Tuesday, November 21, 2017

Valuations - Starting from the end

"It is pure illusion to think that an opinion that passes down from century to century, from generation to generation, may not be entirely false."
—Pierre Bayle (French, 1647-1706)
Word for the day
Macaronic (adj)
Composed of a mixture of languages.
Malice towards none
Has the government erred in not marking the birth centenary of former Prime Minister Mrs. Indira Gandhi?
First random thought this morning
LKA build BJP from almost zero to a force to reckon with. NaMo has strengthened this force materially. But one thing that has confounded many is why LKA could not achieve what NaMo has.
I think I have solve at least first stage of the puzzle.
LKA mobilized millions in the name of Ram temple, but never tried to channelize the mob into a positive force working for betterment of life. Whereas NaMo mobilized millions of youth the name of corruption and has shown intent to channelize them into a positive force to work for clean India, self reliant India, self employed India, etc. This positive intent has made all the difference.
Karni Sena might have a lesson to learn here.

Valuations - Starting from the end


In past bull markets I have seen many analysts reengineering their valuation arguments. Instead of arriving at the fair value of a stock through the conventional earnings, cash flows and replacement value arguments, they would seek to apply innovative and fancy valuation criteria like foot falls (for retail stores), eye balls (for ecommerce portals), price to growth or PEG (for IT start ups), NAV per share (for real estate developers) etc. to justify the current market price (CMP). In this case CMP becomes the starting point of analysis.
I can see a similar trend emerging in the current market environment also.
In conventional sense, the return on the investment in publically traded equity is a function of 3 factors (a) earnings growth; (b) changes in price earnings (PE) ratio and (c) dividend.
The earnings growth is a function of multiple factors, e.g., (a) capacity (production capability); (b) demand environment (market leadership); (c) competitive landscape (pricing power, cost advantage); (d) innovation and technology advantage; (e) resource availability (raw material, labor, capital, managerial bandwidth etc.), etc.
The price earnings ratio (PER), one of the most popular equity valuation criteria, is the ratio between the earnings of a company and its market value. It broadly signifies that at the current rate of earnings how many years it will take for the company to add the value which an investor is paying today. Principally, an acceptable PER for a company's stock is defined by (a) the return on equity (RoE) a company is able to generate on sustainable basis and (b) the growth rate of earnings that could be achieved on sustainable basis. A company that could generate higher RoE consistently and is likely to grow faster, should be assigned a higher PER as compared to the ones which generate lower RoE or has low or highly cyclical earnings growth.
A rise in PER, if not commensurate with the rise in earnings profile needs deeper scrutiny. Sometime the rise in PER occurs due to correction in anomalies (undervaluation) of the past. This is a welcome move. Sometime, PER changes (re-rates) due to relative forces, e.g., rise of PER in comparable foreign markets or change in return profile of alternative assets like bonds, gold, real estate etc. This is usually unsustainable and therefore a short term phenomenon. Many times, demand-supply mismatch in publically traded equities also drives re-rating of PER (excess liquidity chasing few stocks and vice versa). This is again usually a short term phenomenon.
Sustainable rise in dividend yield is generally a sign of stable profitability growth (P&L improvement) and strong financial position (B/S improvement) and stronger cash flows. In some cases however it could reflect stagnation in growth.....to continue tomorrow

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