, home finance, life insurance, general insurance, financial services, asset management etc. Even in these cases the SOTP works to perfection.

The moral of the story is that in practice no model is used singularly for valuing a company. More often, it is a combination of these matrices that gives a real picture of value!


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