Valuation methods

SMARTSHARE

For three years, India's markets have operated in "capital gains" mode as shares rose almost continuously. During bull runs, valuations tend to be optimistic. More than that, the methods of valuation tend to be optimistic.

Of the many commonly-used equity valuation models and accounting ratios, some emphasise growth prospects; others are more focussed on the solidity of balance-sheets.

In bull markets, investors track growth-oriented ratios. That means EPS and PEG (PE versus EPS growth) ratios. Some enthusiasts use even more optimistic models comparing market cap to sales and sales growth, disregarding profitability entirely. During the dotcom boom, hundreds of loss-makers were evaluated as potential superstars on high sales growth from low bases.

When the bulls stop running, it's time to look at more conservative metrics. The arch-conservatives focus on book value (net worth per share) and on book value to share price (PBV) ratios.

While the theoretical basis for this is sound, there are hassles in practice. It is often impossible to unlock asset value, particularly when the assets consist of share holdings in illiquid companies or in real estate. Over the very long-term PBV seems to work. But it doesn't necessarily do so in a timeframe of two-three years.

For example, an investor who believes in buying companies priced below BV would buy most available PSUs. But PSUs tend to be undervalued precisely because they under-utilise the vast assets they own. And, many successful non-PSUs are "overvalued" in terms of BV because they're better at sweating assets.

Another conservative approach uses dividend yields. It's probably more practical in the Indian context where a consistent dividend payer is usually a sound business. Dividend yields can be directly compared to risk-free returns from debt and the same discounted cash-flow models can be used.

Dividends are tax-free in the hands of the recipient. A bank FD offers around 6.5 per cent pre-tax. For a high-bracket tax payer, that translates into a post-tax yield of 4.5 per cent.

Yields are also mean-reverting; it is possible to buy an entire basket of stocks whenever the yield is higher than the long-term return.

The Nifty-Sensex universe is generally low-yield though almost every company in that universe is a dividend-payer. It's far more interesting to look at Mid-caps. In the BSE Mid-Caps, most of the 300-odd stocks are zero or low-dividend.

But about 15-20 stocks offer dividends yields of 4 per cent or more at current prices. Would you rather hold a totally safe investment that delivers 4.5 per cent or a risky investment, which delivers a minimum of 4 per cent and offers a potentially large upside in terms of capital gains?

If you decide to buy an unweighted basket of stocks including companies such as SREI Infrastructure (7.6 per cent yield at current price), Indusind Bank (5.5 per cent), Essel Propack (7 per cent), IndoRama Synthetics (5.51 per cent), Tamil Nadu Newsprint (4.5 per cent), you'd get an average yield of about 6 per cent. That's about 1.5 per cent more than a bank FD.

The risks can be evaluated fairly easily since these are known companies with long track records. The basket could suffer capital loss during a bear market but it's likely to recover in the long-term. A second risk is a sudden radical slash in dividends. Again, the consistency of track records suggests that this is unlikely.