Equity markets have generated highest returns for decades as compared to gold, fixed deposits, debt and other financial instruments. All of us want to generate high returns from our portfolio.
Quite often, while looking at stock prices of different companies, we find the valuation of one company to be very different from that of the other.
One might believe that the cheaply valued stock may get similar valuations as the one valued at premium. While theoretically, this may be possible, but in reality it would be very difficult to achieve.
Value of a company is driven by several factors (internal as well as external). Therefore, before reaching any conclusion/belief, one must first understand the factors driving the valuation and reason for difference in valuation across companies within same or different industry.
Let’s try to understand what an investor should look at before making any investment decision.
Valuation of Company’s may differ across industries. An investor must understand the major source of revenue and profits for a company to determine the industry to which it belongs.
Industries are broadly classified into two categories.
Cyclical companies are those whose performance is correlated with the economy. Performance of cyclical companies is usually volatile. When the economy is booming these companies grow very fast while growth slows during slowdowns. Companies in Metals and mining, Oil and Gas, Financial services, Automobiles, discretionary goods, travel, construction industry are cyclical companies.
Non-cyclical companies are those whose performance is immune to the change in economic scenario. Performance of non-cyclical companies is more stable as compared to cyclical companies. They usually outperform the market when the economic growth slows. Companies in Retail, Consumer products, Pharmaceutical, utility industry are non-cyclical companies. They are also called defensive sectors as the performance is not impacted by the change in the economy.
An investor should understand the cyclicality of the industry before considering whether to buy or sell a stock. For example, a metal company may report huge profit during a period, due to huge surge in demand or increase in metal prices. Stock price may look cheap because of low valuations (multiples), but such high profits may not be sustainable over long time period. Investor should understand how the cash flows would be impacted in case the production or price of commodity declines.
Market momentum is a good indicator of whether to be bullish or bearish on a stock. Positive momentum (Tailwinds) indicates that the sentiment is bullish, while negative momentum (Headwinds) indicate a bearish sentiment.A company’s performance (growth, margins) may be impacted by market sentiments.
For example, an increase in crude oil prices is positive for oil exploration companies, as it would increase their revenues and profits. However, it may negatively impact the profitability of airline companies, if they are not able to pass on the increase in aviation fuel cost to their customers, without impacting the ticket sales.
Government policies, regulatory changes may also impact the market momentum. For eg. Government decision to impose antidumping duty on certain product may lead to increase in price of that product in the home market; thereby positively impacting performance of companies dealing in that product.
Recently government decision to move to more fuel efficient (BS VI compliant) and electric vehicles have severely impacted the demand for automobile companies in India.
Companies can through strategic decisions; like acquisitions, divestitures or introduction of new product or services can positively influence the momentum of their portfolio.
Valuation of a company is driven by its operating performance (eg. Customer base, AUM Growth, Net interest margin, CASA ratio, Gross NPA, Net NPA for banks) and financial performance (Revenue growth, Margins, free cash flows and returns).
Financial and operating performance is also useful in determining the value of an asset; (through discounted cash flow method, multiple based approach etc.).
An investor should go through the annual reports, historical financial statements (3-5 years), investor presentations of a company to understand the business, historical operating and financial performance. They should understand how the company has performed during the select time period, returns generated for investors/shareholders and stability in performance.
A company delivering higher growth and return on equity usually trades at a premium as compared to another company in same industry with low growth and return on equity.
Value of a company is driven by performance and future expectations. Hence, investors outlook on the industry, market, performance (growth, return on equity, free cash flows) is important to understand before reaching any investment decision.
Investors should also have answers to questions such as state of the competition, barriers to entry in the industry, pricing power of the company.All these will help understand whether the company will be able to sustain the current level of cash flows over long term.
A company which has delivered high historical performance but is considered not to sustain that performance due to technological disruption, change in consumer preferences etc. may be valued at a discount. Whereas, a pharma start-up company which has developed a new drug having high sales growth probability may be valued at a significant premium.
Multiples (P/E, EV/EBIT) are good indicators of investor expectations.
Company Strategy and Quality of management
This is another factor that driving valuation. Some of the well-known investors give highest priority to this factor. According to them, a company with high quality management will always deliver better performance and returns compared to other players in the same industry. Risk of an investor also declines drastically if the quality of the management is good.
Knowing the management is difficult as Individual investors may not have direct access. Without meeting the management, it is difficult to know them. To get a fair understanding, an investor can look at the management history, performance track record on how often they delivered on promises (around performance, growth) made to the investors. Also, their strategic vision and aspiration on growth and performance of the company going forward is important to understand.
Identifying good investments is an iterative process. An investor should always keep his eyes and ears open and keep learning more and more about his current as well as prospective investment companies.
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