Stock Valauation Blunders

A concept that can help avert stock valuation blunders! source:equitymaster BHEL, India's largest manufacturer of power and infrastructure equipment in the public sector, is up some 75% in the last 8 odd months. But this is hardly any solace for us. We recommended the stock around 40% higher from the current price. In other words, it is down some 30 odd percent from the time we recommended it. Clearly, this one has not worked in our favour. What has helped us enormously though is the lessons that we've learnt from this and other similar recommendations. If we were to put it in couple of words, valuing a stock correctly is all about finding the 'right valuation anchor' we believe. When we recommended BHEL, we valued the company using the price to earnings method. In other words, the earnings of the company was our anchor for valuation. Similarly, there are other anchors like the book value of the company, EBITDA, dividends and in fact even the growth in earnings has been used as an anchor courtesy the famous PEG ratio. Now, what do you think is the most ideal valuation anchor for all the companies? Well, there is no one size fits all approach to this we reckon. It all boils down to reliability. Say for example if the company has been paying dividends for decades and the same has also been growing for many years, then there' no harm valuing the company on its dividend yield. Also, if the company has been generating growing or steady stream of earnings, then perhaps the PE approach is the right approach to valuing a company. And if the earnings are not reliable and move around a lot like say for a cyclical company, then perhaps the price to book value approach is the right approach we reckon. The error that we made with respect to BHEL we reckon is that we valued the company hoping that some sort of growth in earnings will take place. And hence valued the stock based on a PE ratio. We could have been better off may be taking the medium term earnings volatility seriously and wait out the bad times. Or if we had to still make a valuation, a price to book value approach would have been far more reliable and more objective in this case. You see, a lot of people think that their valuation of a company should fall around the same ball park as to what the markets are valuing it. But this is a wrong way to approach things we believe. What is most important is finding a valuation anchor that's quite dependable and arrived at after looking at the past history of the company. If one's valuation using such method falls short of the current market price, so be it. One can always go on to another company or wait till the price falls well below our intrinsic value calculations of the company. Let us see how we can use this method to value PSU banks. Banks being business models of different kind, have to be valued from a price to book value perspective because historically that's proved to be the most reliable valuation metric. But the problem is there are a lot of bad assets lurking in the balance sheets of most PSU banks and we don't quite know how much more pain is to come. Consequently, while the valuations based on dividend yields look quite mouth-watering, we know, that's not quite the valuation anchor to use. As a result, it is much better to wait out till some more clarity emerges rather than taking the plunge. Use this method of 'valuation anchors' across different industries and we believe you'll see a huge difference in your understanding of valuation matters. Do make it a point to screen companies through these valuation anchors in our Stock Screener from time to time. Recent Articles

SUUTI selloff proceeds rightfully belong to Unit Trust investors. JAGO GRAHAK JAGO

The Government of India is set to make a killing from the assets that it bought for a pittance from investors in US64 and other guaranteed schemes of the old UTI

By Dhirendra Kumar | Jan 13, 2014

Last week, there was a news item in this newspaper detailing how the government is planning to sell off the equity holdings in SU-UTI to help control the fiscal deficit. According to the report, sale of SU-UTI's holdings in companies like Axis Bank, ITC, Larsen & Toubroand others could bring in as much as Rs 47,000 crore within this fiscal year. In effect, this will be the final bonanza that the Government of India out of robbing the original investors of the Unit Scheme 64 and the guaranteed return products of the original Unit Trust of India.

For those who've forgotten the SUUTI story, this is a 'Special Undertaking - Unit Trust of India' that was formed in 2003 out of assets held by the schemes of the old Unit Trust that had to be rescued by the government, which were US64 and the guaranteed Monthly Income Plans.

This rescue meant that the the government took over the assets and made the investors an offer they couldn't refuse, in the sense of the movie 'Godfather'. Unit-holders were given the choice of either taking Rs 10 per unit or taking up five year tax-free bonds from which they would earn 6.75 per cent a year, effectively a total gain of Rs 38 for every hundred rupees invested. Even though the government managed to present it as a rescue, eventually the deal turned out to be a pretty sorry one for the investors and a good one for the government.

Those investors--most of them financially conservative small investors (aam aadmis, so to speak)--lost out because over the years, the government mismanaged the Unit Trust of India. Whether out of incompetence or malfeasance or the usual combination of both, this scheme was run to the ground and its assets were of a far lower value in 2003 than the Unit Trust was pretending.

However, the government did pretty well out of the assets it bought from those investors at what turned out to be a bargain basement price. First, in order to wash its hands off UTI, it sold it off for Rs 2000 crore to four public sector entities, Bank of Baroda, Life Insurance Corporation, State Bank of India and Punjab National Bank. Now, it will manage to get tens of thousands of crores out of assets that rightfully belong to those investors. By the way, these four also did pretty well for themselves by selling part of their stake to the American AMC T. Rowe Price.

The government supposedly mounted this rescue and gave the poor investors something. However, the fact that the investors lost out was not their fault. These weren't people who invested in some shady ponzi scheme. They trusted the Government of India and invested in that magnificent institution called the Unit Trust of India. Effectively, the government ran UTI to the ground, bought back the assets of its victims for a pittance by offering them a Hobson's choice, and is now ready to make a killing by selling off those assets when the equity markets are much higher.

The only fair conclusion of this story would be that the government should now wind up the SUUTI by selling its assets and then return the proceeds to the original investors. It can deduct whatever it paid on those bonds, but the profits on schemes' holdings rightfully belong to the investors who suffered so much because of the government. Of course, there's no chance of that actually happening because this is a taking kind of government and not a giving kind. When worthies like Mr P Chidambaram and Mr Raghuram Rajan next deliver one of their frequent scoldings to the Indian saver for not trusting financial assets, perhaps they should ponder the shabby treatment of the investors.

I only wish we had the kind of legal framework whereby the investors could have gotten together and filed a class action suit against the government. Or perhaps they should just call Mr Kejriwal's hotline.