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.