This article was first published in
the business section of www.rediff.com on November 19, 2013; Co-author: Lokesh Kumar (ISB)
http://www.rediff.com/business/slide-show/slide-show-1-perfin-dont-trust-stocks-experts-heres-how-to-do-your-own-research/20131119.htm
Lucky was fascinated by the world of
stock markets. He had started investing the money made from his stock options
in equities a few months back.
The stocks were mostly selected based
on recommendations made by analysts on business news channels and the
newspapers.
Having lost 60 per cent of his
principal invested in a particular stock, he decided to take matters in his own
hands and learn about stock selection rather than depend on other. With
determination in his eyes, he knocked at Professor Nicky's door.
Nicky:
Good to see you Lucky. What brings you here?
Lucky:
Professor, I invested in a stock based on a recommendation, where the analyst
had used Price-To-Earnings (P/E) multiple. Before you accuse me of
blindly following the analysts, let me clarify that I did Google the term, did
my own analysis and then took a call to buy.
Nicky: The dark
side of valuation!
Lucky: What do
you mean?
Nicky:
Let me elaborate. The same multiple can be defined in different ways by
different people. Multiples can be misleading if you don’t know what
fundamentals drive each multiple and how the multiples are estimated.
Price to earning is not the only
multiple, though it is the most common. There are numerous multiples that
exist.
A multiple is simply a ratio of two
financial variables where enterprise value (measure of market value of all the
securities, viz. common stock, preference stock etc., of a company) and equity
market capitalisation (measure of market value of just common stock) are
used in numerator and various proxies for cash flow are used in denominator
such as Earnings Before Interest and Tax (EBIT), Earnings Before Interest Tax
Depreciation and Amortisation (EBITDA), Book Value, Sales, Employees, etc.
Lucky: But how
do we know which is the right multiple to use for a company? This analyst
always uses P/E Multiple.
Nicky: Keep in
mind that you can’t use these numerators interchangeably to define a multiple.
When the denominator is an enterprise level quantity such as EBIT, EBITDA,
Sales or employees, you should use the enterprise value in the numerator; and
when the denominator represents the shareholder level measure such as earnings
or book value of equity, you should use equity market value in the numerator.
Lucky: That
makes sense. But you did not answer my question. I am wondering whether any specific
multiple is used for a particular industry.
Nicky: Yes.
Some multiples make more sense for a certain industry than the other multiples.
For example, Price/Customer multiple can be used to value Cellular phone and
Internet companies while Price/unit multiple is suitable for soft drinks and
consumer product companies.
Price
to Earnings-growth ratio is generally used for growth Industries such as
technology, health and luxury goods.
Lucky: What
about Banks?
Nicky:
Price/Book value is the more appropriate multiple for valuing a Bank. However,
you must realise that when valuing a company using multiples, average multiple
of the rest of the companies in the industry or few select companies in the
industry is used.
If
the company which you are valuing, is very different from the other companies
in terms of size, geographical area of operation, growth prospects or
technology used, you may not get a meaningful value for the company using
multiples.
Lucky: What
about other valuation techniques?
Nicky: There
are many. Discounted cash flow method, dividend discount model, moat based
valuation, etc. The key is to figure out which model is best suited to the
company, which you want to value.
Lucky: Now, I
realise why you earlier said, “The Dark side of valuation”.
Nicky: Yes.
While valuation can be tricky, it is still better to invest with 'informed
ignorance' than total ignorance.
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