A layman’s guide to equity valuations

In the last post (Link), we had discussed on how equity returns are driven by earnings growth and valuations. We had further detailed on how to evaluate earnings growth. In this post we will move to the second part of the equation – Valuations.

Let’s start with a basic question – How do you put a value to a company?

Sounds kinda geeky . Lets try and simplify.

Imagine this. One fine morning you wake up and you suddenly  see a “number” blinking in red across your dad’s forehead. It reads Rs 2,10,00,000 (Rs 2.1 cr) and keeps blinking and strangely, also changes each and every minute. A little confused, you turn around and to your surprise see Rs 50,00,000 (Rs 50 lakhs) blinking across your brother’s forehead . Throughout the day, each and every person whom you happen to see has a number on their forehead and the same phenomena continues. And just when you are contemplating if you have a serious mental disorder, your phone rings. The display reads “Almighty”. What the heck. A thundering voice orders”I am extremely pleased with your devotion to me. And as a token of love, you and several of my other devotees have been given the special power to receive the entire life time salaries/earnings (as and when they get) of anyone you choose to buy. The price that you will have to pay for buying someone, will have to be bid and its latest bid price will be flashing across their head. I have deposited Rs 10 cr in your account which you can use only for this purpose”…

Take a minute and think of how you will go about choosing the people for the Rs 10 cr?

In order to decide whom to buy, we need to evaluate two things

1. What can be the possible future earnings i.e salaries in the future and how much are they worth in today’s terms (adjusting for the returns you need)?
2. Is the current price which is flashing across their forehead, below your calculated price or above your calculated price?

You see the challenge right. How in the world can you accurately estimate the future earnings of someone. Leave others. To be honest, I would find it extremely difficult to predict my own salary 5 years down the line, leave alone for my entire life. On top of this, imagine that millions of people are trying to do this exercise on valuation, each and every day and are bidding for different people based on the valuation that they arrive. No wonder the prices are going to keep fluctuating.

So we know for sure that we cannot come up with a “precise and accurate” value for the people around us because of the simple fact that we are dealing with the future and the future is uncertain. But by analyzing their educational and professional qualifications, skills, current job, salary, industry prospects, talent etc and making some reasonable assumptions we can try to come up with an “approximately right kind of range” for estimating the value. Since we know that the future is uncertain and our assumptions can go wrong, we decide to

1. Buy around 10-20 people so that even if we go wrong in valuing a few we can still take advantage of the remaining ones that we got right (this in investing parlance is called diversification)
2. Buy them at a price which is at a sufficient discount to our estimated range (this in investing is called “margin of safety” or rather a humble acceptance of the fact that “We can go wrong”)

Some will come up with the valuation based on

1. The evaluation of earnings for the future based on fundamentals like – industry growth, current position, salary, skill set etc (in investing this is called fundamental analysis )
2. Movement of prices at which people are available and decide based on the demand and supply ..etc (in investing this is called technical analysis )

The interesting thing here is that, each and every one may have a different way or method to evaluate the future. Some are sanguine, some pessimistic, some pretty balanced and so on. Hence the final price at which a person is quoting (read as the valuation) is a weighted average opinion on the value at which various people are willing to buy and sell (weighted average in crude terms takes into account that the guy with 100 cr will have a greater impact on the price than the one with 1 lakh).

Now replace the “people” in our imaginary story with “companies” (i.e stocks). Yep..

Welcome to the world of stock markets !!

This is exactly what happens in stock markets, where partial ownership in several companies are available to be bought or sold, each and every day, by millions of people. Further, each and every one has their own way of evaluating the value of the company based on their outlook for the company’s future. Whether we like it or not, the weighted average opinion of market participants are extremely unpredictable and keep changing. There are times when everyone is convinced of an amazing future and valuations are extremely high factoring in high growth in company’s earnings and there are times when everyone believes the world is coming to an end and valuations are extremely low painting a “doom & gloom” outlook for the future. The valuations thus keep altering between periods of optimism, pessimism and balance !!

Now let’s go back to our basic framework which we spoke about in our earlier post,

Sensex = Earnings per share * PE ratio (i.e Price earnings ratio)

Each and every day, or rather to be more precise each and every minute, the Sensex value changes. By this time you would easily be able to guess the culprit who is responsible for that. More often than not, the fundamentals of a company do not change every day, but rather the weighted average opinion of market participants on the future of the company (read as valuations) changes .

The weighted average opinion unfortunately gets driven by news flows, quarterly results, macro economic data, global and Indian events, elections, rainfall ..blah blah. Often, the weighted average opinion, gets carried away and builds a lot more pessimism or optimism than necessary.

Our task is not to become an astrologer and predict each and every event which will affect the weighted average opinion (which is what unfortunately most people think you need to do in investing) but rather to identify periods where the weighted average opinion is building in excess pessimism or optimism. Then all that we need to do, is to take a simple call on human nature – humans will always oscillate between the emotions of greed and fear.

Valuations are the proxy for evaluating the position of the weighted average market opinion moving between optimism (greed) and pessimism (fear). So in reality, the intent is to reduce equity allocation when valuations are very high and vice versa.

Lets see some actual data on valuations in Indian Equities

Source: MOSL Research Report
1Y Fwd PE is the sesex value divided by the estimated next 1Y earnings i.e at how many times the next 1 year earnings is the market currently evaluating Sensex. I have not used other metrics of valuation in this post as I will cover them in detail in my future posts.

You can see that the valuations have oscillated in a wide range between 10.7 to 24.6.

In Jan-2008, at the peak of last bull market, the Sensex was trading at 24 times its expected next year earnings and in Oct-2008, close to the bottom of the bear market, the Sensex was trading at 10.7 times its expected next year earnings. How fast the market opinion changes !!

Our idea as already stated, is not to predict the next recession or catch the exact bottom, but to monitor valuations and be conservative when valuations are expensive (i.e reduce equity exposure) and be aggressive when valuations are cheap (i.e increase equity exposure). I will delve into the exact mechanics of how to increase and decrease allocations in future posts. But generally, if you are looking for a simple rule of thumb, while investing in Indian equities we need to be extremely cautious when Sensex 1Y Fwd PE is more than 18 (earnings growth will have to be extremely strong to support such valuations) and be extremely aggressive when Sensex 1Y Fwd PE is less than 13.

Currently, the Sensex is trading slightly lower than its long term average at 15.7 times its 1 year earnings. The valuations indicate a weighted average market opinion which is neither too optimistic nor pessimistic and earnings growth will have to be the primary driver of returns going forward (if valuations rise and become optimistic, then we have a chance of making added returns over the earnings growth and vice versa).

Thus summing it up,

In the long run, equity markets will be a slave of earnings. Period.

But in the short run, valuations cause significant ups and downs in the markets.
Thus an eye on valuations in addition to earnings growth, will help us take advantage of these frequent bouts of extreme pessimism and optimism.

Equities – dismantling the returns !!

When investing in equities, the most common question is “what returns will I get?”. As seen in the earlier post (Link), equity returns are extremely volatile in the short run (sample this- the 1Y returns for Sensex has ranged from 256% to -56%) and tend to become less volatile with increasing time frame. In order to have an idea on what returns to expect, first and foremost, we need to understand the drivers of equity returns.

Let me use Sensex  as a proxy for equities. The value of Sensex can be broken down into its two components:

Sensex Value = Profit of underlying companies * Valuation (i.e no of times the profit that you are willing to pay)

or in exact geek terms it reads as

Sensex Value = Earnings Per Share for Sensex * PE Ratio

1. EPS (Earnings per share for Sensex) represents the underlying profits of the Sensex companies
2. PE Ratio (Price Earnings Ratio) – This is the valuation or the no of times the underlying profit that the investors are willing to pay

The key takeaway here is that the Sensex value can be alternately viewed as the product of two numbers -EPS and PE ratio. So when we want to evaluate future returns for equities we are essentially asking the question “How much will the sensex value change?” or in other words “How much will the eps and pe ratio change? “

Change in Sensex value = Change in EPS * Change in PE Ratio

So from now on, every time we decide to invest in equities we must essentially try to answer two questions

1. What can be the earnings growth for the next 5 years?
2. Will the valuations move up (increasing returns) or move down (reducing returns) or stay flat (not contributing to returns)?

What can be the earnings growth for the next 5 years?

Now as I have always stated, I don’t think anyone can exactly predict the future earnings growth. In fact, most of investing is about the future and the future always remains uncertain !!

But the paradox is that, we need to have some sense of the possible earnings growth in order to set some reasonable expectations on equity returns. So how do we solve this catch-22 situation.

The answer lies in a simple yet profound statement from one of the greatest investors Howard Marks

Instead of me explaining. Let us listen to what Howard Marks has to say..

I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

Always remember:

Rule 1: most things will prove to be cyclical

Rule 2: some of the greatest opportunities for gain and loss come when other people forget rule number

Let’s check the historical earnings growth for Sensex

Source: MOSL

You can clearly see that Sensex earnings growth has remained cyclical and alternates between low and high growth periods.

• FY 93-96 : 45% CAGR
• FY 96-03 : 1% CAGR
• FY 03-08 : 25% CAGR
• FY 08-16 : 6% CAGR
• FY 16-21 : ????

So as seen above, earnings growth tends to move in cycles. While its impossible to exactly predict when a cycle turns from high growth to low growth or vice versa, we can form a view on approximately which part of the cycle is playing out now. So while we don’t predict, we are rather preparing ourselves for an eventual change in cycle by evaluating our position in the cycle.

Now comes the million dollar question – Theory is fine. But how in the world do I find out where in the earnings cycle we are currently ??

Earnings growth = Return on Equity *(1-dividend payout)

The dividend payout in India as seen below, has roughly been around 25% (Link) and hence we can assume that 3/4 th of ROE or Return on Equity will translate into earnings growth. For eg if ROE averages 20% for the next 5 years, then earnings growth will average around 3/4*20% i.e ~15%. Any additional growth will have to be driven by increasing debt or leverage.

By the way,  in case you are wondering what this return on equity is, think of it as the % of returns (profits) which the owners of the business (i.e shareholders) make on the capital invested. For a detailed understanding refer to the below articles Link1 and Link2

Return on Equity can be further broken down into:

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

In simple terms the equation means you can target a good ROE through:

• A low margin product combined with a high volumes ( think Maruti cars, Fast food restaurants)
• High margin product combined with low volumes (think Mercedes Benz cars, Five Star restaurants/Fine Dining)
• Higher leverage i.e taking a higher debt (relative to shareholder’s equity) as you have more capital in play compared to your own investments ( caveat being your returns from the business is greater than interest rates for debt say >12% at least)

Now that we have come this far, let’s not forget out original intent – to figure out where we are in the earnings cycle – which led to ROE – which further led to profit margin, asset turn over and Debt levels

So now our task is to figure out, where in the cycle are we in terms of profit margin, asset turnover and debt levels.

Source: Capitaline, IDFC Mutual Fund Presentation

The above table shows a glimpse of the data for BSE 500 (Ex Financials) companies. As seen above the ROE is currently at a 15 year low of ~10% versus its 15 year average of 15%. The primary underlying drivers of ROE – Profit Margin and Asset Turnover are also at their 15 year lows.

Profit Margin Cycle:

Let’s first evaluate the profit margin cycle:

Profit margins are currently at a 15 year low. Profit margins have always been cyclical and tend to mean revert over long periods of time. We can clearly see from the above table that in FY15 the profit margin for BSE 500 companies were at historical lows of 5.0% versus the last 15 year average of 7.7% . Hence while we don’t know exactly when it will start to improve  we can reasonable assume that the margins are close to their lows and in the next 5 years they should in all likelihood be better.

Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly.” – Jeremy Grantham

Margins improvements will have to occur through these 4 levers.

1. Higher operating margins
2. Lower interest rates and hence interest charges
3. Lower depreciation charges
4. Lower direct taxes

So what can possibly be the triggers for profit margin expansion in the next 5 years?

1. Higher operating margins – lower costs due to 1)subdued commodity prices 2)possibility of higher capacity utilization leading to fixed costs being spread over a larger sales (think of a flight where % of seats booked improves from 70% to 90% and since most of the costs remain the same, the incremental revenues do not incur corresponding costs thereby leading to higher operating margin. This is also referred to as operating leverage )
2. Lower interest rates and therefore interest charges – Interest rates have started to gradually come down led by RBI rate cuts and lower Inflation
3. Lower depreciation charges – New capacity is not being created given that the system is still running only at a 70-75% capacity utilisation rate and further the high debt levels also don’t allow borrowings to expand
4. Lower direct taxes

Asset Turnover:

Asset turnover is the sales generated by a company’s total assets – this no is at its 15 year low indicating excess capacity, low demand scenario, stalled projects and weak pricing power (negative WPI inflation). This scenario is also expected to gradually improve given the government focus on kick starting the stalled projects and eventual pick up in demand.

Equity Multiplier:

This is probably the only component which will reduce over the next 5 years and hence can have a mild -ve impact on the overall ROE. The last 10 years has been characterized by companies taking up significant debt to expand, put up new capacity etc. In this period the debt equity ratio went up from 0.58 to 1.0. Thus ROE had some positive support from the Equity Multiplier component. However given the high levels of debt and bad shape of the banking system, the debt levels will have to start gradually coming down.

Evaluating earnings growth:

So as seen above, the gist is that – ROE’s over the next 5 years will improve supported by PAT margins expansion and higher asset turnover while the equity multiplier component may slightly pull it down.

So what earnings growth should we expect:

The historical average for Net Profit Margins is 7.70%. Lets make a reasonably conservative assumption that Net Profit Margins will gradually improve to 6 or 7% over the next 5 years from the existing 15 year low of 5.00%. Sales growth is generally in line with Nominal GDP growth (real GDP growth + Inflation). So assuming a real GDP growth of around 6-7% and Inflation of around 5-7% we can expect Net Sales to grow between 10% to 15%.

Conclusion

Hence plugging these assumption ranges, my expectations for earnings growth is around the range of 14% to 23% CAGR over the next 5 years. (You are free to build your assumptions based on your own evaluation of Sales growth and margins). Thus the return expectations for the next 5 years will be a combination of earnings growth (which we expect to be around 14% to 23%) and the change in valuations.

In our next post, we will use a similar framework to evaluate valuations.