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